The credit and liquidity pressure stemming from the drop in oil prices is the key concern for bankers, analysts and buyers for the year ahead. “The impact of rising US interest rates is not what keeps us awake at night as these are expected to be gradual,” says Rasmala’s head of fixed income funds and portfolios at Rasmala Investment Bank.
January 4 2016
The credit and liquidity pressure stemming from the drop in oil prices is the key concern for bankers, analysts and buyers for the year ahead. “The impact of rising US interest rates is not what keeps us awake at night as these are expected to be gradual,” said Doug Bitcon, head of fixed income funds and portfolios at Rasmala Investment Bank.
For a region often embroiled in political unrest, the Middle East’s bond market has historically been one of the most emerging economies. But 2015 was the year the drop in oil prices truly inflamed fears about the impact for capital markets issuance — the bond market will be there for Middle East borrowers in 2016, they just might not like the pricing Steve Gilmore reports.
By Steven Gilmore04 Jan 2016
Since 1931, when it was first discovered in the region near the east coast of Saudi Arabia, oil has dominated the economic and political outlook of the Middle East.
Even those parts of the region — like Dubai — that have tried to diversify their economies and lower their reliance on oil are still surrounded by neighbours who have not.
The halving of oil prices that began in 2014 shows little signs of reversing any time soon, and so budgets will continue to take a battering. Only Kuwait seems likely to keep its breakeven price below the market level. Governments deprived of petrodollars have plundered their bank accounts. The banking system of the United Arab Emirates’ alone lost Dh56bn ($15.2bn) in government deposits between September 2014 and September 2015, according to the National Bank of Abu Dhabi. This trend is replicated across the Middle East and will likely persist in 2016.
“Oil prices have been in a narrow band of $45-$60 a barrel for a while and look likely to stay for there for some time,” says Anita Yadav, head of fixed income research at Emirates NBD in Dubai. “If that continues there’s really no way deficits will lessen.”
The credit and liquidity pressure stemming from the drop in oil prices is the key concern for bankers, analysts and buyers for the year ahead. “The impact of rising US interest rates is not what keeps us awake at night as these are expected to be gradual,” says Doug Bitcon, head of fixed income funds and portfolios at Rasmala Investment Bank. The tightening in regional liquidity has already pushed up lending rates in the Gulf Cooperation Council (GCC) , he adds.
Middle East governments have several levers at their disposal in dealing the drop in oil revenues — cancelling projects, drawing down on reserves or adjusting subsides to name a few. But the bond market is one lever many governments are expected to pull in 2016. Saudi Arabia alone is expected to sell some $5bn of debt internationally.
“It’s not inconceivable that we see $20bn in GCC sovereign supply during 2016,” says Andy Cairns, head of debt origination and distribution at the National Bank of Abu Dhabi in Dubai, “versus the $12.8bn issued in 2015 (as of December 7).” But the need for funding to cover deficits is likely to bring most GCC governments to the dollar market, and ones like Saudi Arabia are going to issue in size.
If the GCC provides $20bn in sovereign supply alone this will significantly increase the overall volume from the region, which, as Cairns notes, averages around $40bn a year from bonds and sukuk.
Writing fewer cheques
The decline in governments’ oil-driven revenues are going to have repercussion for other borrowers too. “Governments aren’t going to be writing as many cheques to their government related entities (GREs),” says Cairns. “Banks won’t be benefiting from cheap government deposits and corporates won’t be receiving the same bilateral loans as they have in recent years when banks were super-liquid. All of which points to more public debt issuance across bonds, sukuk and syndicated loans”.
The good news is there is room for the market to grow. Yearly Middle East supply has actually shrunk in the last three or four years, says Yadav, and across the region the size of the bond market relative to GDP is far smaller than in Europe or the US. The IMF estimates the GCC’s nominal GDP at $1.64tr for 2014, while the volume of international GCC bonds outstanding as of November 2015 was only $186bn.
So although 2016 is going to be a tricky one for investors to navigate, they will at least have the opportunity to diversify. Bitcon welcomes the prospect of fresh paper, although an increase in sovereign and GRE supply only offers limited diversity.
“Diversification is an attractive portfolio risk management tool,” he says. “With the related entities there is clearly government involvement and the benefits of issuer diversification are therefore somewhat limited. What we would ideally want to see is more independent corporates coming to market.”
Sadly, this is one sector of the market where supply is less likely to pick up. Bankers are expecting all the main Middle East states to issue. Banks will likely want to bolster their capital with subordinated deals and raise funding to cope with the fall in deposits.
“But corporates could well find that business growth is subdued due to lower petrodollar inflows and the resultant slowdown in government spending,” says Bitcon. “As a result there may be less need to leverage up at a corporate level. Unfortunately that’s exactly where we’d like more issuance, especially in the sukuk space where there is an abundance of FIG paper and limited corporate issuance.”
The prospects for a more global sukuk market in 2016 have also been hampered by the questions over regional liquidity. The main reason for non-Islamic borrowers to try their hand at sukuk was the chance to access a cash-rich Islamic investor base. This picture has not been irrevocably altered. But those Islamic investors are now a little less cash-rich and a little less inclined to buy into new credits.
Time to pay up
The problem is that the drop in oil prices is going to increase Middle East issuance while lowering liquidity across the regional investor base and the credit quality across the borrowers.
“The catalyst for wider GCC credit spreads has been a seemingly sudden realisation that regional liquidity is much reduced,” says Cairns. “It is this squeezed regional liquidity environment that is pushing borrowers to the public debt markets and, with more supply competing for investors’ attentions, funding costs will continue to rise.”
By the end of 2015 issuers were already having difficulties. Borrowers finished roadshows and then decided against deals, others priced deals in line with initial price thoughts or printed sub-$500m deals having marketed a transaction as benchmark.
“What you might see is investors looking at credit spreads moving wider and rates drifting higher and thinking about whether they really want to take bond risk,” says Bitcon. “They may have already taken a hit on their equity investments, so many might just want to protect their capital. Issuers will also have to compete with regional banks now offering 2.5% for one year local currency bank deposits which looks attractive relative to a five year low yielding bond deal. As the landscape changes, it appears likely that issuers will have to pay up in 2016 to retain investor interest.”
Spreads are unlikely to rise by the same degree across different groups of issuers, however. Because corporate deals are rare and GCC issuance has historically been skewed towards banks, Cairns expects bank spreads to move out more than corporates.
“We’re also seeing a bifurcation between pricing for top tier and second tier names,” Cairns adds. One reason for this particular trend — aside from credit quality — is that the top names are likely to have access to international counterparties and liquidity, whereas second tier credits rely on regional banks, which are suffering from liquidity pressure. But the outlook is by no means dire, and currency pegs in the region mean it will avoid the devaluations seen in other economies.
The World Bank expects regional Middle East economic growth of 3.7% in 2016, well above the developed world.
A far higher percentage of GCC bonds are investment grade than in emerging markets globally, notes Yadav. Liquidity is falling, but should remain adequate, and the small size of the Middle East bond market will help bolster appetite.
Demand from the ALM desks of Middle East banks for investment in debt securities is perhaps $30bn-$40bn, which isn’t small given that the entire bond market is around $200bn, Yadav adds.
“That demand may decrease slightly as liquidity tightens in the local banking system, but will probably be more than adequately substituted by the increasing bid from private bank clients and international investors.”
Local currency a silver lining
There is also the possibility of governments using the oil price drop as an opportunity to build better functioning local currency markets. There were already signs in 2015 that governments were making more use of domestic markets. Oman sold a OR200m ($520m) sukuk in October — its first sovereign sukuk. Saudi Arabia issued its first sovereign bonds since 2007, placing billions of riyal denominated bonds.
Yadav sees strategy in Saudi’s local currency sales. The local market has allowed it to raise larger amounts with relative ease and speed, while furnishing its banks with liquid assets they can hold as part of the requirements under Basel III.
“The local investors will also be more likely to buy and hold,” she said. “It’s a more stable investor base. Local currency issuance can also provide a benchmark for other entities.”
Some debt bankers, however, say issuing large local currency deals is not the answer.
“Governments issuing local currency deals in large size doesn’t solve the problem,” says Cairns. “It’s akin to moving your money from your left pocket to your right pocket. It absorbs finite domestic liquidity and drives borrowing costs higher for everyone.”
But although Cairns is sceptical of sovereigns deciding to issue local currency bonds in large sizes to plug budget deficits, he is an advocate for developing local currency bond markets across the Middle East.
“The development of local currency bond markets could be at least one positive