Risk assets in developed markets had a generally good first quarter this year. Indeed, new-found optimism regarding future growth prospects in the US helped push the S&P500 index to an all-time high by the end of March, in spite of fears of the impact of federal spending cuts.
The Nikkei also had a strong quarter as Japan's new inflation targeting and monetary policies led to a strong rally that was accompanied by significant weakness in the yen. In Europe, returns for the UK FTSE and German Dax indexes were muted by declines in the euro and the British pound.
Peripheral European and emerging-market equities, as well as commodities were the general underperformers after concerns arose about prolonged political stalemate in Italy, following inconclusive general elections there at the end of February.
However, a painfully engineered bailout of Cyprus brought the integrity of the euro zone back into focus. European banks were particularly hit by the terms of the Cyprus bailout as it led to talks that the bailout terms might be a possible "template" for resolving future euro zone banking crises.
Core government bond yields had changed little by the end of the quarter although there was some volatility during the period. Yields also rose early in the quarter in response to good economic news offset by renewed declines on the back of European wobbles later on.
GCC's vibrant debt markets
In the Middle East North Africa (MENA) region, buoyant economic growth in Gulf Cooperation Council (GCC) countries such as Saudi Arabia and the United Arab Emirates (UAE) ensured that demand in the primary and secondary debt markets remained strong throughout the quarter.
In equities, the S&P Pan Arab index rose by more than 5% in US dollar terms, thus outperforming many emerging markets. Growth in trade with emerging markets has, along with tourism and transport, helped buoy Dubai's economy and the government's ability to borrow over longer tenures.
In Saudi Arabia, vast government spending has seeped into the economy, boosting banking and other sectors. Investors have also been encouraged by the prospect of an acceleration in regulatory reforms in Saudi Arabia, including progress in outlining rules for mortgage lending and the appointment of a new head of the Capital Market Authority.
By contrast, Egypt has been a particular source of concern. The country's foreign-currency reserves had fallen to perilously low levels by the end of the quarter while the value of the Egyptian pound continued to slide and the rate of inflation rose throughout the first three months of 2013.
Political instability - including a court decision to delay parliamentary elections - has meant the International Monetary Fund (IMF) had still not released a much-needed USD 4.8 billion loan by the end of the quarter. In any case, the IMF loan, if and when released, may well come with conditions that impose harsh austerity on an already-beleaguered population.
Broad credit indexes such as the JP Morgan Emerging Market Bond Index Global (EMBIG) and the Barcap Global Aggregate Bond Index (Global Agg) lost ground in the first quarter, but still fared better than government bonds as measured by the Citi World Government Bond Index. The Citi MENA Broad Index meaningfully outperformed all three indexes by posting modest positive returns.
Issuance activity mirrors confidence
An early highlight of the quarter was Dubai's successful launch of a two-tranche issue, made up of a USD 750 million 10-year sukuk and a USD 500 million 30-year conventional bond. Even before the January launch of this issue, the order book was more than 12 times oversubscribed.
Qatar Telecom (Qtel) also issued a two-tranche deal in January, starting with a USD 500 million offer of 15-year bonds that carried a coupon of 3.875%. As in the case of Dubai, the success of this tranche and the appetite among investors for longer-dated paper prompted Qtel to follow up with a further USD 500 million tranche, this time issuing a 30-year bond with a coupon of 4.5%. These were the first 30-year bond issues from both Dubai and Qtel.
At the end of January, Emirates, Dubai's flagship carrier, launched a USD 750 million 12-year amortizing bond, followed in March by a 10-year sukuk. The Islamic bond issuance also had an amortizing structure, with an average weighted life of five years.
In March, Saudi Electricity Co, the Gulf's largest utility, launched a dual-tranche sukuk. The issuer priced a USD 1 billion 3.473% 10-year tranche at a spread of 155 basis points (bps) over US Treasuries, and a USD 1 billion 5.06% 30-year portion at a spread of 190 bps over Treasuries. Both tranches were priced at par and were significantly oversubscribed.
There were also several significant issues from banks in the region during the quarter. In February, Abu Dhabi Commercial Bank (ADCB) raised a combined USD 1.5 billion through the placement of a dual-tranche bond offering made up of senior and subordinated notes.
The five-year USD 750 million senior unsecured tranche was priced at a coupon of 2.50% with a re-offer price of 99.636 to yield 2.578%, or 165 bps over mid-swaps. The 10-year USD 750 million subordinated bond tranche had a coupon of 4.50% and was sold at a reoffer price of 99.127 to yield 4.6%, or 265 bps over mid-swaps.
In March, Dubai Islamic Bank (DIB) issued a USD 1 billion perpetual bank sukuk. The issue carried a profit rate of 6.25%. This rate was lower than had been forecast, again indicating solid demand for Shariah-compliant products. The DIB was only the second publicly issued perpetual sukuk.
At the end of March, Emirates NBD, the largest lender in the UAE by assets, issued a USD 750 million 10-year bond after receiving a good response from investors. Orders for this bond significantly outpaced supply, enabling the bank to strike a final price of 4.875%, tighter than had been anticipated.
Market outlook
Despite negative returns in the first quarter, investors have continued to push into emerging market debt as an alternative to other lower-yielding fixed income investments. The development has raised fears in some quarters that some countries may not be able to absorb such large capital inflows without risking investment bubbles.
At the same time, bond markets in many countries have deepened in recent years, while carefully chosen emerging market debt continues to offer exposure to countries with far higher growth rates than developed markets, and with public finances that are often in much better shape. This is particularly true of GCC countries, whose debt dynamics remain among the strongest in the world, while the outlook for hydrocarbon prices should help support expansionary fiscal policies and economic growth.
In addition, continued spending on education, housing, and infrastructure around the Gulf region could help quell any dissent on the margins of society. Moreover, the risk of assuming and dealing with contingent liabilities from banks and government-related entities is receding, while liquidity has been satisfactory and is improving.
At the same time, there are a number of upcoming events that are likely to affect sentiment toward the broad MENA region - the first of which is the fate of the IMF loan to Egypt.
Dubai is expected to be able to roll over maturing debts, but the manner in which the emirate handles any refinancing--including a commitment to greater transparency--will be closely watched by investors. Also, structural developments that support the growth of regional debt markets should help maintain these markets' positive momentum.
Mohieddine Kronfol is CIO Fixed Income and Global Sukuk at Franklin Templeton Investments (ME).
Zawya 2013
