When growth in the global economy slowed dramatically in late 2008, Saudi Arabia's debt market felt the full impact. With borrowing costs high and banks increasingly unwilling to lend, many Saudi borrowers decided to postpone or cancel their bond sales.

At the start of 2008, typical corporate borrowing costs were close to 125 basis points over the Saudi interbank offered rate (Sibor), but by August they had reached 150-175 basis points over Sibor. Saudi investment bank NCB Capital estimates that the GCC debt market suffered a 40 per cent decline in value to $22.5bn in 2008. Islamic debt issuance was also affected.

The lull in activity mirrors that in the global debt capital markets. "With pricing having blown up to extreme levels, it would not have made any sense [for major companies] to tap long-term debt funding," says Khalid How-ladar, senior credit officer for asset-backed and sukuk (Islamic bond) finance at ratings agency Moody's Investors Service. "Instead, they [corporates] will avoid refinancing if they can or take short-term funding and hold off until spreads become more reasonable."

One of the few debt issues in the second half of last year was Saudi Hollandi Bank's SR775m ($206m) sukuk, completed on 30 December, which had a tenor of 10 years and was priced at 200 basis points over Sibor.

In March and April this year, the kingdom's Gulf neighbours Qatar and Abu Dhabi each launched $3bn bond sales to kick-start their debt markets. Their rationale was that sovereign paper would instil confidence in investors by establishing a fresh pricing structure that can be used to price corporate debt.

Long-term financing

Bonds are a pillar of financial markets, providing stable, long-term financing for companies or governments, while also offering investors alternative investments to stocks.

"Over the years, the kingdom has not had to issue debt as it has used its fiscal surpluses," says Nish Popat, head of fixed income for the Middle East at Dutch bank ING. "Qatar and Abu Dhabi have also not had to issue debt, yet chose to do so to kick-start the debt market."

Should Saudi Arabia choose to follow its neighbours' example, a sovereign bond issue would generate huge interest. "Saudi Arabia is the biggest market in the region and the one that a lot of banks are very excited about," says Popat. "Unfortunately, it is the one nation that has never issued any sovereign paper."

Market interest in Saudi sovereign bonds was triggered when Abdulrahman al-Tuwaijri, chairman of the Capital Market Authority (CMA), told viewers of the CNBC Arabiya TV station on 16 April that bond trading could start in Saudi Arabia as early as this year.

Developing a secondary market where previously issued securities and financial instruments, such as stocks and bonds, are bought and sold is critical for the kingdom, particularly in the current climate. Creating tradable debt instruments could provide an effective way to price the cost of borrowing money.

"A healthy secondary market is important to mitigate liquidity concerns," says Howladar. "If cash is needed unexpectedly for whatever reason -for example, if writedowns are worse than usual -you can liquidate your fixed-income investments. They become less of an illiquid, esoteric investment, and more somewhere you can park your cash and earn more yield."

But the CMA chief's words are no guarantee that bond trading will happen. "It is one thing to discuss it, quite another to implement it," says one adviser to the Saudi government.

This leaves sovereign issuance as a more compelling catalyst for corporate bond activity than bond trading. The recent debt issues in Qatar and the UAE met with a strong reception. "If you have an opportunity to buy into the government of Abu Dhabi at 400 basis points [over the London interbank lending rate], it is too good to turn down," says one Gulf-based debt capital market banker.

Corporate issuers need to tap the bond market to diversify their sources of debt, while Saudi institutional and retail investors may start to look more favourably at fixed-income instruments that offer stable returns, having been burned by recent stock market losses.

"There is pent-up demand and there is a need to diversify corporate debt options," says John Sfakianakis, chief economist at Saudi bank Sabb. "We need to unlock demand as corporates have to find non-bank outlets to raise debt."

Some $486bn worth of Saudi projects are in the pipeline over the next six to seven years, but the balance sheets of local banks are inadequate to fund them.

"A bond market diversifies the allocation and source of debt," says Sfakianakis. "If this issue [the lack of a healthy bond market] is not addressed, the supply-demand mismatch will become much more systemic. Banks will be required to grow their asset bases and deposits exponentially if they are to meet the demand for borrowing."

Historic lows

Yet Saudi banks may struggle to grow deposits in a market where interest rates are at historic lows. The kingdom lags behind its Gulf neighbours in corporate bond issuance and is not among the top 10 Gulf conventional bond issuers by volume. UAE ports operator DP World tops the list, with its 2007 bond issue valued at $1.75bn.

On 31 March, NCB Capital, the investment subsidiary of Saudi Arabia's National Commercial Bank (NCB) issued a research note -An Emerging Opportunity -in which it forecast that the Gulf sukuk market is likely to recover in 2009, given the $24.6bn pipeline of sukuk issues (see chart). However, the GCC sukuk market dropped 51 per cent in value in the final three months of 2008, compared with the third quarter, with issuance falling to $9.06bn.

The fall is partly a result of investors' concerns over sukuk structures. In February 2008, the Bahrain-based Accounting & Auditing Organisation for Islamic Financial Institutions issued a ruling that threw into question some of the structures used in recent sukuk, which had pushed the boundaries of what is deemed compliant with Islamic banking principles.

This should not, however, inhibit future Saudi sukuk issuance as the kingdom's sukuk issues typically use more conservative structures than elsewhere in the Gulf.

Already, there are signs that appetite for sukuk is returning. A $500m Indonesian government sukuk closed on 22 April seven times oversubscribed.

"This is a very encouraging sign, suggesting there is appetite for sukuk for the right sort of issuers and where there is the right sort of story," says Farmida Bi, a partner at UK law firm Norton Rose and an adviser on Islamic finance debt and equity capital market transactions. "The CMA chairman is encouraging domestic banks and corporates to issue sukuk to Saudi nationals to develop the secondary market. This is to be welcomed."

In its An Emerging Opportunity report, NCB says listed sukuk are trading at attractive yields. "The widening of spreads due to rising liquidity and credit risk premiums has taken average GCC corporate bond yields to 10-12 per cent and average sukuk yields to 13-15 per cent," says NCB. "Investors may increasingly turn to sukuk issued by government-backed companies with good track records and fundamentally strong assets."

Saudi corporates have a track record in sukuk. Saudi Basic Industries Corporation (Sabic) is the largest non-UAE sukuk issuer in the region, raising $4.26bn through three issues between 2006 and 2008. But it is Malaysian and UAE-based issuers that dominate the sukuk market. Saudi Arabia accounted for just 11.2 per cent of global sukuk issuance in 2008, well below the UAE's 35.6 per cent.

The kingdom will enjoy a mix of conventional and Islamically structured debt issuance once activity returns. "There will always be a place for the conventional, but sukuk are attracting a lot of attention," says Bi.

Three dollar-denominated Saudi sukuk issues are in the pipeline for 2009, according to NCB Capital: for Islamic Development Bank, Zamil Holding Company and Saudi Aramco/ConocoPhillips. But if corporate issuance is to revive, Saudi companies may need to change old habits.

The need for a proper ratings culture is pressing. While most banks and financial companies issuing bonds have a credit rating, too many Saudi firms are uncomfortable about obtaining one, with the attendant transparency commitments it entails. "This must change if they want to widen the audience of investors, since this is one of the key criteria that investors always look at," says Popat.