Israel is funding war via ‘secret private placements’ of sovereign bonds

Carpet-bombing the densely populated Gaza costs money, and Israel has started to feel the pinch.

The size of Israel’s economy shrank by almost 20 percent in the last three months of 2023 on an annualised basis.

It’s expected to run the largest budget deficit – which is the gap between a government’s revenue and expenses in a given year – since the turn of the century.

Its all-out war on Gaza, which has killed more than 29,000 Palestinians, is going to widen the deficit to 6.6 percent of the country’s GDP, up two percentage points from a year ago.

Israel plans to bridge this funding gap by selling what Bloomberg calls “a near-record amount” of bonds. In dollar terms, the expected borrowing is roughly $58 billion, up one-third from the previous year.

Surprisingly, the cost of borrowing for Israel – which is reflected in the interest rate that bondholders receive for loaning money to Tel Aviv – has seen little change since the beginning of its war in Gaza post-October 7.

The relative indifference in the global debt market to the dollar-denominated bonds of a country that’s been at war for months seems out of the ordinary. After all, bondholders are supposed to be extremely sensitive to geopolitical issues that may affect a country’s future repayment capacity.

Analysts attribute the muted reaction of the debt market to Israel’s war in Gaza to multiple factors. One, Israel is mobilising up to 80 percent of its debt in the local currency through domestic sources. The country has a well-developed financial ecosystem with large, cash-rich institutional investors like pension funds eager to invest in government bonds as religion and economic strategy overlap amid war hysteria.

As for the dollar-denominated component of its fresh debt, Israel is relying heavily on “secret private placements”. Unlike regular bond issues that take place in public debt markets and have syndications and road shows, private placements are negotiated with select groups of investors behind closed doors.

As such, the cost of borrowing in these deals doesn’t become public. It’s generally believed that private placements result in a higher rate of interest than a typical bond issued via typical syndication because of limited investor participation.

Quoting unnamed analysts, the Financial Times says Israel’s bond issuances to help fund the war are viewed as controversial in some parts of the debt market.

Some investors view the fundraising as “anathema” because of the humanitarian cost of Israel’s invasion of Gaza, which has killed women and children, since last October.

Moreover, private placements may be reflective of investors growing “nervous” about buying Israel’s debt. Israel is “off benchmark” for many investors in terms of the environmental, social, and governance (ESG) risks, posing reputational damage to international bondholders.

Last week, Israel received an unprecedented snub from Moody’s Investors Service, which is one of the three major credit rating agencies that help investors assess a debtor’s repayment capacity. It downgraded the Israeli government’s issuer ratings for the first time in history for both foreign and local currency bonds.

Changing the outlook to negative, Moody’s said the war and its wider consequences have “materially raise political risk for Israel as well as weaken its executive and legislative institutions and its fiscal strength” for the foreseeable future.

But the growing political risk and a loss of fiscal strength have not deterred the US state governments and municipalities from pouring in hundreds of millions of dollars in Israeli bonds since the beginning of the war. The country has raised over $1.7 billion in the United States since it invaded Gaza.

Israel mobilised this money mainly through the Development Corporation for Israel, also known as Israel Bonds. These bonds are different from other international dollar-denominated debt instruments in the sense that they can’t be sold in a secondary market and, therefore, must be held to maturity.

While the structure may be better suited to the needs of a retail clientele, institutional investors usually view held-to-maturity investments unfavourably. The absence of a secondary market means funds remain stuck in low-yield bonds for years on end - even if better investment options emerge later on.

Yet a large number of US states have ramped up their purchases of Israeli bonds in an explicit show of support for Tel Aviv’s war against Palestinians in Gaza.

With $135 million in purchases, Florida led the group of 14 US states that invested hundreds of millions of dollars to fund the Israeli war effort. Israeli bonds usually pay slightly higher rates of return than the US bonds of comparable tenors.

Given that Israel has foreign exchange reserves of $191 billion, enough to fund the war for about two years, the financial costs are unlikely to be “prohibitive” for Tel Aviv, according to Bloomberg Economics.

“What’s going to end the war isn’t economics, but domestic or international pressure as well as developments on the battlefield,” it says.