We’re seeing a fairly substantial shift between bonds and loans in terms of their popularity in the Middle East. What have you observed? And what are some of the main drivers here?
The syndicated loan market is evidently more active than the public bond market in the GCC at present. In 1Q 2016, estimated new loans written in the loan market were over US$24bn while GCC bond market only saw deals worth less than US$5bn.
Some of the reasons for higher preference for loans are clear. Issuers got wary of the heightened volatility in the bond market in the first quarter of this year; pricing is generally cheaper in the loan market, particularly when money is raised from the European and Japanese banks; the cost and complexity of doing a deal in the loan market is lower than in the bond market; and, there is more ease in dealing with a limited number of known counterparties than the unknown holders of a bond in the public debt market.
Do you think that in the next 6-8 months oil prices will stabilise in a way that will make a material impact on the balance sheets of the region’s sovereigns? What do you think the impact on sovereign debt will be?
Although no material commitments are expected from OPEC, there are clear signs of slowing production and moderating inventory levels in the Americas. Against this backdrop, we expect oil prices to hover in the range of US$40-$50/b this year and rise further next year.
Most sovereigns’ 2016 budgets in the region assumed oil prices around the US$40/b mark. In view of current oil price being higher than US$40/b mark and governments’ active management of expenses, actual budget deficits are likely to be lower than the projected ones. That said, government balance sheets will no doubt weaken as expenditures continue to be materially higher than the revenues and the gap can only gradually be bridged.
Government borrowings, via bonds and loans, are set to increase at a time when bank liquidity is thinning and cost of debt is rising. Also, FX reserves are likely to reduce as sovereigns sell some assets to fund the budget deficits. Credit ratings on Saudi Arabia, Oman and Bahrain have already been downgraded and others are being watched closely. In such scenario of weakening credit quality, rising interest rates and increasing new supply of debt, sovereign bond prices will fall, albeit much of this is already priced-in.
Are we likely to see more corporates hit the bond markets as bank liquidity tightens?
There is no clear justification for the corporates to hit the bond market excessively this year. Need for incremental funding has moderated as companies in the region cut down on capital expenditure and restrain their M&A appetite. Although tightening liquidity in the bank market will give way to higher cost of funding for the corporates, pricing in the loan market is still attractive compared with the bond market. Companies with weaker credit quality are likely to suffer the most as they are likely to fall out of favour with the banks and at the same time may not be large or sophisticated enough to tap the bond market.
Large government owned or government related entities are likely to increase their borrowing in the bond market as they are likely to receive less financial injection towards their funding needs from their respective governments. We also expect issuance from the banking sector as they endeavour to boost capital in preparedness for Basel III. Although some central banks have come out with confirmed guidelines on capital requirements and others haven’t, all of the central banks in each of the 6 GCC countries have readied their banks for Basel III implementation to some degree. The differentiation will come from banking systems that are growing quickly on the loan side. Loan to deposit ratios in Qatar, for instance, are currently at 125%, and when you’re running at the high end of the loan scale your capital needs naturally increase. That’s where you might expect higher issuances.
GCC banks will need to raise between US$25bn-30bn in new capital between 2016 and 2019. In a sense it is a drop in the bucket in European market terms, but, consider that the universe of fixed rate securities in the GCC is only US$171bn. Of that, Tier 1 securities is only US$25bn-30bn. In that sense we’re actually going to see a near doubling of that universe. But this region doesn’t have a substantial high-yield market, so we’re not terribly concerned about any crowding out.
Egypt is often talked about as an emerging opportunity in the Middle East. Is there good value to be found there? Are the barriers for fixed income investors too high?
Egypt had lot of positive sentiment attached to it until last year which now seems to have reversed course as the country suffers from foreign exchange issues. The country is starved for foreign currency as tourism fell after the Russian plane tragedy last year. S&P recently revised the outlook on its 'B-' rating on Egypt to negative. Although Egypt’s large population and domestic consumption led economy present good investment opportunities, the difficulty of doing business there is prohibitive, particularly with capital controls and concerns surrounding foreign exchange repatriation options. Although average yield of over 8% on dollar denominated Egyptian government bonds may appear attractive, the chance of bond prices falling in response to likely rating downgrades is higher than normal.
At the end of the day, Egypt is a very difficult country to trade as an emerging market investor; the words ‘black box’ come to mind. If you look at the money market there, there are significant idiosyncrasies – I could be borrowing money at 9% in the bank market in Egypt and invest it in the country’s treasury bonds at 10.5% and get free money. But the challenge then becomes repatriating funds. The legislation is relatively confusing; the market is dominated by local banks, which have substantial amounts of liquidity, and international bank participation is limited; FX convertibility is an issue. It is very hard to get a clear sense of how to exploit the opportunities there.
Iran seems to be moving fairly quickly in terms of strengthening its capital market regulatory framework? Do you think we’re likely to see strong demand for the country’s debt?
Iran does appear on the horizon as an interesting investment opportunity. However, although the sanctions were lifted in January this year, most foreign banks and companies are slow to embrace the opportunity due to fears of miscalculating or misunderstanding what they can or can’t do. With passing time and hopefully some new activity from American banks and companies in establishing links with Iran, other investors and banks will gain more confidence in dealing with the country.
The true potential of the Iranian market can only be assessed or seized once its financial markets become more accepted and integrated with the wider world. About 40% of Iran’s banking system is Islamic-based, so there is huge scope to stimulate investment from various pockets of the Middle East into Iranian securities, and vice versa.
Perception of Iran’s credit worthiness, rightly or wrongly, is also linked to the oil prices, although it is one of the most diversified economies in the region. Demand for Iranian bonds will really depend on the structure of the deal and the price offered. If oil prices increase substantially, we could see that catalyse American investment in the country – which would be significant; that said, if oil prices were higher, we would have seen the opportunity landscape in the country evolve much faster.
In terms of sectors, what have been some of the brightest spots for you within the Middle East’s fixed income space? What have been some of the weaker areas?
With a recent increase in oil prices, GCC bonds have recovered most of their previous losses. Supported by falling benchmark yields, GCC bonds are currently actually near their alltime highs in price terms. BUAEUL index, that represents liquid bonds from UAE, closed at an all-time high of 111.66 in early May with yield-to-worse at 2.87%.
That said, credit spreads in the region have widened. In the last five years, spreads over treasury for the JP Morgan GCC bond index touched its lowest of 151bps in mid-2014 and is currently at 286bps. The issuers that have held up relatively well in this volatility have generally been from sectors that have low co-relation with oil such as telecoms and high-grade utilities. The sectors that seem to have suffered most are sovereigns and sovereign related entities in Saudi Arabia, Oman and Bahrain, which is not surprising given the pressure on sovereign ratings.