Tuesday , October 17 2017

Yields rise; sovereigns boost issuance

GCC debt yields were volatile in 2015 but finally moved higher in the second half of the year. Rising US rates and further declines in oil prices pushed yields up later in the year, though in most cases yields were unchanged or even lower than at the start of 2015.

Meanwhile, debt issuance picked up as sovereigns turned to the debt markets to finance their emerging fiscal deficits. Yields are likely to climb further in 2016 if current expectations of further hikes in the US federal funds hold. More upward pressure is also likely if oil prices fail to recover from recent lows. Issuance activity was robust in 2015, driven largely by sovereign activity. It is expected to remain healthy in 2016, with debt markets, including bonds and sukuk, likely to play a more central role as financing needs grow and domestic liquidity is pressured.

GCC debt market yields rose in tandem with global rates during the second half of 2015, though in most cases yields closed the year at or below their levels at the start of 2015. Yields on sovereign paper maturing in 5-6 years across the GCC trended mostly downward during the first half of the year on the back of recovering oil prices and a stable global environment. Conditions changed by the middle of the year, with yields moving mostly upward, though in most cases they finished at or slightly below their 2015 starting levels. Yields on Dubai 2021 and Qatar 2022 paper ended the year at 3.64% ( flat on the year) and 2.81% (down 19 basis points), respectively.

Markets spent most of the year anticipating the first US policy rate hike. The Federal Reserve finally increased its federal funds rate in December 2015, signaling the beginning of its interest rate “normalization”; however, by then, most markets had already priced in the hike. As a result, effects of the increase on regional rates were relatively contained compared to 2013’s “taper tantrum”. The rate increase, the first in nine years, pushed the Fed’s target rate up by 25 basis points (bps). Markets expect the Fed to hike rates by a further 75-100 bps in 2016.

Regionally, policy interest rates are expected to move largely in tandem with hikes in the federal funds rate, with central banks keen on maintaining their currency pegs. Indeed, Saudi Arabia, Bahrain, Kuwait, and the UAE all increased key policy rates immediately or within days of the Fed move in December. Central banks in Qatar and Oman were the exception, keeping policy rates unchanged.

Oil prices further exacerbated concerns over fiscal sustainability and contributed to market volatility. Fears were reflected in increases in credit default swap (CDS) rates, which reflect likelihood of borrower default; still, rates remained well below other emerging countries. Saudi Arabia and Bahrain saw the biggest jumps, up by 79 and 106 bps during 2015, respectively, while the rest were up between 6 and 20 bps for the year.

Economic and political uncertainties concerns are likely to push yields and CDS rates higher. Meanwhile, muted global growth, atop an environment of rising rates, is not helping alleviate investor concerns.

The stock of outstanding conventional GCC bonds was boosted by sovereign issuances in 2015, in particular Saudi issuance. Meanwhile, bank activity was modest and corporate activity was virtually absent. Outstanding debt securities were up 13% y/y at the end of 2015, following almost two years of slower growth.

With policy rates on the rise, the gap between the cost of bank loans and bond/sukuk premiums may narrow, possibly increasing issuance activity across all sectors as debt securities grow in appeal with regional borrowers.

GCC sovereigns have turned to debt markets to help finance budget deficits. With most GCC countries expected to register fiscal deficits in 2015 and 2016, financing needs are expected to be high. The IMF predicts a financing gap of $650 million over the next five years for Saudi Arabia and Kuwait alone.

Saudi Arabia led the issuance, offering its first bonds since 2007. Saudi Arabia opted to access its domestic debt market to help sustain expenditure plans and stave off pressures on its foreign reserves. So far, Saudi Arabia has issued $31 billion in domestic debt in 2015 and aims to issue more in 2016.

Most other GCC countries also tapped debt markets in 2015. Bahrain and Oman issued government development bonds and sukuk to the tune of USD 3.9 billion and USD 2.95 billion, respectively. Meanwhile Qatar continued to issue its usual government bonds. Kuwait was the only GCC member not to issue any long-term sovereign paper during 2015.

Most sovereign issuance in 2015 targeted domestic markets. This added much needed activity and supported the development of debt financing frameworks. Saudi Arabia established a domestic credit rating agency, signaling its intention to expand its investor base beyond quasi-sovereigns and local banks; Oman finalized its Islamic financing framework, which allowed it to issue its first ever sovereign sukuk; Bahrain increased its sovereign debt ceiling and updated its debt management framework; and Kuwait drafted legislation that would permit sovereign sukuk issuance and is looking at setting up the necessary framework within the Ministry of Finance for debt issuance.

The focus on domestic market issuance has put some pressure on banking system liquidity, as is evident by the rise in interbank rates. Liquidity has already come under pressure as government revenues from oil receipts declined. This has led some to consider issuance in international markets in an effort to limit pressures on banking system liquidity. Indeed, Saudi Arabia, Kuwait, and Oman are contemplating international bond issuance.

Some sovereigns have increasingly issued syndicated loans financed by international banks in an effort to tap international markets. Syndicated loans are of similar tenors to bonds and are usually priced to USD Libor. Oman and Qatar are looking to tap this market, seeking $1 billion and $10 billion, respectively.

All GCC countries maintained investment grade ratings in 2015, despite the recent downgrades of Saudi Arabia and Oman by S&P. At their current low levels of debt, GCC countries have plenty of room to borrow, backed by sovereign wealth funds, positive economic outlooks, and stable foreign currency regimes. GCC issuance activity is expected to pick up as regional financing needs remain large and issuers maintain robust ratings. Sovereigns will turn to debt markets in a bid to protect their reserves.

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