Investors jump back on the Pakistan merry-go-round

Pakistan completes a hugely successful bond issue, but where is the upside?

The Federal Republic of Pakistan returned to the international bond markets yesterday (Thursday) with its most successful bond to date. Under the lead management of ABN AMRO, Deutsche Bank and JPMorgan, the sovereign priced a $500 million five-year fixed rate deal at par on a coupon of 6.75% to yield 370bp over Treasuries, or 335bp over Libor.

After completing a week of roadshows, the B2/B-rated credit managed to accumulate an order book of just over $2 billion. Such large demand facilitated pricing right at the tight end of a revised indicative range between 6.75% and 6.875%.

Just over 200 accounts participated in the deal, of which 54% came from Europe, 24% Asia, 11% offshore US and 11% Middle East. There was no direct placement in Pakistan. By investor type, fund managers took 38%, banks 30%, retail 22%, hedge funds 7% and others 3%.

All involved acknowledged the impressive roadshow skills of government officials led by finance minister Shaukat Aziz. A number also hoped the bond's success can further strengthen the platform of the Musharraf government as it pushes forwards with its sweeping programme of structural reform.

Most surprisingly of all, Pakistan priced through all of its comparables.

The most direct comp is cited as B1/B+ rated Turkey. With a one notch higher rating from both agencies, Turkey should trade at least 30bp through Pakistan.

Pricing of the latter's deal has, however, has come only 5bp wider, since Turkey's 12.375% 2009 bond was bid at a yield of 6.70% at the time of pricing.

So too from Asia, there is the much higher rated Ba2/BB-rated Republic of the Philippines with a March 2009 bond outstanding. This was bid at 7.15% earlier yesterday to yield 378bp over Libor, some 43bp wider than Pakistan.

For investors, the most pressing question now must what upside can be derived from the secondary market and just how great are the downside risks? Similarly rated sovereigns asides, does Pakistan really deserve to trade through Asian high yield credits such as B+/B2 rated PT Indosat, which has a one notch higher rating on the S&P side?

The Indonesian cellular operator is effectively 42% owned by the AAA-rated Singapore government, has never re-scheduled its debt and has an undisputed growth profile. Yet its November 2010 bond currently yields 7.44% or 355bp over Libor, a 20bp Libor premium to Pakistan.

Bankers argue that part of Pakistan's success can be attributed to scarcity value, since it has not been in the international debt markets since 1999. But there has been a very good reason for that absence - the last time it came was to restructure all of it sovereign debt as a result of a balance of payments crisis triggered by a nuclear testing programme.

For investors the main conundrum with Pakistan's credit is how to quantify geo-political risks and the sustainability of a reform programme that rests on the shoulders of a few men, one of whom has survived at least two assassination attempts during the past few months.

As one credit analyst points out, "The Achilles heel of a country like Pakistan is that there is no single institution capable of sustaining reform in the absence of a powerful executive. Change always takes a long time in any emerging markets country. So far, Musharraf has very been very successful in his attempts to put the building blocks of a dynamic economy in place. But the question is can he put enough blocks in place before he leaves office, voluntarily or otherwise?"

The headline figures are said to have impressed investors. On every ratio Pakistan is now beating even the best figures it achieved throughout the 1990's. For example, whereas GDP growth averaged 4.6% during the last decade and fell to a nadir of 2.6% in 2000/2001, it shot up to 5.1% in 2003.

Where budget deficits have averaged 7.2% for the last two decades, the figure had fallen to 4.5% in 2002/2003. This in turn meant that debt as a percentage of GDP fell from a high of 102% in 1998/1999 to 90% last year.

As JPMorgan wrote in a recent credit report, "Pakistan's multi-pronged strategy of retiring expensive debt, borrowing from multilateral development banks and conservative fiscal stance has gone a long way to ensure that it returns to a more sustainable debt re-payment profile."

As a result, debt-servicing costs have fallen from 63% of fiscal revenue in 1999 to 36% in 2003. Foreign exchange reserves also stand at an all time high of $12 billion, equating to over a year of import coverage.

But investors have heard this all before and their response to this deal mirrors that of the sovereign's last benchmarking exercise in May 1997. At the time Pakistan had a similar B+/B2 rating and set out with ambitions to raise $100 million via ANZ.

Such was the positive response to the three-year FRN that it was tripled in size to $300 million and priced at 395bp over Libor on a re-offer price of 99.90%. Within six months it had traded in to 320bp over and the government laid plans to return to market with a five-year fixed rate issue again via ANZ.

This deal never saw the light of day, however. The country embarked on a nuclear testing programme that led to international sanctions and the overthrow of the Nawaz Sharif government in a military coup under Musharraf.

By early 1999, foreign exchanges reserves had dropped below $1 billion and the country had fallen into a balance of payments crisis resulting in a Paris Club-led debt restructuring for $3.3 billion. Under the Paris Club's comparability requirements, the sovereign was also forced to restructure all its commercial debt obligations including its outstanding eurobonds.

An exchange offer, led by UBS, resulted in the issuance of a new $585 million 10% December 2005 transaction. In many ways, this represented the absolute bottom for the country and since then it has been on a new upswing. In the past year, for example, the 2005 bond has tightened about 145bp to trade around the 215bp level.

Pakistan now has ratings momentum. But having priced no downside risk into the new bond, investors have also signalled their faith in a future, which will not repeat the history of the recent past. And one thing that has changed since 1997 is the fees, with the lead managers receiving just 30bp for their efforts on the new bond.