Lebanon Debt Defies War Turmoil to Lead Region: Riskless Return

With war in neighboring Syria, unrest at home and one of the world’s highest debt burdens, Lebanon doesn’t look like a safe haven -- unless you’re a bondholder.

Lebanese government bonds, rated five levels below investment grade at Standard & Poor’s, have returned almost 12 percent since 2008 when adjusted for volatility, beating Turkey, Israel and Jordan, which also share a border with Syria, according to the BLOOMBERG RISKLESS RETURN RANKING based on Bank of America Merrill Lynch indexes. Bonds in the BofA Merrill Lynch Emerging Markets External Debt Sovereign Index returned 7 percent.

The bonds are mostly held by domestic banks with assets almost four times the size of the economy, thanks to a flow of remittances that survived turmoil following the killing of former Prime Minister Rafiq Hariri in 2005 and a monthlong war with Israel a year later. Helping lure the money is a dollar peg maintained since 1993 under Central Bank Governor Riad Salameh and defended by record foreign reserves.

“It would take a lot to substantially upset the core of Lebanese bond investors,” said Philippe Dauba-Pantanacce, senior Middle East economist at Standard Chartered Plc in London. “Any questioning of the peg would certainly lead to massive pressures on the bond market, something we do not envisage in the short to medium term.”

Proxy Wars

Lebanon, a nation that has been a battleground for proxy conflicts in the Middle East, accumulated most of its $34 billion in dollar-denominated bonds as it sought to rebuild after a 15-year civil war ended in 1990.

The majority of the bonds are held and supported by local lenders such as BLOM Bank Sal, Byblos Bank SAL and Banque Audi Sal. That’s the only junk-rated debt domestic banks are allowed to buy, under rules enforced by Salameh, a former Merill Lynch & Co. banker, to curb risk-taking in proprietary trading.

Because they own so much of Lebanon’s Eurobonds, domestic investors tend to support the debt during emerging-market declines, when foreign holders avoid riskier assets, said Ray Majdalani, senior fixed-income trader at Beirut-based investment bank Cedrus Invest Bank Sal.

Region’s Best

“If you own $2 billion in Lebanese bonds, and there is a $30 million seller, you will buy him off because otherwise it can affect your whole book,” he said by e-mail. When the bonds tumbled after the collapse of Lehman Brothers Holdings Inc. in 2008, “local banks absorbed all the supply,” he said.

Since the financial crisis, buyers of Lebanese bonds recorded returns of 11.6 percent on a risk-adjusted basis, compared with 9.3 percent for Israel, rated 10 levels higher at Standard & Poor’s at A+, 4.9 percent for Turkey and 3.6 percent for Jordan. Lebanese debt had a total return of 53 percent, second-best in the group, and a volatility of 4.6, the second lowest.

The returns, which aren’t annualized, are calculated by dividing total return by volatility, or the degree of daily price-swing variation, giving a measure of income per unit of risk. A higher volatility means the price of an asset can swing dramatically in a short period of time, increasing the potential for unexpected losses compared with a security whose price moves at a steady rate.

The bonds posted a negative risk-adjusted return of 0.2 percent this year, the third-best performer in the group after Jordan and the emerging-market index.

Refugee Flood

The debt has held up even as the conflict in Syria weighed on investments and tourism revenue, driving average economic growth in the last two years down to 1.5 percent, compared with 7 percent in 2010, according to International Monetary Fund data.

Syria’s conflict has triggered an influx of hundreds of thousands of refugees into Lebanon, and caused sporadic clashes between Sunni Muslim opponents of Syrian President Bashar al-Assad and his supporters in the northern Lebanese city of Tripoli and other areas.

Violence has escalated as the Hezbollah Shiite militant group sent fighters to back Assad’s regime as it fights mainly Sunni rebels. More than a dozen people were killed in August when a car bomb exploded in an Hezbollah-dominated southern suburb of Beirut, the capital of Lebanon. The group blamed the attack on radical elements among Syrian rebels. In the same month, two explosions targeting Sunni worshippers in Tripoli killed as many as 50 people.

‘Massive Impact’

The unrest has left some investors uneasy about buying Lebanese debt.

“There could be massive impact on both growth and fiscal accounts and investors’ confidence could disappear and with it the liquidity,” said Jean-Dominique Butikofer, head of emerging-market debt at Union Bancaire Privee in Zurich, an investor in the debt. Butikofer said he has refrained from adding more bonds to his holdings amid the crisis.

Lebanon’s budget deficit widened to 9 percent of economic output last year from 6.1 percent in 2011, according to IMF data. Net public debt is set to increase to 136 percent of gross domestic product in 2013 from 134 percent a year earlier.

The ratio is still lower than the record 177 percent it reached in 2006, when Hezbollah and Israel fought a war in July. Egypt, embroiled in political turmoil since 2011, will have a debt-to-GDP ratio of 75 percent this year, according to the IMF.

Private Deposits

Bank deposits are growing at 8 percent this year, compared with 7 percent in 2012, mainly fueled by non-residents, Salameh, the central bank governor, told reporters on Sept. 29 in Abu Dhabi.

Economic growth will probably accelerate to 3.3 percent in 2014 and 3.9 percent the following year, according to the median forecast of economists surveyed by Bloomberg.

Mohammad Safadi, Lebanon’s caretaker finance minister, said while his country is “encountering major economic and social problems associated with the Syrian crisis,” there is no risk of it sliding back into civil war.

Lebanon’s debt benefits from a “well-deserved reputation for having a loyal domestic investor base and a resilient financial sector,” he said in an e-mailed response to questions on Sept. 26.

Lebanon’s credit risk has dropped 50 basis points, or 0.5 percentage point, this year to 400 on Oct. 8, according to data compiled by Bloomberg. By contrast, the average cost for protection against default for 10 sovereign Arab issuers, including AA rated Qatar, rose 13 basis points this year.

Morten Bugge, chief investment officer at Kolding, Denmark-based Global Evolution, said he’s waiting for an opportunity to buy.

“We are watching the situation,” he said by phone. “We have been in and out over the years. Right now we’re not in, but that could change. Lebanese bonds have been holding up very well but we probably like to see a better entry point.”

To contact the reporter on this story: Alaa Shahine in Dubai at asalha@bloomberg.net

To contact the editor responsible for this story: Andrew J. Barden at barden@bloomberg.net

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