We downgrade our recommendation on Iraq’s bonds to Sell from Buy. Recent events, following the assassination of Iran’s Major General Qassim Soleimani by the US and Iran’s subsequent – but expected – retaliation, have an element of ‘this time is different’, with the risk of an (unpredictable) escalation and concomitant negative impact on Iraq. Iraq’s 2028 bonds have fallen by c5pts since last Thursday, with the yield rising to 7.6% from 6.3% (yield to convention, on a mid-price basis as of cob 7 January on Bloomberg), and were slightly weaker early this morning (yield +8bps).
We think Iraq will underperform the market due to exacerbation of tensions, concerns over regional conflict, and the threat of possible US sanctions. Downside may be protected by (currently) strong debt service capacity, demonstrated willingness to pay, and belief that escalation will be checked. Higher oil prices may also provide some compensation, although this is less relevant if Iraqi oil production is disrupted. Moreover, against this geopolitical backdrop, investors may not be able to rely on IMF support either if it is blocked by the US administration.
Assessment
Geopolitical risks have increased following the assassination of Iran’s Major General Qassim Soleimani by the US on 3 January (See Iran: Why Iraq is so at risk, and other frequently asked questions by investors). The overnight rocket attack on two airbases in Iraq, where US forces are based, is in line with the type of response that might have been expected from Iran; the retaliation was just a matter of when and where (and is reflected in the markets’ limited initial response in Iraqi bonds this morning). But we can only guess if there will be further actions taken from both sides.
Still, our view remains that a wholesale attack on Iran (our definition of an all-out-war) is no more likely now than before Soleimani’s assassination. The arguments against an all-out US-Iran war still stand and further escalation can be avoided. We think Iran’s goal remains sanctions relief, not a war with the US. But the danger of bravado or mis-steps remains.
Indeed, there might be echoes here of the US-DPRK (North Korea), whereby an escalation of rhetoric and sabre rattling over 2016-17 eventually led to negotiations, the common denominator being North Korea’s own desire for sanction reliefs (although such talks have since stalled and not really yielded tangible results). And President Trump himself may be wary of entering into a conflict with Iran in an election year.
However, we think the impact on Iraq (and by extension, its bonds) is negative, unless there is a quick negotiated resolution or truce, which seems unlikely. Clearly, investors (and global citizens) will have more to worry about than some US$4bn of bonds in the event of an escalation that leads to all out conflict in the Middle East. More likely in our view, if there is going to be kinetic military action between the US and Iran (and its proxies), we regard Iraq as a more likely arena than Iran itself. Moreover, the threat of US sanctions on Iraq if it expels US troops (or the seeking of compensation payments) adds another layer of risk to bondholders and the country’s financial position. The expulsion of US troops from Iraq might also leave space for the return of ISIS (Daesh).
But conflict played out in Iraq may ultimately force it to choose between Iran and the US. Ideologically, we might expect the Shia political bloc which dominates, albeit in a fragmented fashion, Parliament to choose Iran over the US; and the old guard are the decision makers who have overseen Iraq’s move to becoming a client state of Iran in the post-Saddam era. Younger Iraqis may prefer no outside interference at all (from Iran or the US) and want a functioning economy, jobs, and less corrupt government. Maintaining social cohesion amid these competing factions will be challenging.
Investment Strategy
We had upgraded Iraq to Buy from Hold following the IMF Annual Meetings in October. This was based on the country’s solid debt service capacity, notwithstanding the well-known and pre-existing geopolitical and security risks, and domestic situation which had seen anti-government protests and ultimately led to the resignation of Iraq’s Prime Minister Adel Abdul Mahdi on 29 November (he remains caretaker PM in the absence of a successor).
However recent events, following the assassination of Soleimani by the US and Iran’s subsequent, but expected, retaliation, have an element of ‘this time is different’, with the risk of an (unpredictable) escalation and concomitant negative impact on Iraq.
We therefore downgrade our recommendation on Iraq’s bonds to Sell from Buy. We think Iraq will underperform the market due to exacerbation of tensions, concerns over regional conflict, and the threat of possible US sanctions. Downside may be protected by (currently) strong debt service capacity, demonstrated willingness to pay, and belief that escalation will be checked. Higher oil prices may also provide some compensation, although this is less relevant if Iraqi oil production is disrupted. We think investors can get better “oil exposure” from, for example, Nigeria (a low but more solid 5.8% yield on the 27s) or Angola (6.8% yield on the 28s); although both with longer duration than Iraq 28s.
Iraq’s debt service capacity is still strong. Debt service on its two bonds (6.752% 2023 and 5.8% 2028) is just cUS$393mn this year. This comprises interest of US$224mn and US$169mn with the first amortisation payment of the 28s in July. Debt service rises to US$547mn in 2021. This compares to reserves of cUS$67bn as of 19 December (most recent data available from the central bank).
Bonds have also been somewhat resilient in the face of previous episodes of conflict and political uncertainty, responding much more on the downside to periods of lower oil prices (Figure 1). Yet, even in those times of extreme distress (2008-09 and 2014-16), Iraq remained current on its bonds. It even secured an IMF programme in July 2016 as part of an orthodox policy response to its BoP crisis following the collapse in oil prices then. Iraq exited that IMF programme, its last financing arrangement with the Fund, in July 2019.
However, the threat of US sanctions could make new financing more difficult to access (financing needs look manageable for now; the next big repayment hump is the 23s’ maturity of US$1bn).
Moreover, against this geopolitical backdrop, investors may not be able to rely on the IMF coming to the rescue again in the event of a future BoP crisis. If the US administration is warning Argentina that its recognition of the Maduro government in Venezuela could jeopardise its pursuit of an IMF programme, then one could imagine that the US would be even more willing to block an IMF programme for Iraq that has expelled its troops and enjoys client-state privilege from Iran. Iraq’s client-state status is nothing new, but its last IMF programme was approved in July 2016, before President Trump’s election. Therefore, absent financing from Iran and its friends, that would appear to raise the risk of default (through either inability to pay or lack of willingness).
Figure 1: Price of Iraq 5.8% 2028
Source: Bloomberg