Could Saudi Arabia’s massive debt issue mark the top for the bond market?

published 21 October 2016

161021-saudi-b — King Salman of Saudi Arabia: the country is not without risk

Saudi Arabia has just managed to flog off a big pile of bonds.

Global investors have loaned the country $17.5bn. And according to the FT, they were queuing up to do it "investor orders reached $67bn".

This is a record issue for an emerging market. It's also the first time that Saudi Arabia has issued a dollar-denominated bond.

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Hmm.

We're in a bond bubble. We've just seen the biggest emerging-market debt issue ever. And that's come from a country that is only having to borrow the money because its critical revenue source oil has an uncertain future.

Hmm.

They say they never ring a bell at the top. But sometimes they get pretty damn close

Would you lend money to this company?

And now, Argentina's record has been eclipsed by Saudi Arabia's $17.5bn.

Saudi Arabia issued the debt in batches of five-year, ten-year and 30-year bonds. The five-year bonds got away with a yield of 2.375%. The ten years went for 3.25%. And the 30 years are offering 4.5%.

Compared to buying US or UK government debt, or worse still, German or Japanese government debt (back near negative levels), these rates look good. But Saudi Arabia isn't the US, or the UK, or Germany, or Japan.

Let's step back from this for a moment. Join me in the MoneyWeek-patented textual VR machine as I present you with a scenario

You run a small bank. The CEO of a highly successful manufacturing company comes to you looking for a loan.

The company has had a good run, but it only makes and sells one product. Its profit margins have been colossally high, beyond any analysts' expectations, for years. But now the bottom has dropped out of the market, and the CEO thinks the company needs to diversify.

You're a little surprised that such a vastly profitable company one that's never had to borrow in the past is already looking for a loan. But you also know that it's been a cash cow for decades, and you're tempted. So you go to visit the premises.

The offices are palatial. The car park is full of Ferraris and Porsches. You ask the CEO about them. Turns out this is just the middle-management car park. "Oh yes, they'll all be taking pay cuts", he reassures you.

You take the non-stop executive lift up to his penthouse office with its ensuite masseur and miniature putting green, and as his butler manicures the (real) grass on the green with a pair of nail scissors, you ask about his turnaround plan for the company.

"Diversify", he says. "We hear that retail's a good business." Despite your desperate efforts not to snort out loud, he catches the look on your face. "Oh and asset sales. We have a lot of land around our factory. I suspect we'll be able to securitise it is that the word? in some way."

You waste enough time chatting to finish drinking the freshly-brewed and ground coffee that the in-house barista lovingly prepared for you, shake hands, and allow him to escort you to the exit.

On the way back to your office, you think: "A bloated giant with a broken cash-burning business model, and the vaguest of turnaround plans. Who'll be daft enough to buy that?"

Then you think: "Then again, if they pay a yield of more than 2%, I'll be able to offload it to some desperate twit." And you call the legal department to get going on the paperwork.

Saudi Arabia might be a turnaround story, but you're not getting paid for the risk

Turnaround stories can be great investments that's how value investors make their money. But the key to turnaround stories is that they're only worth buying at the right price.

As The Wall Street Journal, puts it without ever quite saying it directly investors really aren't getting paid enough to take this risk. "In the near term, buyers of the bonds are betting largely on oil. Swings in the price are likely to have a direct impact on the perception of Saudi Arabia as a credit."

This explains why the bonds have been a relatively easy sell. Oil prices have rebounded strongly this year.

"But further ahead, this is a bet on the ability and willingness of the country to transform itself while maintaining social and political stability. In that, the 30-year bond is much punchier" than the shorter-term bonds that go with it.

The FT says much the same, again in a tactful manner. "Saudi Arabia is not without risk. The country is an undiversified oil economy accustomed to a world where crude prices are double the current level. The non-oil economy has ground to a halt and is on the brink of its first full year of contraction since 1987."

It also "sits in a region suffering geopolitical tension and without enough jobs for its youthful population". And, as one source quoted in the piece put it: "Unfortunately, this bond is not about preparing for the future so much as paying for the excesses of the past."

The success of this bond issue says more about the desperate reach for yield created by developed market central bankers than it does about the odds of success for Saudi Arabia's turnaround plans.

That in turn says more about how imbalanced this market is. Alongside negative bond yields, it's just yet another monument to the irrational exuberance in the bond market right now.

A country whose revenue depends on rising oil prices (widely viewed as inflationary) issues a huge number of bonds (which do best in deflationary environments) and the punters queue up to buy.

One day we'll look back on all this and gawp.

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.