Iraq bondholders eye default risk as conflict escalates

LONDON — Escalating conflict in Iraq is making holders of the country's international debt nervous about whether they will get repaid.

The size of Iraq's dollar debt is relatively small — a $2.7 billion bond launched in 2006 in a restructuring of Saddam Hussein-era commercial debt.

But the bond is held by international investors — including Franklin Templeton, known for its bets on risky markets such as Ukraine — and is part of JPMorgan's closely watched NEXGEM index of frontier market debt, which has performed strongly over the past two years.

Advances by Sunni insurgents across northern Iraq and the emergence of an increasingly viable Kurdish state have got investors worried that Iraq could split. This could lead to a disruption of interest or maturity payments on the bond, particularly as there are no clear market guidelines about what might happen to the debt.

"There is no international framework for a sovereign debt restructuring. If the remaining state is not viable, it may lead to a sovereign debt restructuring — there are no rules," said Stefaan Loosveld, partner and restructuring specialist at law firm Linklaters in Brussels.

"The situation will be uncertain, not to say messy," he remarked.

Iraq had been a popular play with some frontier investors because of the oil producer's low debt and high foreign reserves. But the unrest changes that.

"We revised our view in Iraq and sold our overweight," said Marco Ruijer, emerging debt fund manager at ING Investment Management in The Hague. "We still do not think rebels from the Islamic State of Iraq and the Levant can conquer Baghdad...but they certainly increased their influence."

Iraq's bond, which matures in 2028 but starts paying principal from 2020, has fallen 8 cents in the past week, to 87 cents on the dollar.

Iraq's five-year credit default swaps, used to insure against debt restructuring or default, are trading at multi-month highs above 400 basis points, according to Markit.

Ivory Coast 

Although there are no rules on sovereign debt restructuring, there are precedents.

Ivory Coast stopped making interest payments on its dollar debt during a civil war in 2011, though it has subsequently resumed them.

If a country changed its name or borders it could repudiate its debt, legal specialists said, though this is not a given.

Countries such as Czechoslovakia, which split in two in 1993, were able to make an amicable division of debt.

But this is likely to be harder in the case of Iraq.

"Importantly, [Czechoslovakia] was a consensual split and the creditor countries had the feeling that they would still be paid by the successor states," said Loosveld. "A consensual split with an agreement on the debt division is not likely in a civil-war scenario."

Iraq's next coupon payment of $150 million, due in mid-July, is unlikely to come under threat, analysts said. But the conflict is pushing up the default risk.

"Given the deteriorated security situation...a full partition, if it takes place, would be more likely to occur in a violent fashion," said analysts at Bank of America Merrill Lynch in a client note. "This would most likely be accompanied by a default event on external debt."

Two-way trade

But not everyone is so concerned.

Bill Blain, strategist at brokerage Mint Partners, told Reuters Insider television there had been strong two-way trade in the bond. 

"The shock has driven most people...to be very concerned, or driven them right out of the market," Blain said, but added: "We've seen buyers who think potentially we are headed towards a good solution."

This may explain why the bond is at three-month lows, but has not fallen further.

Iraq's CDS are also well below record highs above 600 bps hit in 2009, at the height of the global financial crisis.

BoA-ML analysts said a separate Kurdish state would be unlikely to shoulder any of Iraq's debt but added they did not think any ceding to that state of territory and oil would be "materially credit-negative to Iraqi external debt".

The Balkans war in the early 1990s and the collapse of the former Soviet Union in 1991 also failed to lead directly to default of debt, which is reassuring some investors.

"The Czech Republic, Yugoslavia and Russia are all good precedents — as long as there was an official successor state that recognised the debt, investors would still be paid," said Richard Segal, analyst at Jefferies.

Iraq's role as the second-biggest oil producer in the Organisation of Petroleum Exporting Countries may also support its debt.

"Financial resources remain plentiful," Segal added.