Iraq bear ‘sells’ appear to offer a good contrarian indicator

[Santanna]

September 18, 2015 8:01 pm

John Dizard’s analyses sell recommendations and says the bad news on Iraq is over-discounted

©AP

I

 always have time to read through “sell” recommendations from the dealer community. Not only is there often more analytical depth, but the entertainment value is usually higher than it is with the humdrum “buys” and “holds”.

Also, I noticed a while ago, broker sells appear to be a good contrarian indicator. Frequently, shares that are not just left for dead, but desecrated, will outperform the “strong buys”.

I wrote about this pattern in the US equity world when I started with the FT back in 2001. There has since been some interesting academic research by Dr Leslie Boni that seems to confirm the effect is still noticeable even after waves of securities analysis “reform”.

So when, at the beginning of this month, I received two “sell” recommendations for Iraq’s traded debt, my interest was piqued. Both of them, from Barclays and Exotix, were solidly based on an IMF report that had been issued in early August, and included additional work on the credit and on the gloomy outlook for the oil price.

Also, both reports were issued in the middle of aninvestor roadshow by Iraq’s financial officials and their advisers from Deutsche Bank, Citigroup, and JPMorgan. The country has been seeking to issue a listed and rated bond, initially intended to be for $2bn, as part of a $6bn two-year borrowing programme. So the analysts and their managers were openly accepting the possibility of disfavour from a would-be active issuer.

My own view is that the analysts may be picking a bottom-tick for Iraq. There is currently one traded Iraq bond, the $2.7bn issue due in January 2028, which was issued with a 5.8 per cent coupon back in 2006. It has been hitting its lows for the year in the past couple of weeks with desultory trading at just over 73, which represents a yield of 10.7 per cent.

To begin with, the IMF, Barclays, and Exotix analyses are valuing the country’s debt to the Gulf Cooperation Council countries at its issue price. While formally that might be the case, all the GCC countries have informally agreed that they will either write off the debt to zero (UAE), or accept an 80 per cent haircut (Saudi Arabia).

Also, the Iraq bears assume that the internal, dinar-denominated debt of the Iraqi state should be considered as pari passu with the country’s international traded debt. Again, formally, they are right, but as a practical matter . . . no. The dinar state debt held by the banking system could be subjected to a haircut with the stroke of a keyboard if the state, or any successor states, chose to do so.

Frequently, shares that are not just left for dead, but desecrated, will outperform the ‘strong buys’

If so, then the $8.7bn in currently authorised international private tradeable debt of Iraq is supported by a country that even now is producing nearly 4 million barrels of oil per day. The outstanding official “Paris Club” debt from the Saddam era is being amortised in an orderly manner over the next eight years.

Iraq had built up arrears in payments to international oil companies, but those have been paid up through the second quarter of this year, with a third-quarter payment scheduled for the end of this month.

Consider one of the worst possible cases for Iraq: a splitting of the country into separate Sunni, Shia, and Kurdish states. As a sovereign debt lawyer friend of mind notes, “The practical precedents are pretty good. In the case of the USSR, Russia took over the Soviet Union’s international debt in return for the title to its international assets. In the much worse case of Yugoslavia, there was a lot of bickering, but in the end the constituent states divided up its international debt.” Since Iraq has the third-largest oil reserves in the world, there would be a large “estate” to cover its international borrowing.

Also, some of the governance shortcomings that the analysts and the IMF identified work in the bondholders’ favour in the form of underspending on necessary infrastructure. By the end of August, even while conducting the war with the Islamic State of Iraq and the Levant, known as Isis, Iraq had spent only 35 per cent of its annual budget. Since 2004 Iraqi governments have consistently spent less than they have budgeted for, leaving more cash for debt service.

Since the Saddam-era debts were restructured Iraq has paid its international paper on time. Now, after a gap of several years, the IMF and World Bank are back, working to improve Iraq’s financial administration. The IMF has put up a $1.24bn condition-light “rapid financial arrangement”, and next month will start formal negotiations on a “standby agreement”, a form of conditional lending that effectively gives more internal authority to those “technocrats” who always seem to spring up like weeds in a bombed-out ruin.

We will see very shortly the terms of the proposed (New York law) bond issue. My view is that the bad news on Iraq is over-discounted. That is probably why the Iraqis are not including a prepayment penalty in its documentation. They figure they will be able to borrow more cheaply in the future.

 

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