Saudi Arabia may now hold the record as the fastest sovereign Sukuk issuer in the history Islamic debt capital market (after its book building process lasted 14 hours and half) without the need to conduct roadshows but with such greatness comes array of challenges for its domestic debt capital market. In July 2018, Saudi Debt Management Office (DMO) introduced an issuance system, entailing the use of Dutch auction, which coincided with the yields on government Sukuk soaring across all traches.
THE DUTCH AUCTION MYSTERY
By the time the DMO raised $2 billion in international 10-year Sukuk in mid-Sept 2018, observers were wondering about the reasons that led to the higher yields for July and August issuances. As a background, the DMO has appointed five primary dealers with whom they will use a Bloomberg auction platform.
To widen the investor base for the Saudi Arabian Government SAR-denominated Sukuk programme, the appointed primary dealers purchase Sukuk sold through a Dutch auction directly from the Government, and subsequently place these securities in the secondary market for final investors, acting as market makers for government securities.
YIELDS EDGE HIGHER
While the DMO succeeded in widening the investor base to reach more than 20 investors, we noticed a spike in the Sukuk yields, clearly seen in the yields of the sixth offering (April 2018) and seventh offering (July 2018). On average, between the two issuances, the yield increased by nine bps across all tranches. In fact, the yield on the five-year Sukuk in July was the highest it has ever been since the start of the programme.
Essentially, under the new auction system (which is similar to that used by the US Treasury), the DMO gave the primary dealers a ceiling above which they could not price the Sukuk—the final price had to be at that level or below. But over the last two issuances, we have noticed that investors have remained right at the top of that ceiling.
There are three possible answers that might justify the increase in Sukuk yields for two consecutive months. First, is that this is a totally new experience for both the issuer and the investor (whom pricing of the instruments is conducted through new platform).
The second is that, despite the newly appointed market makers, there is currently very little active tradability of Government Sukuk in the secondary market. This makes it significantly more complicated for the issuer to define fair market value for each tranche. Thus, actual price discovery is not existed yet.
The third reason the issuer may have decided to be generous when it comes to pricing (as the Ministry of Finance tries to widen its local investors base). Note that over 20 participants have participated in the July issuance compared to the usual 12. Once you widen the investor base, you increase the demand for issuances and this should hopefully lower the cost of issuance for the government. We have not yet seen active trading, even though it is already two months after the appointment of the market makers, but hopefully this will happen soon.
Lack of secondary market trading will remain the biggest obstacle. We need to find a way to encourage the tradability of government debt instruments in the secondary market. In particular, Tadawul needs to address the fact that the fees for trading Sukuk are too high compared to other markets. We understand that they have promised to address this, and we expect them to lower the fees in the near future.
DISPLAYING THE RIGHT INFORMATION
The way that the local exchange (Tadawul) displays information related to government Sukuk is not conducive to making investment decisions— Tadawul needs to improve the pricing display. At the moment, Sukuk pricing is displayed in the same way as equities. We need to see the yield, the tenor, the rating, to help investors make a decision—in a similar way to Malaysia, which recently created a special platform to help retail investors access the Sukuk market.
What makes Saudi Arabia special is that you have two active currency markets, the US dollar market for government-related entities, and the local debt capital market, which is primarily for local corporates. We believe that the Capital Market Authority (CMA) is relaxing its issuance requirements for corporates to issue Sukuk, and what we would like to see in the near future is corporates aiming for public listed Sukuk.
Unfortunately, at the moment, around 90 per cent of issuing corporates go for privately-placed Sukuk because the regulations currently make that choice much faster and easier.
In terms of the local debt capital market in Saudi Arabia, the most commonly-used debt instrument for corporates is Sukuk. Saudi firms may opt for bonds with their dollar-denominated securities. In addition to banks, the most anticipated issuer is the Saudi Real Estate Refinance Company (SRC). As it purchases the housing loans portfolios from banks, SRC is a regular issuer of Sukuk. One notable monthly issuer is the Government of Saudi Arabia. The Debt Management Office (within the Ministry of Finance) keeps issuing Riyal-denominated Sukuk.
This is very helpful for corporates who use the yield curve for pricing their debt.
At the moment it is the banking and real estate sectors that will be driving the Saudi issuance. Nevertheless, it all boils down to the creditworthiness of the potential issuer and whether it has reached the level of maturity that enables it to consider tapping the debt capital market. The main issue here is how to change the mentality of the firms and shift their focus from banking loans to consider Sukuk or bonds. You have this learning curve that they need to go through first. Such events help in sharing knowledge and raise awareness in one of the most promising debt capital markets in the emerging markets.
The commonly used maturity is five years. We have seen the following recently: First, issuers do call their Sukuk before its maturity. Second, there have been very rare incidents where some sectors (under pressure) do breach certain clauses in which they need to amend the Sukuk offering circular and reconfirm that they would be able to serve their debt obligations.
One thing to note about the Saudi debt market is the fact that the majority of the corporate Sukuk issuance take the form of private placement. This is uncommon for any debt market worldwide. The regulator is trying to change such issuance behavior by encouraging them to consider going public.
Saudi Arabia has implemented many reforms in the local debt capital market (in which IMF has pointed them out). However, there are some shortcomings spurred from the private sector. One is in changing mentality. Treasurers of firms need to realise that short-term loans with a floating rate linked to SAIBOR are not the answer for their long-term funding needs.
The Government does price its Sukuk with fixed profit rate and therefore they need to build up on the sovereign yield curve. Even if they manage to overcome this issue, the limited size of the investor base may dictate the use of a floating rate for Sukuk. If this is the case, then they need to consider dollar denominated issuance, or fixed rate.
There is also the challenge of finding Saudi debt capital market specialists, which is a real dilemma for the industry. This is illustrated by the fact that 95 per cent of the Saudi banks are not on the list of top lead arrangers in the Middle East.