(Bloomberg) -- Trading in Lebanon’s defaulted sovereign bonds has jumped in the past two weeks as Israel escalated its military campaign against Hezbollah.
The unusual uptick in interest for the defaulted notes is a result of long-shot bets that whatever comes after the conflict will be better for investors than the status quo. Traders are buying the debt on the idea that Lebanon’s best prospects for reform hinge on a weakened Hezbollah, the Iran-backed militia that holds an outsized influence over Lebanese politics
While investing in Lebanon now may well be “wishful thinking,” the trade is also “highly asymmetrical,” according to Soeren Moerch, a portfolio manager at Danske Bank.
By that, Moerch means it’s cheap. Buying Lebanon’s defaulted bonds costs an investor pennies on the dollar, and prices “could go to around 25 if Hezbollah is removed and some kind of solution is found,” he said. “We invested with the idea that Israel’s attack on Hezbollah would be the ‘tipping’ point - that would turn Lebanon into a country with some hope for prosperity again.”
Hezbollah is designated a terrorist organization by the US and regularly engages in fighting with Israeli forces, breaking into a full-blown war and Israeli invasion of Lebanon in 2006. It also has a political wing and has held seats in Lebanon’s parliament since the 1990s.
Betting on the group’s setbacks sent Lebanese bond prices to their highest levels in more than two years this week.
Nine of the country’s dollar bonds ranging in maturity from 2026 to 2037 have moved to trade closer to 9 cents, compared with an average of around 6.5 cents for most of this year. On paper, that translates into an almost 40% return for bondholders over the past month, the biggest in emerging markets, though the securities remain in default, with little progress on restructuring or relief.
“One possible fundamental explanation for this move up in the eurobonds is that the severe degradation of Hezbollah (both as a formal political party and as a de facto ‘state within a state’) will redraw the party political map of Lebanon,” Tellimer’s Hasnain Malik said in a report on Tuesday. While much else would need to happen for that to be possible, a degraded Hezbollah “may allow for more market-friendly alternatives in government.”
Still, except as a signal of long-term prospects, Lebanon’s bond rallies have little meaning on their own. The market remains broken and the defaulted state shows no sign of imminent change. Investors demand 252 percentage points to leave the safety of US Treasuries and take exposure to the country, which in reality means the notes are seen by the majority of investors as untouchable.
“The spike has been driven by the idea that the Israeli attacks will weaken Hezbollah and that could eventually lead to a resolution for Lebanon’s defaulted bonds,” Bruno Gennari, a strategist at KNG Securities LLP, wrote in a note. “Hezbollah has been seen as one of the main opponents of market-friendly reforms and a key obstacle to the restructuring of Lebanon’s debt.”
Crises, Default
Since Lebanon stopped meeting international payment obligations in 2020, its gross domestic product has shrunk to a fraction of its former level, hyperinflation has pushed most of its citizens into poverty and its sources of foreign funding have dried up. Reforms necessary to end the spiral following a banking crisis and currency collapse haven’t even begun.
The country now faces a daunting post-conflict agenda to enact economic and political reforms that would allow money to start flowing in again. Yet Lebanon barely even has a functioning government, with a caretaker administration in power since 2022 and no president in place following several failed election attempts since then.
“The country has been in political paralysis for some time,” said Kaan Nazli, senior economist and portfolio manager at Neuberger Berman Europe Ltd. “There’s a lot of uncertainty, but to the extent that Hezbollah weakens and de jure institutions become stronger, there’s hope for headway on issues that investors have been waiting for for some time: electing a president, forming a new government that can move to pass IMF reforms and start debt-restructuring talks.”
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