Early in 2010, the Gulf’s long-suffering banks were looking forward to a pipeline of Islamic securitisation as corporates and sovereigns alike prepared a return to the market underpinned by significant borrowing requirements.

Whether sharia-compliant or conventional, risk appetite is down almost everywhere in the GCC

Faisal Hijazi, Moody’s Investors Service

Most Gulf issuers had already written off 2009 as a lost cause, with high-profile defaults and the global recession destroying demand for sukuk (Islamic bond). This year was supposed to see the revival of Islamic debt issuance, as economic confidence returned to the region.

To some extent, the picture is much improved: global sukuk issuance topped $13.7bn in the first six months of 2010, nearly double the $7.1bn recorded during the same period in 2009. But it is Asia, rather than the Gulf, that has set the pace in the volume and quality of issuance. 

Malaysia leads sukuk issuance market

In the first six months of 2010, Asian issuers were responsible for 70 per cent of global sukuk issuance, compared with the Middle East’s 30 per cent, according to data from US-based ratings agency Standard & Poor’s.

Malaysia alone accounted for around 53 per cent of global issuance, with a robust local-currency denominated medium-term note sukuk programme. Growth was driven by strong appetite from state-related issuers, such as the Malaysian central bank, and a deeper investor base that included pension funds, mutual funds and insurance companies.  

The GCC continues to lag behind Asia, despite a handful of sizeable sovereign-linked issuances this year led by Saudi Electricity Corporation’s (SEC’s) $1.8bn sukuk, and a $1.4bn sukuk from the Qatar government. Of the non-sovereign issuers, Saudi’s real estate developer Dar al-Arkan, with a $450m sukuk, was the standout deal.

“Whether sharia-compliant or conventional, risk appetite is down almost everywhere in the GCC,” says Faisal Hijazi, business development manager at ratings agency Moody’s Investors Service’s Islamic finance unit.

“In Malaysia, with the support of a solid regulatory framework, they have managed to boost their issuance market through several multi-billion Malaysian ringgit sukuk. These have helped the market to fly.”

The lack of new issuance from the Gulf is surprising, given the strong interest expressed at the start of the year. A growing need for long-term financing coupled with low interest rates ought to provide ideal conditions for a burst of new sukuk launches.

With only one corporate sukuk issuance in the second quarter, the market is still clearly concerned by an uncertain economic backdrop. Rather than test whether investor confidence has revived, corporates have opted to postpone their bond issuance plans, waiting until the financial climate appears more favourable.

Issues delayed in the Gulf

“A number of both government and increasingly private institutions were seriously intending to tap the debt capital market at some point. But these have ended up delaying those plans for reasons beyond their control,” says Jarmo Kotilaine, chief economist of NCB Capital, the investment arm of Saudi Arabia’s National Commerical Bank.

One reason for delaying is the sense that investor appetite has still not fully recovered from the defaults that hit Islamic securities last year. In May 2009, Kuwait’s Investment Dar defaulted on a $100m sukuk and in December, Dubai real-estate developer Nakheel requested the postponement of a $3.4bn sukuk repayment. In early 2010, Kuwait-based International Investment Group defaulted on a $200m sukuk.

The emergence of European sovereign debt worries this year amid the ongoing restructuring of state-backed Dubai World’s $23.5bn debt obligation also created new stresses on the market. “We’ve clearly seen indications of these stresses in the market in credit default swap spreads. Even though people have learned to differentiate between Gulf markets, there’s been a consensus that now was not the best time to do a sukuk,” says Kotilaine.

That consensus may now be starting to weaken; there have been distinct signs of a re-engagement in the market from sovereign issuers in the second and third quarters of this year.

The near to medium-term outlook for the GCC debt markets is promising, thanks to a large project pipeline and active government spending, says NCB Capital in a September 2010 GCC capital market review.

Figures for the second quarter showed a revival in Islamic debt issuance from corporates in the GCC, with total offerings reaching $4.1bn, compared with $1.1bn raised in the same quarter in 2009. It was also ahead of the $600m issued in the first quarter.

Alongside the SEC and Qatar sukuk, the Central Bank of Bahrain has tapped the market with six short-term issues, with a value of $176m in the second quarter. The aggregate value of GCC sovereign sukuk issuances in the second quarter – $1.5bn – was almost eight times the $200m seen in the first quarter.

Lead arrangers are more positive about prospects going into 2011. “We have several transactions on the go that we are looking to bring to the market over the course of the coming weeks,” says Mohammed Dawood, head of debt capital markets at HSBC Amanah, the UK bank’s Islamic division.

Investor confidence improving in the Gulf

The recent settlement of the Dubai World debt restructuring will help galvanise interest in fresh sukuk issuance. In May, the firm unveiled a plan involving repaying Nakheel’s 2010 and 2011 bonds in full, with other lenders waiting up to eight years for full repayment. By September, Dubai World said it had won over nearly all its creditors to its debt-restructuring plan.

Reflecting the improvement in investor confidence, Dubai’s credit default swaps have declined by about 20 per cent since the second quarter. “Since the Dubai World settlement, you are starting to see some positive signs and spreads on Dubai are starting to turn. This will help GCC issuers as it becomes less expensive for them to tap the market,” says Hijazi.

The reception afforded stronger credits has been positive when these have come to market. “Look at Saudi Arabia. They had a complete cracker in terms of the SEC sukuk this year,” says Dawood. “We moved the market in terms of duration from five to seven years. Pricing was tighter than achieved last year, but at the same time we were able to garner a far stronger orderbook than we’d seen before.”

The priority now is about getting the right credits through the door. “The outlook for 2011 is strong – you’ve got Islamic financial institutions, which have got refinancing needs, coming up and there are corporates, financial institutions, and sovereign-related [firms] looking at getting into the market,” says Dawood.

Government-backed issuers remain the market driver in the Gulf. Out of the eight GCC sukuk issued during the second quarter, seven were sovereign issues from Bahrain and Qatar – forming part of state programmes to develop a local debt market and create new ways of managing excess liquidity in the financial system.

In Saudi Arabia, the biggest Gulf economy, a healthy domestic market is developing. However, it also remains dominated by sovereign-related issuers, such as state petrochemicals producer Sabic and SEC, which together accounted for 73 per cent of new issuance in 2009. Of the six Saudi sukuk issues in the pipeline for the remainder of the year, only one is by a listed firm.

The climate remains difficult for corporates, and they still tend to pay much more to borrow than the government-linked firms.

There are still significant structural impediments that will undermine Islamic securitisation in the region. Gulf sukuk issuance lags conventional debt, for example. The GCC conventional bond market saw issuances worth $7.9bn during the first half of 2010, around twice the level of sukuk in the same period.

To inject momentum back into the Islamic debt capital market, it is critical that sukuk defaults are avoided and that liquidity is boosted. One way of revising issuance is to develop a local currency sukuk market in the same way that Malaysia has created a strong ringgit-denominated programme.

Another obstacle that may thwart Gulf sovereign issuance in the near-term is the relatively healthy state of government coffers after more than a year of high oil prices.

The Saudi government, for example, is opting not to roll over a $7.7bn government bond maturing in January 2011 and is keeping away from the debt market until it has brought down its debt to 10 per cent of gross domestic product. Abu Dhabi also has no plans to tap the debt market in the near future. This could leave more room for corporate sukuk issuers.

Debt, whether Islamic or conventional, is not widely used as a source of corporate finance in the kingdom as it is elsewhere, says local investment bank Jadwa in an August research note. It says the total debt-to-equity ratio for Saudi listed companies is around a quarter of that in leading global markets.

The authorities have taken some measures to help encourage corporate issuance, mostly through the launch last year of a trading platform via the Saudi stock exchange (Tadawul), which aims to create a secondary bond market.

Secondary market in the Gulf

Listing both bonds and sukuk on the Tadawul has helped issuers, such as SEC, to tap the Saudi riyal market. “Once this platform is active, it will provide a good framework for secondary trading, especially for takaful companies and fund managers,” says Hijazi. “Once you have a liquid secondary market, investors can easily and efficiently sell and buy sukuk.”

The Qatar Exchange may even follow the Tadawul’s lead and start secondary bond and sukuk trading later this year.

These initiatives have come against the backdrop of a shift in issuance from over-the-counter instruments placed privately, towards listed instruments on stock exchanges. Listing sukuk on organised markets is important for the liquidity of the instrument itself and also makes it easier to use for financial institutions seeking to broaden asset classes, says Standard & Poor’s.

It is still early days for the Gulf sukuk markets. Secondary market activity has been subdued. Despite the primary market revival, secondary trading on Tadawul saw drops in both trading values and volumes. The second quarter of 2010 saw a decline in the number of trades to nine, from 57 in the previous quarter, says NCB Capital. The total value of trades fell to SR46.6m ($12.4m) from SR365.7m in the first quarter. 

Further measures could help create a stronger platform for sukuk issuance. A Gulf common currency would allow issuers, whether in Qatar or Bahrain, to tap the wider market and benefit from the Saudi market’s greater depth. Better protection for investors against defaults could also help to assure confidence in this asset class.

Further legislative groundwork will be needed to rebuild confidence and deepen the Islamic debt capital market. Only then will Gulf companies be able to widen their funding sources and tap into the pools of liquidity that Islamic instruments can provide.