With oil prices slumping, several Middle Eastern countries began issuing sovereign bonds this year. But amid a year of uncertainty, what opportunities and risk do those bonds present to investors?
Several economic factors had tipped the scale in favour of emerging-market bonds earlier in the year, including compressed yields from U.S. treasuries and continued low interest rates on bonds issued by more developed countries, according to Kevin Daly, portfolio manager on the emerging-market fixed-income team at Aberdeen Asset Management Inc. in London, England. Investors have also looked for alternatives as Britain’s vote to leave the European Union led to a decline in global bond yields, he says.
But this fall, things took a turn when Donald Trump’s victory in the U.S. presidential election spurred an increase in U.S. treasury rates, leading to a swift sell-off in emerging-market bonds, according to Scott DiMaggio, director of global and Canada fixed income at Alliance Bernstein. “That’s the first knee-jerk reaction that has occurred. . . . So you definitely saw outflows of emerging markets from an unexpected outcome.”
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However, DiMaggio is optimistic some countries will bounce back. While Trump may have plans for Mexico and China, that’s not the case for other countries, he says. So what are the investment prospects for those searching for yield when it comes to bonds newly issued by Middle Eastern governments and the region more generally?
The impact of falling oil prices
With oil prices plummeting, many Gulf Cooperation Council countries have had to look for new sources of funding to fill widening fiscal deficits, according to a regional outlook report published by the International Monetary Fund in April. The organization noted projections that suggest the cumulative fiscal deficits of Gulf Cooperation Council countries (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates) and Algeria will total almost $900 billion from 2016-21.
Among the countries that have turned to the bond markets is Qatar, which issued US$9 billion in bonds in May, and Abu Dhabi, which raised US$5 billion the month before, according to Bloomberg.
Saudi Arabia, meanwhile, held its first international bond sale in October, raising US$17.5 billion from foreign lenders.
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Saudi Arabia, however, brings its own set of economic challenges, says Rashique Rahman, head of emerging markets at Invesco Fixed Income. “There’s a decline in growth and fiscal deterioration, and their response has been to institute prospective reform. The national transformation plan they’ve mentioned has highlighted that they want to reduce the country’s reliance on oil, and these are all part of the reaction to the lower oil prices that we’ve seen.”
Indeed, Saudi Arabia has signalled plans to privatize public assets, specifically state-owned Saudi Arabian Oil Co., in early 2017, according to Jane Lesslie, vice-president and senior portfolio manager of global fixed income and currencies for emerging markets at RBC Global Asset Management Ltd.
“They’re instituting a 30-year plan, but it’s very ambitious,” says Lesslie, adding that while Saudi Arabia’s fiscal measures are impressive, she’s not as confident about how much value the country’s bonds will offer to institutional investors. “They have an awful lot on the plate that they’re trying to bring about.”
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But for investors limited to bonds that meet investment-grade standards, the Saudi Arabian development offers an opportunity to diversify portfolios as the country has a strong credit rating, says Daly. “It isn’t going to be the most exciting investments, because the yields are set so low, but you’ll probably get interest from big institutions who are looking for something that has reasonable pickup from U.S. treasuries.”
In contrast to Saudi Arabia, some Middle Eastern countries outside of the Persian Gulf that import oil should have benefited from low oil prices, says Lesslie. Many of those countries, however, face their own unique challenges.
Egypt seeks external funding
Egypt, in particular, has been going through years of political unease that has negatively affected its economic situation, says Rahman.
Still, the country signed an agreement with the International Monetary Fund this year for a loan of US$12 billion over three years and it has received some funding from Gulf countries that support it, says Rahman.
Lesslie, however, isn’t sure external financial support is enough to pull Egypt out of a difficult situation. “I think they’re going to find [the IMF’s] requirements onerous,” she says, noting the country’s use of foreign-exchange reserves as it deals with the Egyptian pound’s continued weakness.
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Rahman notes that while investors should expect some risk when putting their money in emerging markets, they should get higher returns in light of the volatile circumstances.
“It’s one of those situations where, as an investor, you want to make sure you’re getting compensated for the asymmetric risks you’re taking.”
Turkey struggles with coup fallout
Turkey, meanwhile, faces its own unique challenges.
The biggest problem it faces is the political risk it represents for investors, says Lesslie. She notes the recent coup attempt against the government and the subsequent events there have shaken confidence in Turkey.
“What’s gone on recently with the coup attempt there has made investors nervous, in part because nobody saw it coming, which is an interesting aspect with emerging markets. You have a higher preponderance of event risk,” says Lesslie.
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In fact, Turkey has fallen into a “downward spiral” since the failed coup attempt, say DiMaggio. But while the country has seen its credit rating downgraded, he still thinks Turkey will remain attractive.
“At the end of the day, we think the spread you can get from Turkish sovereign assets is still appealing, relative to the rest of the universe.”
Despite its challenges, Turkey has maintained a reputable track record, specifically with how it has reduced its ratio of debt to gross domestic product, says Lesslie. She adds that while the country is still vulnerable on the economic front, the situation isn’t as stark as it was three years ago.
‘Not all emerging market is equal’
In light of the ups and downs of 2016, DiMaggio says it’s no longer prudent to take a passive approach.
“What’s incredibly important is that investors know not all emerging market is equal and the notion of buying a passive index to us is even more dangerous with emerging markets, where you can get a big difference between the best-rated and worst-rated credit and the fundamentals that go with each of those,” says DiMaggio.
The landscape for investors has definitely changed, according to Rahman. Before, investors who were generally optimistic about global growth prospects would invest in emerging markets as a whole, a strategy that’s becoming less effective, he says.
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“It’s becoming increasingly difficult to do that. You’re seeing a lot more diversions and differentiations across countries in terms of their outlook. So it’s a different context for the market. What’s really important is to understand the dynamic and invest accordingly.”
Jann Lee is an associate editor at Benefits Canada.
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