Bonds: getting the price right

To ease the forex mind, Pakistan is looking to access global capital markets for fourth successive year. Reportedly between $2 billion and $3 billion will be borrowed in a few weeks’ time, via one ten-year Eurobond, one thirty-year Eurobond, and one five-year Sukuk. (For a detailed macro context to the upcoming bond issuances, read “Bonds calling,” published October 27, 2017).

Few independent economists will have a beef with these bonds’ issuance, given no other immediate forex-buildup option to boost the deteriorating import cover. But can Pakistan get the pricing right this time? While the 2016 Sukuk issue – $1 billion, five-year bond at 5.5 percent – looked like a good sell, the 2015 Eurobond issue - $500 million, ten-year bond at 8.25 percent – was an expensive deal.

Let’s have a look at both internal and external factors that can impact demand for and hence pricing of Pakistan’s upcoming sovereign bond issues.

Internally, the macroeconomic situation is becoming precarious by the day, despite exports and FDI showing some rhythm this fiscal. The current account deficit had ballooned to $5 billion in 4MFY18, after clocking $12.2 billion in FY17 (FY16: $2.6 bn).

Then, there is the uncertain political situation in the wake of Nawaz Sharif’s ouster. It’s unclear who is calling the shots anymore, with a question mark over national elections that are officially less than a year away.

The political theater is made worse by government’s decision to keep a struggling finance minister. Wanted by Pakistani courts in an accountability trial, the current finance minister is portraying a man on the run. Will that kind of perception sell during all those road shows soon taking place in fancy financial districts of the world?

Overseas, market appetite for emerging-market (EM) sovereign bonds will likely remain strong. The yield-hunting investors continue to fish for riskier sovereign issues as cheap capital is abundantly available in low interest-rate environment backstopped by the FED and the ECB. That augurs well for Pakistan’s issue, just as other EMs. But analysts continue to cite recent issues of Iraq and Argentina to argue that Pakistan will also do well, even though Pakistan’s is a retail-led economy and theirs is mineral fueled.

Iraq, a country wracked by civil war which was recently able to raise $1 billion through a ten-year Eurobond at 6.75 percent, holds fifth-largest oil reserves and its debt have previously been backed by the United States. As for Argentina, the serial defaulter’s 100-year Eurobond issue last June proves the point that hungry investors will lap-up juicy yields despite clear risks. At nearly 8 percent, that bond repays the holder in full in about 12 years!

For a comparison, Pakistan will likely be competing with itself. Recall that the Sep-2015 Eurobond was issued in political and economic situation that was much better than today. Would investors be okay paying less than 8.25 percent in these circumstances?

It appears that Pakistan can get a better bond price this time around. Looking at the credit default swap (CDS) – which is effectively an insurance against default on a bond – Pakistan ranks fourth amongst EMs most exposed to default risk (barring the outlier/defaulter Venezuela) after Lebanon, Ukraine, and Egypt. But the good thing is that all the political uncertainty and economic wobbles in 2017 haven’t really bumped Pakistan’s CDS spread to the north. The latest price of a five-year CDS for Pakistan’s sovereign bonds was 331 basis points (bps) (Nov. 20, Bloomberg). (That means, to insure against default of $100 of Pakistan debt, an investor will have to pay $3.31 per year).

Pakistan’s current CDS spread is roughly ten percent down from exactly a year ago. In the year-to-date period, the CDS hit a low of 258bps on August 28, 2017. Since then, it has gradually risen, but has consistently remained below 400bps. In any case, the CDS is way lower than the high of over 600bps seen in early 2016.

Also note that current yields on Pakistan’s previous Eurobond issues range from 4.5 percent to 7.5 percent for maturities from 2019 to 2036, as per Topline Research. The Brokerage House expects Pakistan to raise $2 billion to $3 billion with a coupon in the range of 5.5 percent to 7.0 percent for 5 to 10 years.

This time around, the finance ministry needs to better assess the market’s mood after the road shows and then tighten its bond pricing accordingly, just as other EMs routinely do when they sense high demand. Pakistan may be needy at the moment, but the overseas investors may turn out to be needier.