The Daily Update - Insatiable appetite for yield

Regular readers will know that at Stratton Street we are value driven, and often look at the world in a different way from many. One of our favoured regions over the past 10 or so years has been the Middle East. From a Net Foreign Asset perspective alone, most investment grade nations in the region have NFA ratings of 5 stars and above, or, NFA above 25% of GDP. Also until around five years ago, the Middle East was untouched by many indices, and local markets previously only held paper up to 10 years in maturity. More recently, however, demand for new issue paper from the region has ramped up from the likes of the US and Europe, who have previously shied away from such debt, and Middle Eastern banks and investment houses are less discriminatory about maturities across the regions’ curves.

A clear example of this demand is today’s Iraq issue. The USD1bn, 5-year deal came to the market at a yield of 6.75%, very attractive levels for those on the hunt for yield; so much so that the bond was reportedly 7 times oversubscribed. The deal was also brought to the market by high tier global investment banks: Citi, Deutsche Bank and JPMorgan. Although the country sits on the world's 5th largest hydrocarbon reserves and has an NFA score of 3 stars, this issue is not one for us. For starters most readers will be aware that we favour investment grade bonds across our portfolios; this bond is rated B- by Fitch, and S&P rates the country B-. Next, using our proprietary Relative Value Models, we calculate that this bond at issue is actually expensive. Issued at a spread of 493.10bps over Treasuries, that may seem like sufficient cushion for what most would call a war-torn and highly unstable country’s debt. However, we calculate that bonds with a similar rating and duration trade at ~557bps over; implying that the bond is priced 0.60 credit notches expensive.

We would much rather hold Ruwais, Abu Dhabi’s special purpose vehicle established to operate and maintain an electricity and desalination plant (Shuweihat 2), in turn supplying Abu Dhabi and parts of the UAE with power and water. This strategically important company has a 10.5% 2036 bond outstanding, which offers a yield of 4.6%, and an expected return over 10%; attractive levels for an A3 rated bond. This issue also offers just under three notches of credit cushion; another important factor we consider when we look at holding a bond.

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