Mutual Funds Look Beyond Chaos In Iraq

Wall Street Journal

March 17, 2006

By JENNIFER LEVITZ
March 17, 2006; Page C1

Considering the strife bordering on civil war, this may not seem like the best time for mutual funds to put money into Iraq.

But some are doing just that. Looking for high yields -- and confident that oil reserves will be there to repay the debt -- mutual funds are among the investors quietly buying small chunks of about $2.8 billion in bonds issued by the Iraqi government in January as part of its restructuring of debts left by Saddam Hussein.

T. Rowe Price Group Inc., based in Baltimore, says about $16 million of its $558 million Emerging Market Bond Fund is invested in the new Iraqi bonds. Standish Mellon Asset Management Co., of Boston, says it has about $2 million in Iraqi bonds, spread out among some of its emerging-market mutual funds. It declined to identify the funds but said they had a total of $400 million in assets.

ING Group and Merrill Lynch & Co. recently showed up on a brokers-only computer network as bidders for the Iraqi bonds, one person with access to the system says. It couldn't be learned whether the firms were interested as buyers for their own accounts or for customers. Merrill and ING said they couldn't comment on interest in Iraq.

John Peta, a portfolio manager for emerging-market strategies at Standish Mellon, isn't surprised that the topic is touchy. "Given what's going on in Iraq, people don't want to fess up to owning" Iraqi debt, he says.

Interest in Iraq is a sign of how hungry some fund managers have become for high-yielding issues that can satisfy investors in emerging-markets bonds, which have been on a hot streak. During the past three years, diversified emerging-market funds have earned an average 36% annual return, according to Chicago fund-research firm Morningstar Inc. Investors put $10.1 billion into emerging-market bond funds in 2005, more than double the amount in 2003, according to Emerging Portfolio Fund Research, of Cambridge, Mass.

Iraq attracts some investors hungry for yields.

Scouring ever-riskier corners of the globe, U.S. money managers once considered Nigeria exotic, but not anymore. Places like Kazakhstan, Lebanon or Serbia are beginning to appear acceptable as places to invest. Few countries, it seems, are off-limits, Don Phillips, managing director of Morningstar, says. "If there are pockets of yield, fund managers are going to be attracted."

The new Iraqi bonds, which haven't been rated by any of the major credit-rating companies, are due in 2028 and were issued with a 5.8% interest rate. After the recent Sunni-Shiite violence, the market value of the bonds has dropped to just above 68 cents on the dollar, which turns into a yield of 9.5%. That is the highest yield -- and riskiest profile -- of any dollar-denominated sovereign debt, besides Ecuador, according to Emerging Portfolio Fund Research.

Many troubled countries have issued bonds to recover from strife or economic crises, and they can sometimes be good bets. Brazil's 40-year bond issued during the country's economic crisis in 2000 has steadily gained value since 2003. But investors were burned by Argentina's default on $141 billion in government debt in 2001, which left holders with 34 cents on the dollar.

Some put Iraq in a class by itself. Morningstar's Mr. Phillips hesitates to even call it an emerging market; he prefers "pre-emerging" market.

"It's unthinkable," says Arijit Dutta, an analyst who follows emerging markets at Morningstar. "If you're betting on Iraq's debt, you have to take a guess as to what it's going to be like" when U.S. troops leave, which he sees as extremely difficult to predict.

Indeed, individual investors aren't jumping in. Jones Cavanaugh, a 50-year-old radiologist who lives in Pinetop, Ariz., for instance, says he actively invests in emerging markets and dabbles in Vietnamese, Thai and Korean markets. But he won't touch Iraq, which he says is "unstable as all get-out."

Iraq is so dangerous, money managers who travel the globe researching emerging-market debt won't go there. They are meeting Iraqi officials in places like Jordan.

A pariah in the international capital markets since the first Gulf War in 1991, Iraq is trying to clean up its debt to get back into good standing. The country got a big head start last year when 19 nations, including the U.S., Japan, Russia, and European countries, agreed to write off 80% of the $38.9 billion Iraq owed them.

But Iraq also had some $14 billion in unpaid commercial claims accumulated under Mr. Hussein, including debt owed to banks and to individual companies. Negotiating through financial advisors, J. P. Morgan Chase & Co. and Citigroup Inc., Iraq offered the commercial creditors notes -- or bonds -- with a face value of $20 for every $100 of claims. In all, about $2.8 billion in bonds were issued. But after getting the bonds, many creditors didn't want to hang on to them -- so in January they began selling to investors.

If things go right, Iraq could be a very wealthy country, say both Mr. Peta of Standish Mellon and Mike Conelius, portfolio manager of Emerging Market Bond Fund at T. Rowe Price. They say they believe that if the country stabilizes, it will have more than enough in oil revenue to meet its debt obligations from its 115 million barrels of proven reserves, the third largest in the world behind Saudi Arabia and Iran.

Though the U.S. hasn't guaranteed the bonds, or promised to do so, Mr. Peta says he takes "comfort" in knowing the U.S. has a strong stake in supporting Iraq.

Iraq still has plenty of debt that hasn't been forgiven, including $40 billion owed to Saudi Arabia, $20 billion to Kuwait and $15 billion to China. Mr. Peta says he believes some of these countries will follow the first group in further easing Iraq's debt load. And he sees the country getting a boost from Middle East investors, who are flush with oil revenue and want to invest in their own region.

J.P. Morgan on March 3 had a conference call with investors and Ali Allawi, Iraq's minister of finance, about recent violence and "debt sustainability." According to a Morgan report on the call, Mr. Allawi said oil revenues were down because of attacks on northern pipelines.

Nonetheless, he said, the "medium-term outlook is that of a united country with sufficient stability to ensure that sovereign-debt obligations are honored."

Write to Jennifer Levitz at jennifer.levitz@wsj.com1