A revival of international bond issues from the Gulf is set to draw heavy demand from local and foreign investors, despite the latest geopolitical upheavals in the Middle East and the approach of higher U.S. interest rates.
Gulf bond issuance has dried up since early July, because of a traditional summer lull in local investor activity as well as global market instability due to the crisis in Ukraine.
During that period, tensions in some parts of the Middle East have worsened dramatically. In June, Islamic State militants in Iraq stepped up a campaign that threatens to dismember the country; fighting in Libya has intensified, and Yemen’s government has moved closer to collapse. Israel has launched a war against Palestinian militants in Gaza.
On the face of it, that is a poor environment for a series of Gulf bond issues which is expected to start next month, and is likely to include a sovereign sukuk from the Emirate of Sharjah as well as a sovereign U.S. dollar conventional bond from the Kingdom of Bahrain.
But the vast majority of investors have decided that the geopolitics do not come close to posing any existential threat to the rich Gulf Cooperation Council economies.
That means next month’s bond issuers will be able to demand favourable terms as investors focus on the GCC’s economic strengths, including big current account and budget surpluses that set it apart from many other emerging markets.
“While geopolitical fears are always on foreign investors’ minds, they are unlikely to temper any demand for solid credit stories in the likes of Abu Dhabi, Dubai and Qatar for example,” said Anthony Simond, a London-based emerging market debt analyst at Aberdeen Asset Management.
Over the last few months, only a small amount of foreign money has been withdrawn from Gulf bonds in response to political events in the Middle East – and it has been easily offset by fresh inflows of money from local funds, said Zafar Nazim, credit analyst for the region at JPMorgan.
“Dedicated emerging market funds are staying put in the region and consider the region a safe haven,” he said, noting that some GCC economies – especially Dubai – were still attracting capital flight from less stable countries in the Middle East, Africa and South Asia.
International bond issuance from the Middle East shrank 16 percent from a year earlier to the equivalent of $22 billion in the first half of 2014, according to data from Thomson Reuters and Freeman Consulting. The drop occurred largely because cash-flush banks in the Gulf are eager to lend and offering rock-bottom pricing on loans.
But the process of loans replacing bonds may be close to reaching its limits, for several reasons. One is that issuers are looking ahead to higher U.S. interest rates as soon as next year, which would work through the Gulf’s currency pegs to boost local loan rates.
Some issuers want to maintain or establish presences in the bond market now, so that they have another option when the loan market eventually starts to tighten.
“Many names are looking to tap the bond/sukuk market to take advantage of low coupons and also to replace bank borrowings, where they see upward re-pricing risks,” said Stuart Anderson, Middle East head at credit rating agency Standard & Poor’s.
In the United Arab Emirates, there are two additional motives for issuance. Last November, the central bank announced caps on banks’ exposure to local governments and the companies linked to them. Banks have five years to comply with the rules, but in the long run they are likely to push many state-run firms towards financing via bonds.
Also, Dubai is keen to develop itself as a centre for Islamic finance; one way to do so is encouraging sukuk issuance.
These factors are expected to push international bond issuance to resume in September as bankers and investors return from summer holidays and issuers decide they can wait no longer.
The first issue may be from Sharjah, which appointed HSBC, National Bank of Abu Dhabi and Standard Chartered earlier this year to manage a debut sukuk. The Sharjah deal, likely to be at least $500 million, is expected to hit the market in early September, a banker with knowledge of the deal said.
DIFC Investments, the investment arm of the company running Dubai’s financial free zone, may follow soon afterwards with a sukuk deal. The issue may aim to refinance a $1 billion syndicated loan which DIFC took out in May 2012, a banker said.
Bahrain has hired four banks including Citigroup, Gulf International Bank and Standard Chartered to arrange its sovereign bond issue, and has plans to issue before the end of the year, bankers familiar with the plan said.
Meanwhile, Bahrain’s Gulf Finance House said this month that it planned to issue $200 million of sukuk “in coming months” to repay outstanding debt and for acquisitions; the paper would be listed on NASDAQ Dubai.
Other issues from firms in Dubai and Qatar are possible but less certain in coming months, bankers said. In June the Emirate of Ras Al Khaimah sent requests for proposals for a sukuk deal, but it has since sent RFPs for a syndicated loan, casting doubt over whether the sukuk sale will go ahead.
Anderson said there had been strong interest among some government-related enterprises, companies and smaller banks in the Gulf in seeking credit ratings over recent months, possibly in preparation to issue bonds. He declined to name the firms.
The primary market is likely to have no problem coping with this surge of issuance, even if geopolitical tensions in the region worsen further. That’s because most investors – foreign as well as local – believe the GCC has managed to insulate itself from the turmoil.
The Arab Spring uprisings of 2011 were seen as potentially a much bigger threat to stability in the Gulf, because they were domestic threats to the stability of governments. Since GCC authorities showed they were able to cope with that crisis, the markets are largely unconcerned about sectarian conflict in non-GCC countries such as Iraq.
“The Arab Spring stress-tested this region and the results were largely positive,” said one international fund manager in Dubai.
In late June, one-year U.S. dollar/Saudi riyal forwards – commonly used as a proxy for risk in the region – briefly jumped to their highest level since 2011 as events in Iraq triggered a burst of hedging activity by foreign banks in thin volume. But forwards began retreating on the following day, and are now back at their previous levels.
The cost of insuring Dubai bonds against non-repayment with credit default swaps rose as much as 37 basis points between late June and early August. But that followed an 80 bp drop to six-year lows since the beginning of this year.
CDS for China and Indonesia rose between 20 and 25 bps during the same period, suggesting Dubai’s move was mostly due to global trends; its move may have been relatively sharp because of historically greater volatility and lack of liquidity.
“We have not seen any significant outflows in foreign liquidity to-date, though in recent weeks international investors have shown a preference for shorter-dated instruments,” said Mohsin Ali Nathani, chief executive for the UAE at Standard Chartered Bank.
“In our numerous conversations with local and international investors, we continue to note an optimistic tone towards participation in local deals and we don’t anticipate this to change in the near future.”
More than geopolitics, the biggest threat to the Gulf’s primary bond market may be expectations for U.S. interest rates. The currency pegs mean eventual U.S. rate hikes are expected to feed through into official Gulf interest rates quickly.
But because of its current account and budget surpluses – and in Bahrain’s case, the implicit financial support of Saudi Arabia – the Gulf looks likely to outperform most emerging bond markets if U.S. rate hikes cause global instability.
This year the “Gulf premium” – the mark-up that issuers in the Gulf have to pay over developed-country issuers when they sell similarly rated paper – came close to disappearing as the region gained ground as a mainstream investment destination.
In recent weeks the premium has widened slightly, but traders and analysts attribute this to low secondary market activity in the Gulf during the summer rather than to any change in investor perceptions of the region.
The spread of Abu Dhabi’s dollar bond maturing in April 2019 above Canada’s December 2019 U.S. dollar bond , which was 16 bps in mid-June, has widened back to 28 bps. Canada is rated two notches higher than Abu Dhabi.-Reuters