By Davide Barbuscia

DUBAI, May 23 (Reuters) - Regulatory change and surging high-grade debt issuance by governments are encouraging Gulf insurance companies to invest in bonds, bringing the region closer to investment patterns in developed economies.

Traditionally, Gulf insurers have shown little interest in bonds, partly because of a lack of supply of highly rated debt issued by governments or blue-chip corporates.

Equities and real estate account for most of United Arab Emirates insurers' portfolios; bonds comprised about 11 percent of listed UAE insurers' assets in 2016, and only a small portion of that was investment grade, according to Moody's.

In Saudi Arabia, insurers traditionally invest in shorter-term money market funds or fixed bank deposits. By contrast, many European insurers allocate more than 70 percent of their funds to bonds.

The pattern in the Gulf is changing, however, as governments of the six Gulf Cooperation Council (GCC) nations issue an unprecedented amount of bonds to cover budget deficits caused by low oil prices.

Most of the new debt is rated investment grade, such as Saudi Arabia's $17.5 billion debut sale of conventional bonds last October - the largest-ever emerging market bond sale - and its issue of $9 billion of Islamic bonds last month.

"Some UAE insurance companies are slowly increasing their investments into fixed income, and we expect allocations towards fixed income overall to increase slightly this year," said Emir Mujkic, associate director of insurance ratings at Standard & Poor's.

In Saudi Arabia, the move toward bonds has begun but has not progressed as far; some insurers invested in April's 11.3 billion riyal ($3.0 billion) sukuk issue by national oil giant Saudi Aramco, for example.

So far, the volume of high-grade, local-currency bond issuance in Saudi Arabia remains small, limiting insurers' opportunities to invest.

"There is interest but at this stage, given the low supply in the local market, the shift is minimal," said Mujkic.

However, Saudi authorities are keen to develop the domestic bond market to reduce companies' near-complete dependence on bank loans, while Saudi state firms need to raise money as they receive less support from their cash-strapped government. So the supply of corporate debt in the kingdom is expected to grow.

In a sign of insurers' rising interest in bonds, Abu Dhabi-based Invest AD Asset Management, in partnership with Swiss bank Julius Baer, said this month it was launching an investment product for institutions that was based on high-grade GCC bonds.

The product provides exposure to U.S. dollar conventional bonds and sukuk with a weighted average portfolio rating of A- minus and above.

Mohammed al-Hashemi, executive director at Invest AD Asset Management, said increased GCC bond issuance across a range of ratings and maturities in the past year had broadened the market.

"This in turn will encourage innovation and the creation of a wider variety of financial instruments and structured products, from a variety of issuers, with regional fixed income as the underlying asset class," he said.

Hashemi said Invest AD's new product was also spurred by regulatory change in the GCC. In the UAE, for example, rules issued in early 2015, and now being implemented gradually, limit exposure of insurers' balance sheets to various asset classes.

"Insurance companies will be shifting towards higher-rated bonds which have lower capital charges under the new regulations. Some insurers we speak to want to divest some of their BBB-rated bonds in favour of instruments rated in the A range," said Mujkic.

Mohammed Ali Londe, assistant vice president for regional insurance at Moody's, said GCC insurers were smarting from 2015, when plunging oil prices triggered a tumble in local equity markets that damaged their balance sheets.

Now, "the abundance of issuance from sovereigns and corporates has given insurers a pool of assets in which to invest which simply wasn't available before," he said.

"We now expect insurers to subscribe to fixed income exposure gradually, while gradually divesting from riskier assets, which will mean improved asset quality, higher liquidity and more stable profitability for the sector."

(Editing by Andrew Torchia and Raissa Kasolowsky) ((Davide.Barbuscia@thomsonreuters.com;))