By Matein Khalid: Chief Investment Officer and Partner at Asas Capital
Saudi Arabia’s decision to issue $5 billion in seven-, twelve- and even thirty five-year maturity Eurobonds in the first sovereign GCC new issue of 2020 tells us a lot about the current pulse/zeitgeist of the global capital markets.
One, investors in the Eurobond market do not believe that the tensions between Washington and Teheran after General Qasem Soleimani’s killing in Baghdad will escalate in a full scale war in the Gulf. This is the message of the dramatic fall in crude oil prices, after an initial spike, to $64 Brent and $58 West Texas Intermediate (WTI). The credit spread of Saudi Eurobonds, issued last October, spiked higher after the January 3 drone hit but fell back to year end levels when geopolitical tensions deescalated.
Two, Saudi Arabia does not expect a significant rise in crude oil prices, even though Prince Abdelaziz bin Salman negotiated a 1.7 MBD output cut with Russia’s Alexander Novak and his OPEC ministerial peers in Vienna back in early December 2019. Since the 2020 State Budget will be the most expansionary in the history of the kingdom, Saudi Arabia will need to borrow $32 billion in the local/Eurobond market in 2020 to offset an estimated 6% of GDP budget deficit.
Three, given that the kingdom possesses the world’s biggest proven oil and gas reserves, the lowest drilling costs in global energy and the most spare capacity in OPEC, its AA rating is not reflected in the sovereign credit risk spreads it pays in the Eurobond market. The Saudi seven year note is priced at 85 basis points over the equivalent maturity US Treasury note while the twelve year and thirty five year bonds offer juicy spreads of 110 and 135 basis points over Uncle Sam debt.
If investors believe that the Federal Reserve will not raise interest rates in 2020 or even cut the overnight borrowing rate (Fed Funds) if global growth disappoints, then the longest duration Saudi Eurobond (35 years) at 3.8% will rise in price. Since I believe the US Treasury yields will rise in 2020 due to wage inflation risk, I will recommend buying the kingdom’s longest ever maturity bond at a 4.5% YTM, especially if it is financed as a carry trade by the Swiss franc or the Euro. Saudi Arabia’s credit rating is stable but the Chinese coronavirus epidemic could escalate, as SARS did in 2003-04 and trigger a vicious sell off in Brent crude as well as the prices of petrocurrency/EM debt. After all, China is the world’s largest market for petroleum and commodity exports from the Middle East.
Four, institutional investors in the Gulf and Asia have strong demand for Saudi Arabian sovereign debt, the best performing among all GCC issuers. As usual, the crème de la crème of international investment banking are leads, co-leads and syndicate placement agents in the $5 billion Saudi Eurobond new issue tranches – Citigroup, J.P. Morgan, Morgan Stanley, BNP Paribas, HSBC, Stan Chart and NCB capital.
Five, Saudi Arabia is now the biggest sovereign serial borrower in the Eurobond market from MENA after the Turkish Republic, a much riskier credit. The kingdom borrowed $13.4 billion in the international capital markets in 2019. The kingdom’s willingness to pay higher yields to lock in financing in the global capital markets and its role as the largest economy in the Arab world have enabled its sovereign paper to be a hit in the emerging market debt new issue market.
The thirty five year Saudi note is obviously offered to global pension and life insurance companies desperate for long duration assets to match long dated liabilities. This need is particularly acute in Japan, Taiwan, South Korea and Singapore pension funds/life insurers.
The IMF has cut its global growth forecast on the eve of the Davos talkfest in Switzerland. India’s GDP growth could well plunge to 2% due to its shadow banking credit crunch in 2020 while Chinese GDP growth is the lowest since 1990, when the People’s Republic was a global pariah after the Tiananmen Square massacre in Beijing. Yet this does not negate the fact that the US jobless rate is at 50 year lows, the US economic expansion is among the longest in the post war era and wage inflation is at 3%, above a complacent Powell Fed’s tolerance range. This spells all the ingredients of an embryonic credit sell off to me sometime this summer. While I doubt if Lebanon’s sovereign debt meltdown and Iraq’s political chaos will trigger contagion in the Gulf’s capital market, it could force Saudi, UAE, Kuwaiti, Omani and Bahraini borrowers in the Eurobond markets to pay higher credit risk spreads. This is the point where I hope to buy the Saudi long bond at a 4.5% yield in the secondary market.