Seneca said: "Luck is what happens when preparation meets opportunity." If you believe that, 2012 was a particularly lucky year for the GCC credit market. Credit spreads tightened strongly and deservedly so as the preparation part came from solid macroeconomic fundamentals, a stable operating environment, excellent liquidity and improving credit metrics. Opportunity manifested itself in relatively subdued geopolitical tensions and a very benign environment for corporate credit overall.
2012 could be seen as a year of inflection in terms of innovation and enlargement of the debt capital markets (surge in sukuk issuance, first sukuk hybrid Tier 1 perpetual note). In particular, one should not underestimate the importance of change that happened in the GCC market this year. There is still room, however, for improvement as GCC credit spreads tightened by less than those in other regions and here lies the lucrative investment possibility.
Despite the positive trend, one could easily claim that the GCC market is still somewhat a bipolar investment case: on the one hand, the GCC that mandates a higher risk premium due to the "what if" of the geopolitical risk and fears of a significant conflict escalation; on the other, the strong economic fundamentals supported by generous government spending, healthy oil prices, and the improving credit profiles and the scarcity of its bonds are not truly reflected in the level at which its corporates trade.
In fact, high quality AA and A rated corporates in the GCC market have historically traded and continue to trade twice as wide as peers in the US or in Asia at a credit spread close to 200 bps over US Treasuries while similarly rated global peers are closer to 100 bps over US Treasuries. The discount between GCC credit and global peers should compress further as long as the geopolitical risk is contained.
In absolute terms, the GCC credit market has been growing steadily with many newcomers this year. But its pace of growth has lagged the rest of the emerging markets. Indeed, the share of GCC bonds issued has declined compared to the broader EM issuance year-to-date. Middle Eastern corporates issued only USD 25 billion of debt representing less than 9% of total issuance, half the proportion realized in 2006.
The scarcity of supply is a key factor for a robust technical backdrop as outlined by the recent outperformance of GCC high yield corporates. Little supply from the GCC high yield segment but also a reassuring news flow on Dubai Inc.'s debt have driven a superior spread compression close to 300 bps year-to-date, 50 bps more than EM counterparts.
A fundamental change is the surge of sukuk issuance. The share of sukuk compared to conventional bonds has grown relatively fast this year, representing 65% of market share year-to-date compared to 21% in 2011. This is fuelled by a strong demand for sukuk paper, the supply-demand imbalance, as well as interest from global players to target Islamic accounts and to tap new markets. Better pricing for sukuk issuers was also a key driver, as the lack of sufficient supply to meet the high demand for sukuk drove spreads on sukuk tighter than their conventional counterparts.
Saudi Electricity Company and Emaar can be named among the most popular sukuk issued this year (Saudi Electricity 2017 sukuk and Emaar 2019 sukuk were respectively 18 and 9.2 times oversubscribed).
While Europe and Asia continue to share the bulk of the international allocation, investors from these regions have started to recognize the defensive credentials of the GCC bonds and to look beyond the usual suspects, the high rated corporates. Indeed, European investors started to go down the quality spectrum by getting involved in low investment grade and high yield new issues. For instance, European accounts received 61% of the allocation in the recent Majid Al Futtaim 2019 bond.
Supply was muted in the GCC sphere and was mainly concentrated in the financial area, particularly in Dubai and Qatar, with a remarkable absence of issuance from the quasi-sovereign sphere. We can expect going forward more issuance from sovereigns and quasi-sovereigns as upcoming bond redemptions in 2013 and 2014 are concentrated in the aforementioned sub-sectors.
In the financial sphere, issuance from Qatari banks is set to continue to increase as the banks act as a channel for the government's ambitious expansionary plans. Debt issuance among Saudi banks is expected also to pick up, going forward. The enactment in July of the Saudi mortgage law could stir more mortgage lending and thus induce Saudi banks to enhance their long-term funding sources and to tap the sukuk / bond market.
Also, subordinated debt could become a more common debt instrument in the region, Abu Dhabi Islamic Bank being the first bank to test market appetite for a sukuk hybrid Tier 1 perpetual note. The challenge is in convincing traditional Islamic accounts to step into an unfamiliar structure where Basel III rules and Shariah principles converge.
Going forward, the key motives for issuing subordinated capital are the increase of the capital adequacy ratio ahead of the implementation of Basel III or, in the case of the UAE, the repay of the Tier 2 capital injected by the government early 2010.
The large infrastructure plans in the GCC are also set to fuel the issuance of asset-backed sukuk and project bonds. Project bonds which have been a quite popular source of financing in Brazil (Odebrecht, Grupo Schahin, OSX, Queiroz Galvao Oil & Gas, etc.) could become more fashionable in the Middle East and act as a supplement to bank lending capacity, especially for multi-billion projects. RasGas and Dolphin Energy are so far the only existing project bonds in the region but other issuers could be encouraged to come to the market.
One can easily see the investment opportunities that are likely to be offered in project finance, given all these developments. The low correlation with broader EM assets, the stability of the project bonds, the long-term funding facility, the premium offered vs. counterparts, the good track record and the low historic default rate are elements that underpin the investment case.
In sum, this year has been great for the GCC credit market in terms of change and developments. And it is only the beginning. Given such a strong start one could be nothing but excited to see what comes next.
Christiane Nasr is director and senior investment advisor for the Middle East at Credit Agricole Suisse.
© Zawya 2012
