At a time when developing market debt is not the most favored asset class, debut issuer Azerbaijan’s recent E1.25 billion, 10-year Eurobond did remarkably well – and not just because the largest nation in the Caucusus region has oil.
According to Doug Coté, chief market strategist for ING U.S. Investment Management, the success of the Azerbaijani sovereign bond is largely a function of investors’ desire for investment opportunities that provide diversification within the broader developing markets asset class.
“There is a difference between the performance of frontier markets and emerging markets and as an investor, you want to put frontier markets in your portfolio now and wait for three to five years because longer-term, frontier markets are going to continue doing better than emerging markets,” he said. “Frontier markets have lower debt -to-GDP ratios than emerging markets, they have a younger workforce, and they are usually commodity centric. Azerbaijan, which has oil and gas, fits all those frontier market themes, so it’s good for investors to have it in their portfolios.”
“What you can say about Azerbaijan and other small issuers is that they offer a way to diversify within an asset class that is actually pretty highly concentrated,” agreed Clem Miller, investment strategist for Wilmington Trust Advisors. “There are a few countries that dominate the indices for emerging markets sovereign debt – Russia, Turkey, Indonesia, Mexico and Brazil – so there’s a premium for being able to diversify to other countries, and the diversification desire did, in this case, outweigh the broader issues affecting emerging market bonds.”
Azerbaijan was also able to successfully place its bond at a time when tensions in the broader Central and Eastern European region are high as a result of Russia’s involvement in Crimea. But that issue isn’t likely to affect the nation at all, according to Daniel Broby, former CIO for London-based boutique investment firm Silk Invest and an expert on frontier markets. Although Azerbaijan, like Ukraine, is a member of the Commonwealth of Independent States (CIS), “there is little love lost between Azerbaijan and Russia, the latter having destroyed much of Azeri culture,” Broby said. “Unlike in Ukraine, few in Baku [the Azeri capital] are yearning for Russian assistance.”
However, Azerbaijan is susceptible to tensions on the border it shares with long-time rival Armenia, since the two countries have been in a fiery conflict over the region of Nargorno-Karabakh.
Armenia, which is a poorer nation and far more indebted than Azerbaijan, issued its first Eurobond last year. Dubbed the “Kardashian Bond,” proceeds went to repay a bilateral loan extended by Russia during the financial crisis. Armenia has also reportedly lauded Russia for its involvement in Crimea.
Although geopolitics may be a concern, Oil, of course, is the key word for Azerbaijan and the medium term production of oil is key to its future rating, said Charles Seville, director in Fitch Ratings’ sovereign and international finance group. Oil output, which increased significantly after 2004 and the discovery of a new field, is stabilizing after a 15% decline since its 2010 peak, he said, thereby improving the short-term outlook for growth and public finances, and the country’s oil fund grew last year by $1.7 billion, topping out at $35 billion.
Azerbaijan indeed is set from impressive growth on the back of increased recovery in the country’s crude oil reserves, Broby agreed and “as a result, its bonds benefit not only from their rarity value, but also from the ability to service them.”
However, it’s important for oil output to remain stable, just as Azerbaijan also needs to develop its non-oil economy and encourage diversification.
“Until now, growth in the non-oil sector has been driven in large part by government spending,” Seville said. “Construction has been the fastest growing sector and agriculture has also picked up significantly, but given the extent to which the government has funded these and other areas, the question is whether the non-oil economy can grow without its involvement. And that would also depend on the government’s willingness and ability to improve the business climate, since the economy is characterized by high levels of monopolization by a few business groups and transparency governance are definitely issues.”
Overall, however, the diversification opportunity that Azerbaijan presents, bolstered by its energy reserves, will continue to serve the country well as far as investors are concerned.
“The more issuers you have in an asset class the better it is,” Miller said. “This year, too, you have elections in most of the countries that form the emerging markets index: India, Turkey, South Africa and Brazil, among others, so there’s a lot of uncertainty associated with emerging market sovereign bonds in general. Any new entrant is therefore likely to be greeted well, even if they are somewhat risky.”