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Three reasons to like Middle-East bonds

They're high grade, issued by countries with large net foreign assets, yet trade on high spreads. Investing in wealthy Middle East countries' bonds makes a lot of sense, according to Stratton Street Capital, the London-based investment manager & adviser.

Founded in 2001, Stratton Street Capital, which has assets under management and advice of over $1 billion, has a number of significant investments in the Middle East. Its two largest funds are the managed Renminbi Bond Fund and the advised New Capital Wealthy Nations Bond Fund.

Launched in November 2007, the Renminbi Bond Fund is a rather unusual offering. The fund has not yet invested in any Renminbi bonds. It is fully exposed to the Chinese currency, a process achieved by buying investment grade US dollar bonds across various regions in Asia including the Far East, the Middle East, Russia and Turkey. These are then hedged back into Renminbi through the non-deliverable forward (NDF) market, and in doing so give investors extra exposure to an appreciation in the dollar against the Chinese currency.

The Wealthy Nations Bond Fund, launched in September 2009, evolved from the investment process of the Renminbi Bond Fund, which had investment-grade bonds at the time yielding in excess of 10%.

"A lot of investors said to us they were interested in the bonds but did not necessarily want the currency exposure. We set up the fund with EFG to invest in a global universe of wealthy countries as opposed to an Asian subset" says Andy Seaman, partner and portfolio manager at Stratton Street Capital.

The Wealthy Nations Bond Fund invests in undervalued investment-grade bonds in countries, or companies within those countries, which the managers believe have the greatest ability to repay their debt. A key component of Stratton Street's decision when selecting a qualifying country is looking at its Net Foreign Assets (NFA).

"The NFA is a measure that we use to work out which countries are wealthy and which ones are not, and which, despite the fact they are high grade with high ability to repay, trade on very wide spreads," Seaman says.

In Stratton's database of 128 countries only 34 countries have a positive net wealth as measured by net foreign assets as a percentage of GDP. The other 94 countries are indebted and therefore owe the money to a relatively small group of countries.

"This mismatch between borrowers and lenders is unhealthy for the world economy as it means that any decline in credit availability will impact a large number of countries simultaneously," the fund argues.

Using the NFA method shows Qatar is one of the wealthiest countries in the world with a net foreign asset surplus of 263% of GDP. Unsurprisingly, at the other end of the scale are Eurozone countries like Greece, Portugal and Spain with net foreign liabilities (NFL) of more than 100% of GDP. The Wealthy Nations Bond Fund specifically excludes countries with liabilities greater than 50% of GDP.

"Because the Middle East has been running current account surpluses for many years, and very large surpluses at that, they have grown a very large stock of overseas assets which could in extremis be used to repay its debt. Contrast that with the likes of Portugal, Spain and Greece - which have very large foreign liabilities. It would take many, many, many years for a country like Qatar with Net Foreign Assets in excess of 200% of GDP to actually turn negative and therefore not be able to repay its debt", Seaman points out.

Stratton Street therefore believes a strategy involving tracking bond indices "makes little or no sense at all".

"The way the indices are constructed leads to this really perverse situation where the safer AA credit pay you more than the risk in sub-investment grade credit," Seaman explains. "What you end up doing is lending the most amount of money to the most indebted countries because that's how the indices are constructed. The bigger the debtor, the bigger the debt. The more indebted that country becomes the more the weight increases. So what you end up with is a very poor mix of assets which are largely debtors - the Middle East almost doesn't feature in those indices for example. Not only is it full of debtors, those debtors tend to pay you less than the creditors. You lose out on both counts."

International Petroleum Investment Company (IPIC) is one of Stratton Street's favourite corporate holdings in the Middle-East. The Abu Dhabi, Aa3-rated sovereign wealth fund invests in energy-related projects. Stratton owns a couple of IPIC's bonds with maturities 2041 (denominated in US dollars) and 2021 (in euros). Amongst other holdings in the Middle East Stratton counts Kuwait Projects, Qatar's Nakilat, State of Qatar, the Central Bank of Bahrain, Taqa and Dubai Government.

"Some people in Europe, wrongly I think, consider a high percentage of 'AA' Middle-Eastern names to be risky. I would say having a high percentage in Eastern Europe would be risky, but lots of people have exposure there without worrying too much about it and they seem particularly upset by having double A credit in the Middle East," Seaman stresses.

"The risk is not nearly as high as people think," he believes. "Any problems in the Middle East are very likely to be impacted globally. It's very unlikely Brazilian or Venezuelan government bonds would be going up in a period of high tension in the Middle East."

In fact, one of the key attractions of investing in wealthy Middle-Eastern countries is their reliability. "When a government or central bank in the region say they're going to repay you their debt, they mean it," notes Seaman.

As for the massive infrastructure projects embarked on in the region, the London-based fund sees them as "tremendously positive."

"It's a win-win for both the investors that will lend their money and the countries who then become more developed and advanced and have the right infrastructure in place to deal with the next 100 years. Think of a country like Qatar. It ran up large current account deficits whilst they financed the development of oil and gas fields and as a result it's one of the richest countries in the world. So development projects that have an economic return in the future are very good," Seaman concludes.

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