Initial public offerings (IPOs) are usually the favourite topic of conversation about the Saudi capital markets. But this year, it is debt, not equity that has captured the attention of companies seeking alternative sources of financing.

For conventional and Islamic bond sales, activity has shifted from the UAE and Qatar and is now centred on the kingdom. Since February, four issuers, either based in the country or Saudi-owned, have come to the market. And more are expected to follow as spreads tighten and banks remain cautious about lending.

Saudi Electricity Company (SEC) was the latest to approach the market, selling SR7bn ($1.9bn) of sukuk (Islamic bonds) in May to local investors. SEC is part of a growing trend for seasoned issuers to return to the bond market. This latest sukuk was its third. The kingdom’s largest developer, Dar al-Arkan Real Estate Development Company, issued its fourth sukuk in February, and Saudi-government owed Gulf International Bank (GIB) issued its second in April.

Bullish sentiment

GIB’s first issue was a three-year, SR2bn sukuk sold in November last year. The bank had started to market a dollar-denominated issue later the same month, but Dubai World scuppered its plans. The Dubai conglomerate announced it was seeking a standstill on $26bn of liabilities on the day GIB was due to price the dollar issue. The announcement threw both equity and debt markets across the region into turmoil, so GIB cancelled its plans. It was not alone in doing so; sales from a regional pipeline full of deals were cut off mid-flow.

Dar al-Arkan’s February sukuk reopened the market. While some analysts said the size of the sukuk was less than expected at $450m, others applauded the high-yield deal as a remarkable achievement, given the low level of confidence in the regional bond markets. The bond was sold with a 10.9 per cent coupon. “I’m bullish on Dar al-Arkan,” says one bond trader. “They have a strong business model. It’s a good name.”

With local banks still wary of lending, more companies are expected to take the opportunity to diversify their funding sources and approach the bond markets.

“The lack of bank credit is helping the bond market,” says Paul Gamble, head of research at Riyadh-based Jadwa Investments. “More companies will come to the bond markets as they get comfortable with the process.”

Telecoms and petrochemicals firms are among those believed to be gearing up for future issues, according to one Riyadh-based banker. Saudi Aramco subsidiary, Saudi Aramco Total Refining & Petrochemical Company (Satorp) is rumoured to be considering a bond issue to help finance its $10bn Jubail refinery scheme. This raises the prospect of a long-awaited project bond from the Gulf. But most bankers expect much of any future bond activity to be in the financial sector.

The lack of bank credit is helping the bond market. More firms will come … as they get [used to] the process

Paul Gamble, Jadwa Investments

The local Banque Saudi Fransi sold $650m-worth of bonds in March. The transaction was marketed in Europe, Asia and the Middle East. “There were strong bids from Saudi as well, even though it was a dollar issue,” says another banker.

Now Banque Saudi Fransi has broken the lull, other issues from commercial banks based inside the kingdom are expected to enter the market. “Banks face an asset-liability mismatch and need to be able to borrow over the longer term,” says Gamble. “Across most sectors, debt is under-utilised as a source of corporate financing.”

Saudi banks are highlighting the kingdom’s fundamentals as a key advantage that differentiates them from financial institutions elsewhere in the region. “Banque Saudi Fransi positioned itself as a Saudi bank and different to the rest of the banks in the GCC due to the inherent strength of the market,” adds the second banker.

This has proven to be a successful tactic. Despite the fact that Banque Saudi Fransi is almost two-thirds owned by private investors, it was able to price its bond issue inside that of a $750m bond sale from National Bank of Abu Dhabi (NBAD) earlier in March. NBAD has an iron credit rating as it is 70 per cent owned by the Abu Dhabi government.

Bonds are increasingly attractive to issuers as the spreads on riyal issues tighten on the back of strong demand. Illustrating this, SEC set the initial price guidance on its latest sukuk at 95-105 basis points (bps) over the benchmark Saudi Interbank Offered Rate (Sibor). That was within the 110 bps final pricing on GIB’s April sale. From an issuer’s perspective at least, this is in turn compares favourably to GIB’s November 2009 sukuk, which was sold at about 127 bps over Sibor.

Attractive option

The kingdom is awash with liquidity looking for a home and banks rich with deposits are looking for ways to deploy that money. For treasuries, pension funds and asset managers, the story is the same. The low interest rate environment makes bonds offering a better yield an attractive option. And, although bond issuance has picked up this year, the number of sellers is still small in contrast to the large number of interested investors.

Whether local companies opt to sell bonds locally or internationally depends on their funding needs, and the kingdom has seen a mix. In general, those seeking dollar financing, which tend to be banks already loaded with riyals, have taken their bond road shows abroad. Locally listed, non-finance companies such as SEC and Saudi Basic Industries Corporation (Sabic), recognise that local investors prefer investing in sukuk; their government shareholding also ensures they cater to local tastes. Consequently, they have tended to sell riyal-denominated Islamic bonds. Sabic has three sukuk listed on the Tadawul with a total nominal value of SR16bn.

“Companies go outside the kingdom only if they want to access dollars. They get a tighter-priced deal in riyals,” the second banker says.

The case of the Dar al-Arkan issue mixes the two tendancies. The sukuk was sold through an international road show. Significantly, it is one of few Islamic bonds ever to be sold with a 144a designation. This means its documentation clears the bar set by US regulators that allow it to be sold to US investors. Although most of the orders for Dar Al-Arkan’s sukuk came from European and Middle East investors amid limited demand from the US, the 144a designation is an achievement. It signals that the company has met more rigorous disclosure requirements.

[Firms] go outside the kingdom only if they want to access dollars. They get a tighter-priced deal in riyals

Bond trader

The kingdom’s Capital Market Authority (CMA) is eager to develop a local bond market as part of a general push to modernise the Tadawul, which, on the equity-side, includes the recent introduction of exchange traded funds.

“The CMA is encouraging issuers to sell sukuks or bonds. They have spoken to a lot of investment banks and they have looked at different options to improve the process,” the second banker says. The Saudi government itself has issued domestic bonds, building a local yield-curve. At the end of February, treasury bills and government bonds outstanding totalled SR170bn.

Market restrictions

The CMA is also urging issuers to sell paper to the primary market suitable for retail investors. For issuers, this is not such welcome news. The increased level of documentation required to sell to the retail market makes the process much more expensive. And getting retail investors interested is easier said than done. “Sukuk are by nature attractive to institutions,” says another banking source.

Despite the high-level support, restrictions remain on which companies can issue and which type of bonds can list. As an immediate consideration, the size of a bond sale is capped at a company’s paid-up capital.

Most entities that have come to market are listed, large and well-known. There are very few high-yield deals such as the Dar Al-Arkan sukuk. Companies do not have to be rated to issue bonds or sukuk, but the CMA discourages local funds from buying unrated paper. This shrinks the pool of possible issuers. Furthermore, it is difficult for limited-liability companies – such as large family conglomerates, which would be attractive to investors – to issue paper. This cuts out big names, such as Saudi Oger or Saudi Binladin Group, from
a list of possible issuers.

“There are restrictions on limited-liability companies issuing securities,” says a Riyadh-based lawyer. “They would not be able to issue themselves and would have to use a special purpose vehicle (SPV).”

Setting up an SPV in Saudi Arabia presents an immediate obstacle to companies, and in the past issuers have been forced to do this in an offshore jurisdiction. The easier route for large, local family businesses is to leverage their bank relationships and borrow.

For foreign investors, getting a slice of the riyal-denominated bond market is a struggle. First, their funds are extraneous. And second, legally there are restrictions on them buying local issues.

“If they are desperate, there are mechanisms through which it can be done, but it’s difficult,” says the banking source.

The Tadawul remains a venue for exclusively riyal listings. However, there is talk of permitting dollar-denominated bonds and sukuk to trade. But volumes on the secondary market remain meagre. The Tadawul’s bond and sukuk platform launched to some fanfare last year when over-the-counter trading moved to an electronic system. But in the whole of April, there was only one trade during which 1 million notes worth SR995,000 changed hands. Saudi investors, particularly institutions seeking scarce sharia-compliant assets, prefer to buy-and-hold.

“The regulator is encouraging companies to list sukuk,” says Abdullah al-Rashoud, chief executive officer of Riyadh-based KSB Capital Group. “But the problem is low liquidity [in the secondary market]. It is frustrating and it makes [retail] investors hesitant to get into the market.”

Despite this lack of retail investor interest, Gamble believes the bond market can offer an attractive alternative to the volatility of the equity market. It will be a sign of market maturity when individual investors take this advice and drop the quest for quick profits and move into more stable, fixed-income instruments.