Credit Rating’s Pressure And the Middle East Bond Market

Traders work at the Egyptian stock exchange in Cairo April 1, 2014. REUTERS/Mohamed Abd El Ghany

BY Philipp Good

The countries of the Middle East, especially the ones in the Gulf Cooperation Council (GCC) , with their high dependency on oil exports, will face some significant budget deficits this year and in to 2017.

For the foreseeable future there will be various adjustments to bring these numbers back in balance, including a combination of fiscal reforms, privatizations and other asset disposals or restructurings.

The first round in this process has already started in most of the GCC countries and the process has been given considerable impetus with Saudi Arabia’s announcement of its National Transformation Plan.

The region now presents considerable opportunities for frontier and emerging market investors. It is expected that, in the immediate term, GCC deficits will be funded either by drawing down from their local large foreign reserves or via debt instruments.

The hard currency bond market will see regular issuances from various sovereigns in the GCC and wider Middle East region as well as from the quasi-sovereigns, banks and corporates.

These new issuances will offer diversity and improve liquidity in the region, leading to a broadening of the fixed income investor base. We believe that we will probably see a leverage increase at all levels.

As opposed to many other emerging market regions, the starting point in the GCC is relatively comfortable. The average ratings in the Gulf region are amongst the highest globally at A- and most of the countries deal with little debt. However, there is now widespread acknowledgement, both within the region and externally, that the budget deficits will have to be rapidly and firmly addressed.

Over the coming years, hundreds of billions of dollars are expected to be issued in the hard currency bond market.

As a consequence, the ratings will come under pressure and the risk premiums will increase. The market has already priced in some of the impact of these issuances and for some credits the premium may rise still further.

With the growing investment universe more international investors will look at the credits and the overall liquidity in the secondary market is likely to increase.

The effects of these new conditions will impact not only the bond market but also the equity markets which will be increasingly pressured and show greater willingness to open up.

We think, for example, that Saudi Arabia might get a substantial share in the MSCI World if Saudi Arabia’s “Vision 2030,” a comprehensive plan which includes various economic and social reforms, is realized. The impact of the behemoth that will be Saudi Aramco’s listing could help accelerate this process.

From a global investor perspective, Corporate Governance will be highly important in pricing all the securities.
Investors will request detailed information about the strategy and the use of proceeds and will expect to receive regular updates. Corporate Governance in the region will need to improve.

This improved transparency will, in turn, require improved dialogue between issuers and investors, which we expect to positively affect credit assessments for issuers. Overall, we see this as an opportunity not just for investors but also for issuers.

However, in the short term, we believe that the Gulf region needs to overcome a period when challenging fundamentals, legacy valuations and negative market technicalities will act as a barrier to pick-up on new issues.

In addition, the relative flood of new issues has, and will continue to create an imbalance between supply and demand. Over time, this disparity will be absorbed by the market but issuers will need to do more work to entice the market and stimulate demand.

Two recent examples illustrate the ongoing challenges of the regional bond market: Abu Dhabi Sovereign, holder of about 6 percent of the world’s oil reserves, successfully raised $5 billion in a five-year and 10-year tenor with a credit risk premium of 85 basis points and 125 basis points, respectively. This was its first bond sale in seven years as it seeks funds to plug a budget deficit left by crude oil’s price plunge. The same day Bank Muscat completed a five-year bond in the international bond market.

Once we know the new normal for oil price, we will be better able to assess valuations and to make assumptions on where the ratings will be in the medium-term. This should allow for fairer or more realistic prices which should, in turn, stimulate demand.

Philipp Good is the Head of Portfolio Management at Fisch Asset Management, and leads the Convertible Bond and Corporate Bond Portfolio Management Team.

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