On sovereign bond yields

The latest SBP quarterly report mentions that the PML-N government had issued sovereign bonds totaling $4.5 billion so far in its term. At the time of Eurobond issues there was criticism on expensive coupons. While that debate could be won by either side, the good news is that due to a combination of internal and external factors, the yield on those bonds has come down in 2015 and 2016 (see the graph).

Declining yields mean that Pakistan’s sovereign bonds are in good demand as they are being traded at higher than their par value in secondary markets. Sovereign risk has somewhat declined. Between 2013 and 2016, Pakistan’s sovereign ratings have improved three notches to stand at Moody’s ‘B3 Stable’ and two notches to stand at S&P’s ‘B Stable’.

That augurs well, as the central bank also highlighted in the report, for sovereign bond issues in the future. But there is no guarantee that the factors – both external and internal – that have underpinned this ‘yield decline’ would hold.

First, let’s look at the external factors. The long-running policy of quantitative easing in the developed West – which resulted in migratory capital moving into developing market sovereign bonds since the 2008 financial crisis – is coming to a halt as inflation is rising. The US Federal Reserve has recently increased its policy rate and has also signaled to hike it several more times this year. The European Central Bank, the other monetary heavyweight, has also signaled that a tighter monetary stance is coming.

Tighter monetary stance in the West means that sovereign bond issuers in developing markets will have to offer higher coupon yields to compete for a shrunken amount of available capital. That will affect yields of current issues and terms of new issues.

It is not just the higher interest rates in the West that may reduce appetite for investing in developing market bonds. There is also the threat posed by rising economic populism in the American economy whereby domiciled firms are being badgered to invest in the US and bring the outsourced and off-shored jobs back home.

Let’s turn to internal factors. The SBP report noted, “The oversubscription in almost all bond issues suggests that the country has secured a minimum credit rating required for investors’ comfort.” Indeed, the trajectory in rating has been positive in the PML-N term so far. But is the improvement sustainable? Will the rating hold, and possibly leap upward in the short term?

On one hand is the optimism, fueled in part by domestic consumption and construction activities and in part by CPEC’s ambitious scale. But on the other hand are economic fundamentals that don’t completely explain that optimism.

The era of low inflation, which backstopped monetary easing and some economic recovery since 2014, is coming to an end. The twin deficits have widened lately. Non-debt-creating forex inflows – exports and remittances – tell a sorry tale for an expanding current account deficit. Entering an election year in 2018, fiscal deficit, already under strain relative to target, will further slip as spending on infrastructure projects and patronage schemes intensify. Then, threats to political transition can also heighten the country risk.

In short, while it is a nice fact that Pakistan’s sovereign bond yields have come down in last couple of years, it in itself offers scarce reassurance that things will turn out the same way in the future too.