Bond markets in acceleration
Dr. Nawazish Mirza, Associate Professor of Finance and Director Industry Interface Projects at SP Jain School of Global Management provides an analysis of trends across the GCC’s debt capital market.
The debt market enhances economic efficiency by facilitating cost effective intermediation and risk allocation. A transparent and well-functioning fixed income market provides favourable fundamentals such as funding stability, safer yields, liquidity and adequate capacity to absorb volatility shocks emanating from asset price bubbles. This contributes towards improved performance, discipline and resilience of the financial system, consequently driving economic growth.
Historically, the bond markets in GCC countries have remained conservative towards funding of private and public sector projects. However, post an unprecedented decline in oil prices over the last few years, sovereign debt issues surged and resultantly dominated the 2016 debt market in an attempt to curtail the budgetary deficit of these petro economies. In FY16, the new issues in GCC amounted to $69.1 billion compared to $22.6 billion in FY15, registering a YoY increase of 2.1x. This increase was primarily on account of bond issues by Saudi Arabia, Qatar and UAE.
Regional sovereigns offered attractive yields at issue
The colossal debut of Saudi Arabia’s sovereign debt in 4Q16 raised $17.5 billion, which is the single largest issue (three tranche) financing acquired by any emerging economy. The funding comprised of US dollar denominated bonds with a contractual maturity of five, 10 and 30 years, carrying a premium of 135 bps, 165 bps and 210 bps respectively over US treasuries.
The Saudi bonds outpaced issues from Qatar and Abu Dhabi that managed to raise $9 billion and $5 billion, respectively, in 1H16. This was followed by Oman, Bahrain and Dubai that acquired $4.5 billion, $2.6 billion and $0.9 billion in sovereign debt, respectively. The original issue yields remained moderate compared to historical levels. The Saudi instrument (10-year) was priced at 2.65 per cent, Abu Dhabi’s bond at 3.13 per cent and Qatar managed to trade its paper at around 3.5 per cent. These were low on a historical basis, however in the economic environment where negative rates were not atypical, these yields were deemed adequate.
When these sovereign issues were making their way to the capital markets last year, the sovereign debt of most of the European economies were offered at less than one per cent. A US 10-year paper was trailing at 1.41 per cent and countries like Hong Kong that maintain a hard peg with the USD were priced at one per cent. Although, the yields increased in 4Q16, the global benchmark performance remained depressed. JP Morgan EMBIGD registered a return of -4.02 per cent while Citi Mena Broad Index managed a -2.2 per cent in the quarter.
It can be argued that the risk profile of GCC countries is less favourable compared to developed economies, however the risk adjusted spread still makes them attractive. The regional markets catered to diversified risk profiles with opportunities available for risk tolerant investors to earn around seven per cent from Bahrain.
Similarly, short term instruments provided interesting opportunities with the Saudi one-year bill offering more than 2.5 per cent compared to 0.78 per cent for a US treasury of same maturity. This increased investors’ interest and almost all of these issues were oversubscribed with phenomenal participation of international investors.
At the structural level, this has given a boost to the regional bond markets which were previously nascent. Globally, the equity markets are usually half the size of bond markets, while in GCC, stock markets dominate their fixed income counterparts by approximately five times. Therefore, the recent pattern of bond issues, albeit sovereign, will deepen the bond markets by contributing transparency, liquidity and offering investment alternatives.
This development is important because bond markets, in medium term at least, are likely to be instrumental in funding budgetary deficits and the created liquidity should lead to a positive investing momentum.
The corporate debt market remains nascent
The regional corporate bond issues in 2016 remained subdued amidst prodigious sovereign offerings. Kuwait-based EQUATE Petrochemical funded $2.25 billion through five and 10 year bonds. Etihad Airways raised a five-year debt worth $1.5 billion with a coupon rate of 3.86 per cent and a spread of 210 bps above midswaps. Abu Dhabi National Energy Company structured two tranches, the first was a five-year $250 million paper, with a coupon rate of 3.62 per cent, while the second was a 10-year $500 billion paper, with a 4.37 per cent coupon rate. Other prominent offerings for the year included a Sukuk issuance of $200 million by Ahli United Bank and a $700 million issuance by International Petroleum Investment Company.
The banking sector in GCC contributed around $11.7 billion (15 per cent of total issues) which was primarily aimed at complying with capital requirement for Basel III. The GCC banks face substantial maturity gap emanating from very short term customers’ deposits and medium term lending. Therefore, it is expected that these liquidity concerns will be addressed by offering longer tenure bonds that will ensure continued, albeit moderate, contribution towards new issues.
Modest performance in January 2017 amidst interest rate volatility
The year 2017 is likely to be very dynamic for the fixed income markets. While it was expected that the rising trend in global benchmark rates will continue, a decline in retail sales along with investors’ caution towards the new US administration resulted in a declining yield curve for US treasuries in the first two weeks. The two-year, 10-year and 30-year instruments witnessed a decline of two bps each. This is likely to stabilise once US president Trump’s disruptive exuberance is settled.
The Japanese and UK sovereigns mimicked this trend. However, on account of economic recovery in EU, bond yields gained four bps. The GCC bonds registered modest performance owing to the dual benefits of declining yields and favourable investors’ supply demand equilibrium.
The concerns about credit quality are premature
At present, the credit strength of the region is adequate with an average MENA rating of approximately BBB+ (S&P), despite caution from rating agencies about slow economic growth, fiscal deficits and oil price volatility. Although these concerns have their own merits, some fundamentals are likely to result in economic robustness of the region.
The volatility in oil prices is not a hindrance as they are much higher compared to 2014 and some countries like UAE already have diversified revenue streams, while the rest are following suit. The aggregate GCC deficit of 8.7 per cent in 2015 is likely to squeeze down to 7.5 per cent in 2017, and further reduce to 4.9 per cent in 2018 owing to support from a VAT being instated for the first time in the region.
On a country level, the deficits will remain high for Saudi Arabia, Bahrain and Oman while for UAE, Qatar and Kuwait it is expected to be range bound between three per cent and four per cent. The overall growth of the region is likely to stabilise around two per cent through hefty contribution of non-oil activity going forward.
Therefore, for 2017 and 2018, the major GCC market funding is expected from Saudi Arabia and Bahrain while for other countries it will be a mix of moderate debt and government reserves. Similarly, an astute participation from the banking sector will persist to bridge regulatory liquidity and capital deficits. These developments will continue to attract more international investors who will be willing to increase their GCC exposures in search of better returns. This will continue to support the momentum in the regional bond markets, with an expected increase in benchmark rates, which will provide a unique opportunity of increasing portfolio duration along with augmented spreads.