Saudi Arabia's monster bond offer balloons to $17.5 billion as deal launches

Saudi Arabia launched a $17.5 billion sovereign offering Wednesday in its first foray into the international bond market, drawing strong demand for the dollar-denominated offer.

The debt offering is a key part of the kingdom's economic reform plan as it would give Saudi Arabia a sovereign benchmark that would help open its capital markets for future offerings, such as corporate issues. It also is a necessary boost to cash flow to help the country withstand a long downturn in oil prices.

The deal was initially expected to be $10 billion-$15 billion, but demand was strong with a total order book of $67 billion. According to Informa Global Markets, the offering is the largest Middle Eastern sovereign deal and is now the largest emerging market deal, surpassing Argentina's $16.5 billion debt offering earlier this year. Moody's rates the Saudi bonds as A1 with a stable outlook and Fitch rates them AA- with a negative outlook. Argentina was a high-yield issue.

Final pricing terms were more favorable than initially anticipated, tighter by more than 20 basis points per issue. The $5.5 billion in five-year notes are expected to yield 135 basis points over the U.S. five-year Treasury; the $5.5 billion 10-year notes are expected at 165 bps over the U.S. 10-year and the $6.5 billion 30-year is expected to yield 210 over the U.S. long bond. The final deal pricing and allocations are expected at about 3 p.m. EDT.

Saudi officials ended a weeklong roadshow for the multi-tranche dollar offering with an investor meeting in New York on Tuesday.

Strained by low oil prices, Saudi Arabia would use the proceeds for operating expenses. While far richer than other producers, the kingdom has been running a deficit and has been forced to take painful cost-cutting measures, such as trimming and paring wages for public workers and ministers. The deficit in 2015 was a record at nearly $100 billion.

The kingdom has targeted balancing its budget by 2020, and it has been reducing expenses in a country where subsidies have been heavily used. The Saudi population is young, with half of all citizens younger than 25, and it's a country where there are not enough private sector jobs for workers entering the labor force.

"It'd be ambitious to close the gap by 2020. But they can reduce it drastically in coming years. They've been implementing many different measures, such as reducing water and energy subsidies and introducing VAT in 2018. They are likely to be partially successful in implementing their medium-term program, which should stabilize credit fundamentals," said Jerome Audran, emerging market analyst at UBS Wealth Management.

Saudi Arabia's "Vision 2030" economic reform plan, orchestrated by Deputy Crown Prince Mohammed bin Salman, is an effort to transform the Saudi economy into a much more diversified one, less dependent on oil revenue. Petroleum now accounts for 75 percent of its revenue, and bin Salman has proposed developing other industries, such as mining, finance and technology.

As part of the plan, shares are expected to be floated in state oil company Saudi Aramco to help the country build a large sovereign wealth fund. Investors were told the Saudi fund would begin to pay a dividend to the government.

Informa said the Saudi narrative around the issue and price will be key to "sending the right signal to markets, as the kingdom will want to demonstrate it can attract a deep and diverse pool of investors." Informa said price is also key because Saudi Arabia will need to return to the market.

Officials on the roadshow told investors of plans for a new "sin" tax on tobacco, and one investor said it could also include power drinks.

The investor described the Saudi comments as fairly candid for a country that has been viewed as not very transparent and ultra-conservative. During the roadshow, Saudi officials discussed the budget balancing goal, which they believe they could meet with oil prices in the current range.

"They did say they are considering the political impact of everything they do, including their ability to meet the 2020 budget target," the investor said. "They said they could balance the budget next year but the societal cost would be too great. They've taken into account political and societal costs."

That could change if the price of oil becomes more volatile again. Saudi Arabia and other members of OPEC have been trying to work out an agreement with non-OPEC producers on an output deal, in an effort to steady the price of crude. Just the talks alone have helped push oil prices over $50 a barrel.

On Wednesday, Mohammed Barkindo, secretary-general of the Organization of the Petroleum Exporting Countries, gave the oil market a boos t by saying he is confident about the prospects of a planned production cut after an OPEC meeting on Nov. 30. Saudi Arabia's energy minister, Khalid al-Falih, also helped lift prices when he said he believes oil market fundamentals are improving, and the downturn is coming to an end.

Audran said the Saudis have been depleting foreign exchange reserves at a pace of more than $9 billion a month as of July, and it is realistic for the kingdom to use the bond for operating expenses instead of FX reserves. Those reserves started to decline in January 2015, not long after OPEC embarked on a policy of letting the market set oil prices, a plan that resulted in plummeting crude prices. The country's foreign exchange reserves stand at about $550 billion.

Even without an agreement among oil producers, the crude market is already in the process of rebalancing and analysts mostly expect higher prices next year.

"I think the debt deal is a key policy priority," said Helima Croft, global head of commodities strategy at RBC Capital Markets. "Borrowing gives them a little more breathing room on their foreign exchange reserves. If they keep draining their FX reserves, people will question the Saudis' ability to maintain the currency peg."

More from Global Investing Hot Spots:
Monster $15 billion+ Saudi debt deal gets set to hit market
Saudi Arabia finds a new, $15 billion way to battle oil cash crunch
Op-Ed: How the Middle East can recover from the oil crunch

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