|Date||24 SEP 2020|
In our last report dated 12-May-20, we highlighted the fact that Sri Lanka will not default this year. We also compared Sri Lanka with its closest Asian peers such as Mongolia, Papua New Guinea, Tajikistan, Pakistan, and Iraq. In this report, we update with recent events on the country and relative valuation of Sri Lanka’s SRILAN complex.
Despite deterioration in macroeconomic fundamentals (falling revenue vs. USD1bn debt instalment in October) further worsened by COVID-19, we remain confident that it is unlikely for Sri Lanka to default on its debt obligations in the next 12 months, given its success in securing new credit facilities partially offset by a suspension of IMF Extended Fund Facility (EFF) this month.
S&P’s downgrade of Sri Lanka’ s issuer credit rating to B- from B should lead to Moody’s downgrade of the same rating to B3 from B2 in October in the worst case scenario of which we do not believe investors will be surprised with. We have viewed Sri Lanka as a B- sovereign credit and at the “B-“ range, and we see the SRILAN complex as attractive versus peers despite a rally. We like SRILAN 21s to 24s as the most attractive within the SRILAN complex and assign our OVERWEIGHT recommendation. We assign a NEUTRAL recommendation to the rest of the SRILAN complex.
The Asian USD bond universe has outperformed since many countries exited the first wave of COVID-19. Our base case scenario calls for the mass adoption of vaccines to be at least a year away and we expect the default trend to head upward and the global economy to slowly make a comeback, starting in 2022. That said, we expect a depressed yield environment to make Asian USD bonds attractive versus developed market USD bonds. That said, we expect defensive sectors such as sovereign, telecommunications, utilities, insurance, and defence to outperform cyclical sectors towards 2021. We also like issuers which will be supported implicitly and explicitly by sovereign credits.
A Debt Update
Sri Lanka’s external debt was c.USD58.1bn in December, of which more than 10% is owed to China. Foreign exchange reserves rose to USD7.4bn in August from USD7.1bn in July. The ratio of external debt to foreign reserves was well within 10x which is a “B-“ range, in our view. The country’s debt service obligation was USD4.6bn this year with c.USD2.5bn remaining to be paid from now until the end of the year (USD1bn in October), according to the government. The Sri Lankan government said it is comfortable to pay back foreign debt in 2020 and expects new borrowings to be taking place in time for the proceeds to pay back debt services next year. We expect Sri Lanka to use its foreign exchange reserves and foreign direct investments as well as additional credit facilities to pay back its debt services this year and do not expect the country to default at least in the next 12 months.
So far, Sri Lanka has secured: (1) USD300m loan from Asian Development Bank; (2) USD86m loan from Asian Infrastructure Investment Bank; (3) USD400m in 9-month currency swap facility with the Reserve bank of India in July, and (4) USD500m 10-year term loan from China Development Bank in March. We understand Sri Lanka is still in the process of seeking a debt moratorium for 2021 and seeking additional loans from multilateral development bank (which, in our view, can lend more to Sri Lanka as the country’s exposure at those banks remain minimal). On the other hand, the IMF suspended Sri Lanka’s ongoing USD1.5bn EFF as the Central Bank of Sri Lanka does not wish to go through IMF’s conditions. We note that the Central Bank opts to apply for IMF’s Rapid Financing Facility (RFI) for USD800m.
A key political event since our last report is Mahinda Rajapaksa’s landslide victory in a PM election on 5-August. Mr. Rajapaksa is viewed by the market as pro-China, in our opinion, and that means Sri Lanka will move closer to China which could come in handy to help Sri Lanka on its debt situation. We also believe China has a strategic interest in Sri Lanka on Sri Lanka’s location on China’s maritime Belt & Road Initiative. China’s lease of Sri Lanka’s Hambantota Port in 2017 for USD1.1bn for 99 years stirred controversy although a large portion of the lease proceeds are used to repay non-Chinese lenders. A closer tie between China and Sri Lanka could also upset Sri Lanka’s relationship with India, which, in our view, is as important as Sri Lanka’s relationship with China. Mr. Rajapaksa’s victory, at the very least, will give Sri Lanka more options to consult with China on its debt situation.
Overall, we believe Sri Lanka’s debt situation has improved but not to a level that investors are looking for. We expect one more downgrade from Moody’s in a worst case scenario (See Rating Actions below) but we also do not expect many negative surprises in the near term. In general, we are looking for the following events in the next 12 months as a spread-positive event:
- The government is successful in securing funding to service external debt this year without overly destabilizing the macroeconomy;
- The appeal for debt moratorium succeeds, and
- Necessary reforms are carried out to ensure Sri Lanka’s economy will be back on a healthier track (See our Sri Lanka report dated 20-May).
S&P followed Fitch and downgraded Sri Lanka’s issuer credit rating to B- from B on 20-May but keeps the outlook at stable (versus Fitch’s negative outlook). Given Moody’s current review of Sri Lanka’s B2 rating and Fitch’s 24-April downgrade, S&P’s downgrade is not a surprise. We believe the market also expects Moody’s to downgrade Sri Lanka to B3 when the agency concludes the review perhaps in October on the prolonged COVID-19 crisis, a lack of progress toward appealing for debt moratorium, and the suspension of IMF EFF. We have seen Sri Lanka as a “B-“ credit and we believe Moody’s upcoming downgrade is irrelevant at this point. A rating affirmation, which we believe is unlikely, would be a major spread-positive for the SRILAN complex, on the contrary.
The SRILAN complex remains attractive versus its “B-“ peers even after a recent rally. EXHIBIT 1 shows the SRILAN credit curve quoted with a significant spread against its Asian B- peers.
EXHIBIT 2 shows the SRILAN complex in different maturities. We see the bonds in three maturity groups: 2020s, 2021 to 2024s, and 2025s and beyond.
SRILAN 20s will mature in less than 2 weeks and YTM (ask) rallied from 18% to 16.5% in a week as we believe the market now expects the bonds to be repaid. The price is now very close to par (99.7c) at the time of this report and we do not believe it is worth getting into the bonds now. As such, we assign a NEUTRAL recommendation on SRILAN 20s.
SRILAN 21s to 24s yielded from 14% to 18% and SRILAN 25s to 30s yielded c.12% at the time of this report. EXHIBIT 3 shows outperformance of the SRILAN complex, excluding SRILAN 30s, since July. At YTM of 14% to 18% (ask), we see SRILAN 21s to 24s as most attractive among the SRILAN complex. As such we assign an OVERWEIGHT recommendation for SRILAN 21s to 24s. For SRILAN 25s to 30s, we believe these bonds remain attractive despite the fact that they are less attractive than SRILAN 21s to 24s, in our view. As such, we assign a NEUTRAL recommendation on SRILAN 25s to 30s.
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