Iraq to pay high price as it lures back bond investors

Iraq looks set to make a successful return to the international bond market after nine years, raising billions of dollars but at the cost of high interest rates that could worsen its financial problems in the long run.

Baghdad launched an investor roadshow last week for a series of sovereign U.S. dollar bond sales that it hopes will raise up to $6 billion.

War against ISIS militants, tensions between the central government and the Kurdistan region, and low oil prices are pressuring its finances.

When Standard & Poor’s assigned Iraq a B-minus credit rating this month, six notches below investment grade, it said security and institutional risks were among the highest of any sovereign it assesses, on a par with Egypt and above Greece.

Magnifying the domestic risks are an unstable international market environment and the expected start of U.S. monetary tightening as soon as this month.

Five-year Iraqi credit default swaps, used to insure against a sovereign debt default, are up 77 basis points year to date at 576 bps, near six-year highs.

Partially offsetting the risks, however, is the potential of the oil industry in the second biggest OPEC producer.

The country boosted crude output to 3.80 million barrels per day in June from 3.05 million bpd a year earlier.
Baghdad has said it aims to lift overall capacity to 8.5-9 million bpd by 2020.

Bureaucratic obstacles, security fears and insufficient pipeline and storage capacity are slowing increases in output.
But southern oilfields which account for most production have escaped violence, and the country may be able to pay its debts comfortably if it achieves at least part of its oil plans.

“Iraq currently has approximately $65 billion of forex reserves, and a surge in oil production will definitely help in building this further,” said Ram Mohan, portfolio manager at Abu Dhabi’s Invest AD, which is reviewing the bond prospectus ahead of making an investment decision on the issuance.

So Iraq will find buyers for its bonds, but only if it pays ultra-high rates, fund managers say.

Baghdad has not stated the size or maturity of its first issue, but bankers expect around $2 billion of five- to seven-year paper.

The yield on Iraq’s outstanding dollar bond maturing in 2028 soared to a lifetime high of 10.80 percent last week from 8.3 percent at end-2014, partly because of expectations for additional supply.

“Given where the Iraqi 28s are trading and the level of benchmark rates, a new 10-year issue out of Iraq will have to have a coupon of 10.75 percent just to be in line with the existing bonds,” said Raza Agha, emerging sovereign debt analyst at VTB Capital.

Pricing

Pricing in that area would give Iraq the highest-yielding bonds of any oil exporter in the Middle East and Africa, he added.

Iraq held investor meetings in London on Thursday and Friday, and meetings are to continue this week in New York, Boston and Los Angeles.

The focus on Western financial centres suggests Iraq may be aiming to sell many of its bonds to hedge funds and other professional investors willing to accept a high level of risk, rather than to the Gulf banks which tend to buy higher-rated bonds from the region.

Shwan Ibrahim Taha, founder of Baghdad-headquartered Rabee Securities, said the bond issue was ill-timed given low oil prices and Baghdad’s increased spending on its battle against ISIS.

“The first thing is you’re switching from huge surplus to huge deficit, but the impact of that immediately should be a very strict fiscal policy not ‘let’s go borrow money.’”

But if the issue forms part of a concerted programme to strengthen Baghdad’s finances, investors could react positively. The bond prospectus suggests that may be the case, saying Iraq will use a range of options such as domestic bonds and loans plus special drawing rights at the International Monetary Fund (IMF).

In early June, the IMF agreed to lend Iraq $833 million, and the World Bank is expected to provide $1.7 billion.
“The silver lining is that for the first time, people are thinking about all this, thinking about what happened, how to correct the economy, how to train, how to institutionalise, how to save,” Taha said.

Some fund managers think Iraq’s outstanding bond is attractively priced compared to Egypt’s 2020 bond, which is rated one notch above Iraq and also faces big political and security problems. That bond is trading at 4.68 percent.