Triumphant Egypt return to Bond Market Risks Ultra-Tight Pricing

Egypt’s return to the international debt market after a five-year gap is set to attract heavy demand – so heavy that the new bonds risk pricing at precariously high levels.

The government plans to issue a $1.5 billion Eurobond in April and to return regularly to international capital markets in coming years, Hanan Salem, first deputy minister at the Ministry of Finance, told Reuters last month.

Trade in Egypt’s outstanding U.S. dollar bond maturing in 2020 shows how dramatic the return of confidence in Egypt has been since President Abdel Fattah al-Sisi took office last year, oversaw the installation of a technocratic cabinet that is starting to reform the economy, and forged an alliance with rich Gulf states to obtain aid and investment.

The yield on the bond is at 4.47 percent, near a life low of 3.98 percent hit in December and down from a peak of 11.09 percent in June 2013, when the country was frozen out of the global debt market by political and economic turmoil.

Some mainstream emerging market funds have resumed buying the bond, asset managers say; in the years immediately following Cairo’s Arab Spring uprising of 2011, foreign buyers were largely limited to adventurous hedge funds.

“We expect the Eurobond issue to go well. Even after the al Sisi rally, Egyptian spreads still trade cheap relative to their pre-Revolution average,” said Bryan Carter, portfolio manager at Boston-based Acadian Asset Management.

“Our view is that medium-term, this country should have very high returns on investment for those willing to go in.”

Spreads with other bonds reflect that view. Rated ‘Caa1’ by Moody’s, well below investment grade, the Egyptian bond trades inside Pakistan’s 2019 dollar bond, which carries the same rating, by a whopping 235 basis points.

Egypt is outperforming even more highly rated bonds. Last June, the Egyptian paper was trading 44 bps inside Lebanon’s March 2020 Eurobond, which is rated two notches higher; now it is trading 113 bps inside.

RISK

The risk for investors is that such tight price levels are based almost entirely on expectations for improvement in Egypt’s economy, not on its current economic situation.

Investors are betting the improvement will trigger a string of credit rating upgrades in the next couple of years. That would increase demand; many global funds only invest in bonds that are rated at least ‘B-‘ by the three main agencies, while other funds have higher floors.

“Markets tend to be ahead of rating agencies, and Egypt is already trading on the expectation of an upgrade. Though spreads are tight relative to other ‘B-‘ rated sovereigns, the proper comparison is with the ‘B+’ or ‘BB-‘ cohort,” Carter said.

There is no question that the economy is being run more professionally now than it has been for many years. Sisi has begun cutting energy and food subsidies, building infrastructure and improving regulation. But he faces a huge task.

Gross domestic product is expected to grow 4 percent in the current fiscal year to end-June, Prime Minister Ibrahim Mehleb said last week; that would be up from 2.2 percent last year, but still below levels which many economists think necessary to make a big dent in Egypt’s youth unemployment.

Mehleb predicted a government budget deficit below 10 percent of GDP this year – a big improvement from 14 percent last year, but still at extremely high levels.

“Fiscal deficits, expected to remain in double digits in FY15, are amongst the widest in emerging markets, and the adjustment outlook is not particularly heartening,” said Raza Agha, emerging sovereign debt analyst at VTB Capital in London.

Agha said an International Monetary Fund loan programme would be critical in confirming Egypt’s economic reforms were working. An IMF deal would be politically sensitive within Egypt, however; the finance minister said last week that there were “no concrete plans” to consider one.

In December, Fitch upgraded Egypt to ‘B’ after the government cut subsidies and raised taxes. Moody’s, however, has only changed its outlook to stable from negative.

Lucio Vinhas de Souza, managing director at Moody’s sovereign risk group, said in December that even the plunge of global oil prices, which will benefit Egypt as an energy importer, wouldn’t necessarily mean a quick upgrade.

“The inherent weaknesses of the economies don’t disappear, they just get smaller,” he told Reuters, adding that other factors such as political and policy risk were key.

Another factor buoying Egypt’s international debt is a shortage of it. The government has only two outstanding Eurobonds, making Egyptian dollar debt very scarce for investors seeking exposure to the country.

That shortage could begin changing quickly as the government and Egyptian companies return to the international markets to fund heavy investment plans.

There is already an ample supply of Egyptian local currency debt, and foreign investors have certainly not regained confidence in it. At the end of 2010, foreigners held more than 22 percent of Egyptian Treasury bills; last October, they held just 0.13 percent of the $63 billion market, latest data shows.

A third factor is the global debt market environment, with yields extremely low around the world and geopolitical risks in countries such as Ukraine and Nigeria making Egypt look relatively attractive.

But again, this could change, with the U.S. central bank expected to start hiking interest rates this year and Egypt facing its own low-level Islamist insurgency.

Such issues may ultimately dampen interest in Egyptian debt – but not for now. “Investors have short memories and the economy is improving,” said Daniel Broby, chief executive at London-based Gemfonds, an emerging market specialist.

Source: Reuters