Sri Lankan sun shines on high yield bond market

Strong order book allows sovereign to upsize bond as central bank governor tells FinanceAsia policy makers are preparing to take tough measures to improve tax collection.
Emerging and frontier markets debt: paradise re-gained for investors?
Emerging and frontier markets debt: paradise re-gained for investors?

The Democratic Socialist Republic of Sri Lanka returned to the international bond markets on Tuesday  for the second time this year.

It came with an upsized $1.5 billion Reg S/144a issue that demonstrated just how much confidence has returned to emerging and frontier markets debt in recent weeks despite the looming threat of US interest rate rises.

Having initially marketed a $1 billion transaction, the B+/B1/BB- rated sovereign decided it had room to increase it by 50% after attracting demand that topped $4 billion at its height. 

The order book went on to close around the $3.3 billion level once final price guidance was released but this is still very strong compared to recent precedent. This has been marked by no-show deals from the likes of Iraq, or the struggles of sovereigns such as Pakistan, which did well to attract demand of just under $1 billion for a $500 million deal almost exactly one month ago when sentiment was much weaker.

Final pricing for Sri Lanka's 10-year offering was fixed at par on a coupon of 6.85%, some 15bp tighter than initial guidance around the 7% level. 

Bankers estimated Sri Lanka's new deal offered a 25bp to 30bp new issue premium relative to its existing $650 million 6.125% June 2025 bond. This latter deal was bid at 97.625% to yield 6.46% during Asian trading hours on Tuesday, having gapped out about half a point when the new issue was announced. 

Bankers calculated there was roughly 10bp on the curve between the June and November bonds.

Distribution was dominated by US-based emerging market funds, the mainstay of Sri Lankan bond deals. Bankers said US accounts picked up 55% of the paper, with 29% placed in Europe and the remainder in Asia.

A total of 290 accounts participated of which funds accounted for 88% of the allocations followed by banks on 5%, private banks 4%, with pension and insurance funds 3%. 

The new transaction represents Sri Lanka's largest international bond deal to date and pocketing the proceeds will come as a welcome relief to the country's central bank governor Arjuna Mahendran as he tries to re-build the country's foreign exchange reserves before a potential new storm buffets emerging and frontier markets.

Reserves stood at only $6.797 billion at the end of September, equating to about four months of import coverage and down from roughly $8.8 billion one year earlier. Over the past year, Sri Lanka has spent $500 million re-paying foreign currency debt that matured in February, plus a further $2.7 billion defending the rupee, before finally deciding to let the currency float freely early last month. 

No US rate rise before Christmas

Mahendran told FinanceAsia that central bank governors across emerging markets remain acutely conscious of the potential headwinds that may be stirred up by US interest rate rises.

"It's estimated that $750 billion to $1 trillion has already flowed out of emerging markets back to the US over the past few years," he said. "There's precious little anyone can do if investors decide to bail out en masse. What we can do is counteract those capital outflows by building up our reserves."

Mahendran said he tends to agree with most analysts who now believe the US Federal Reserve is unlikely to raise interest rates until next March at the earliest. "We have about four months before the emerging markets may have to ride out a storm that could be quite fierce," he added.

In bringing its deal one day before the Fed's latest monthly meeting, Sri Lanka appears to have found a sweet spot in the market, which other Asian high yield sovereign issuers waiting in the wings such as Vietnam and Mongolia may try to build upon. 

Over the past two weeks, emerging and frontier market debt has been buoyed by the receding threat of an imminent rate rise following a low US non-farm payroll number in early October and a spate of poor data points from China.

Bankers said Sri Lanka's debt has tightened about three to four points since then. "At the end of the day, the Fed is going to raise rates by 25bp, which will have precious little effect on a country like Sri Lanka, which is paying 6.85%," one banker argued.

"We've noticed a discernible trend of investors locking in profits from off-the-run bonds trading above 115% and re-cycling the money into new bonds at the longer end of the curve and in sovereigns they like," the banker added.

Sri Lanka has been a beneficiary of the trend having established good investor relations as a result of its five-year history tapping the international capital markets.  

China makes way for India, Japan and the West

However, going forwards President Maithripala Sirisena's government is set to adopt a very different debt management and economic strategy to its predecessor under Mahinda Rajapaksa. The latter was ousted from power last December and unsuccessful in trying to make a comeback during parliamentary elections in August. 

The new government has adopted two very striking changes in policy.

The first has been a renewed emphasis on democratic principles and good governance compared to Rajakpaksa's authoritarianism.

The second is what the government describes as a non-partisan foreign policy. The latter term is a polite way of masking a very strong pivot away from China, which funded many of Rajapaksa's infrastructure projects including a number of white elephants such as an international airport close to the former president's hometown, which was dangerously sited on the flight path of migrating birds.

In his interview Mahendran mentioned China just once. When asked why investors should still be buying emerging market debt if there is a squall brewing, he replied, "Equity markets are richly valued, so investors are looking for yield. Countries with solid fundamentals will do well and Sri Lanka is very well shielded from a China-led slowdown.

"Sri Lanka has minimal links with China," he noted. "Our trading partners are primarily India, the US and Europe."

Instead, Mahendran flagged the prime minister's recent visit to Japan and the potential for bilateral loans at sub 1% coupons, which could do much to improve the country's credit metrics.

Concessional loans not commercial debt

The change in government is likely to have a strong impact on the availability of concessional loans from friendly nations and multilaterals that had previously shunned Sri Lanka because of its alleged corruption and human rights record relating to the ending of the 26-year civil war in 2009. 

"The previous regime over-borrowed and crowded out the private sector," Mahendran continued. "Our strategy is to re-finance with concessionary loans rather than with commercial debt on commercial terms. We also want to smooth out and lengthen our re-payment stream."

Bringing down debt to GDP is one of the chief tasks flagged by international rating agencies. In a recent analysis, Standard & Poor's highlighted that, at 34% of government revenues, Sri Lanka's debt servicing costs were second only to Lebanon among the sovereigns it covered in 2014. 

The agency said it expects net government debt to GDP to fall to 60% by the end of 2018, down from 70% in 2013. 

It also believes foreign exchange reserves will improve given an "increase in remittances from overseas Sri Lankans and the country's rising earnings from tourism." It also cited Sri Lanka's access to external debt markets and the availability of a $1.1 billion cross-currency swap facility from the Reserve Bank of India as buffers against volatile capital flows.

Local analysts told FinanceAsia that the government and related agencies will have to meet about $4 billion to $4.5 billion in foreign currency principal and interest payments in 2016 and in a currency that has now appreciated about 7.5% against the rupee. 

Improving revenue collection

Shiran Fernando, head of macro research at Colombo-based Frontier Research, noted that recently released figures shows that the budget deficit had risen from the government's targeted 4.4% level to 6.5%-6.8% so far in 2015. 

"During the past two budgets a lot money was put into the hands of consumers through increases to allowances and salaries," he remarked. "I do hope and believe the new government will only now provide concessions where they are absolutely needed."

Mahendran concurred that the government is well aware it needs to increase revenues as a percentage of GDP from the current dismal 3.6% figure back to the 20.4% levels Sri Lanka was hitting in the mid 1990s. 

The country's narrow tax base is the second big challenge cited by the rating agencies and all eyes are focused on the forthcoming budget due on November 20.

Ahead of that, the ex-HSBC banker said the central bank has already taken a number of measures to re-balance the economy. "We let the currency float, which was very important as the previous peg was leading to excessive debt creation and making exports less competitive," he said.

"Secondly we have taken some macro prudential measures to curb imports on consumer goods such as cars."

He said the budget will contain strong measures to rein in the fiscal deficit. "The president was elected last December but he did not get a parliamentary majority until August, so there has been a short delay getting economic reforms in place," he acknowledged.

Fernando agreed that the government will make moves in the right direction in the forthcoming budget, but also queried whether the recent introduction of coalition partners will lead to some new concessions as well. 

"I think three policies are very clear," he remarked. "Firstly, the government wants the economy to be more export-driven. Secondly it wants more private sector involvement and thirdly tourism will continue to be a very strong propeller.

"But the government really needs to improve direct taxation," he argued. "There are a lot of indirect taxes at the moment."

Addressing human rights

Bankers said that one reason international investors were drawn to Sri Lanka's bond deal is because of the government's commitment to reduce what S&P terms as "entrenched patronage" and improve overall governance. "It's the kind of sentiment that really resonates in the US," one banker commented.

Mahendran highlighted two very important moves the government has made in this direction, which he believes will have a very positive impact on the economy and foreign direct investment. 

Firstly he cited the government's recent announcement that it is setting up a South African style truth and reconciliation commission to try to heal the ethnic divisions between Tamils and Sinhalese majority created by the civil war. 

He described the UN's recognition of the efforts the Sri Lankan government is making as a significant foreign policy coup for president Sirisena. He also flagged the work being done to draft a new constitution, which will wrest powers away from the executive and into the hands of parliament. 

"The economic consequences of all of this should be that our major trading partners will be far better disposed towards us on a diplomatic level," he concluded. "Sri Lanka now has a very reform minded government and president Sirisena has handled foreign policy very well."

Joint global co-ordinators for the country’s bond deal were four banks, which all have a physical presence in the country: Citi, Deutsche Bank, HSBC and Standard Chartered

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