The growth of bond issuance in Arab markets, includingconventional and Islamic paper, has taken off in 2006-2007.Figures circulated by the financial industry say that bondissuance by GCC corporations reached $18.2 billion in 2006,compared with less than $2 billion in 2003. In total, GCCbond issuance surpassed $40 billion last year, comprisingsovereign, banking, project finance and corporate issues aswell as shariah-compliant issues.
The increase of 2006 was exceptional because numbers wereinflated by some very large issues from the UAE, namely aconventional bond by Abu Dhabi energy company Taqa worth$3.5 billion and by two similar-sized shariah-compliantissues from real estate developers Nakheel and from Dubai’sPorts, Customs, and Free Zone Corporation (PCFC), PhilippLotter, a senior credit officer of international ratingsagency Moody’s Investor Services, told Executive.
Lotter authored a study that forecasts 2007 to be anotherextraordinary growth year, with issuance of corporate bondsin the GCC to at least double by end of December and withoutrunning out of steam. Even issues much smaller than theheadline-making multi-billion-dollar bonds “faced strongdemand,” he said, and there is no danger yet that smallerissues will be crowded out.
Bond experts from the banking industry also see the MiddleEast just at the start of an epochal journey to develop theprimary and secondary markets for tradable fixed-incomesecurities. Coming from a minuscule base, “the market hasdeveloped very well. We foresee healthy growth for bonds andsukuk in 2007 and beyond,” said Tim Harrison, associatedirector of HSBC Bank Middle East for corporate andinvestment banking.
Corporates and government-backed companies last year werenot the region’s only forces with a mind to issue morebonds. According to Lotter, bond issuance in the GCC in 2006originated to $13 billion from banks and to $9 billion fromgovernments. Project finance for $3.5 billion pushed thetotal to $40.3 billion. Corporate issues were split 60-40between conventional bonds and sukuk.
The volume of fixed-income securities in the Middle East hasexpanded across all type of products, affirmed Adel Afiouni,a managing director with Credit Suisse based in London.Conventional and Islamic, debt, asset backed orequity-linked, etc. has increased substantially over thelast years and there is clearly room for much more growth,added Afiouni who heads CS’s Middle East & North AfricaInvestment Banking Coverage.
The bond market’s spell… You are getting verysleepy
What creates the spell of the bond market? Bond varietiesare much more numerous than spy movies but on average alsomore boring. An Aston Martin is not required, and neither isa Martini, but small is the band of people with fascinationand license to deliberate on semi-annual coupons, redemptionvalue, floating rates, puttability, and the inverse relationof price and yield.
The fixed-income market is also the domain of specialists.While individuals do buy bonds and US households have beensaid to hold about 10% of US bonds in circulation, theretail investor mostly interacts indirectly with the bondmarket—either through owning stakes in bond-investing funds,or as beneficiary of pensions and returns from otherinstitutions which rely heavily on sovereign bonds orcorporate issues.
But for companies as issuers and institutional investorsas buyers, the fixed-income market is a sexy propositionbecause it is a merry match to equity for serving fundingneeds, to such an extent that bonds today are amulti-trillion dollar market which makes the current size ofArab bond business look like an orientation course.
However, the exponential growth has been quite recent whentaken in the historic context of bond issuance which hasbeen closely aligned with the rise of the financial industryfor some four centuries.
Initially, the lenders of post-medieval Europe conceivedof bonds to meet the large funding needs of rulers and thosenoble families whose nobility referred to running upexpenses in chronic excess of their income.
Bonds helped the early bankers to source funding that theycould not provide on their own and distribute risk inserving such customers. The idea also caught on for warfare,the real money-burner of all ages. European countries andlater on the United States issued war bonds to cover theimmense cost burden of the World Wars. Depending on thesuccess and righteousness of the conflicts, war bonds werethe—by all means risky—mixture of patriotism andprofiteering that could generate excessive gains for somebut usually meant sacrifice for many, or ruin after lostwars.
Trains push developing bond market
Another great source feeding the evolution of bonds wasinfrastructure finance, especially railroad bonds, whichwere the rage in the 19th century rail transport revolutionfrom economizing Czarist Russia over train spotting Britainto freewheeling North America. In an age of wild expansionand no supervision, the surge of railroad bonds offered theunintended side-effect of giving fraudsters handyinstruments for duping gullible buyers with worthless fakes.
The transport industry debt instruments thus contributedprominently to the emergence of the credit ratings industry,which started out with small providers of information ondebt instruments such as railroad bonds to investors at thebeginning of the 20th century. But it wasn’t until theproliferation of debt markets and bond issues from the 1970sthat ratings agencies started booming and fee-based ratingof corporations and debt issuers became a phenomenal growthbusiness.
US corporations were the first to delve into bonds asalternatives to equity and bank debt, followed in the 1990sby European companies. Researchers say that issuance ofcommercial paper alone increased almost threefold in the USin the last 10 years of the 20th century, supporting annualrevenue growth rates of 15% for the leading ratings agency,Moody’s. Europe’s corporate bond market benefited from theMaastricht treaty and euro introduction and more thandoubled between 1995 and 2000.
The growth was accompanied by introduction of newregulatory and ratings mechanisms. But risk shocks have notentirely vanished in corporate issuance, even when theissuer is not an unrated entity or producer of a junk bond.An example for a bad risk that caught the US market offguard was the case of telecommunications firm WorldCom fiveyears ago.
Investors in bonds by WorldCom—which had made the recordbooks with an $11.9 billion corporate bond issue rated byagencies as investment-grade just a year before itsdevastating fraud and financial scandal in 2002—lost abouttwo thirds of their money when the company went belly up.The partial recovery of investments meant that bond holderswere still better off than other WorldCom stakeholders butthe case reverberated in the courts.
In the Middle East, bonds are coming into big play a good30 years later than their rise in the US and about 15 yearslater than in Europe. But this does not mean that the bondidea is past its prime. Given the relative saturation of theUS bond market, indicators suggest that the Middle East candraw a lot of attention to its bond issues, bothconventional bonds and their Islamic equivalent, sukuk.
Benefiting from a ‘virtuous circle’
The bond market in the Middle East is benefiting from a“virtuous circle of increased issuance by regional borrowersand increased interest from international investors,” saidAfiouni. He told Executive that the increase in the volumeof new corporate bonds over the last years is the result ofissuers realizing that they can benefit from globalliquidity to diversify their source of funding away fromtraditional local banks lending and tap into a new investorbase. International bond buyers in turn are attracted by thefact that Middle Eastern bonds provide diversification andstill offer some premium and an attractive risk returnprofile over comparably rated bonds from issuers in otherdeveloped markets.
In April, the growing role of regional bond finance wasfurther illustrated by news that Saudi billionaire Maan AlSanea (a Saudi Arabian financier who won global attentionthis year by being included for the first time in the Forbesbillionaires list) intends to finance acquisitions andexpansion measures of the Saad group by issuing conventionaland Islamic bonds worth about $5 billion. The news came onthe heels of an announcement that Sanea bought a $6.6billion stake in HSBC.
Given that integration of financial markets andliberalization/deregulation measures are among the mainelements that stimulate the growth of the financialindustry, Arab bond markets are likely to get further boostsfrom convergence measures, including the planned monetaryunion.
Euro gains currency as bond instrument
In this context, European central bankers have pointed outthat the euro has gained in importance as bond issuingcurrency through the European Monetary Union, which moreoverhas boosted intra-eurozone trade volumes by around 10%without hurting external trade. This raises the question howstrongly the GCC joint currency project will influence thegrowth of trade and financial markets in the region—if itsucceeds as planned—and how much this will enhance the bondscene.
However, the majority of current GCC bond issuers addressinternational markets, said Harrison, implying that theimpact of regional economic integration will be less of afactor for the Middle East bond market boost.
“In the Dubai ports issue, 95% of investors came fromoutside,” he said, adding that the majority of currentissues, including Islamic ones, are denominated in dollar,because that makes them much more appealing to internationalbuyers.
Elements of the overall bond issuance picture incurrencies and formats that appeal internationally are alsothe Euro Medium-Term Note Programs (EMTN), debt instrumentswhich several regional banks have deployed successfully inthe past two years.
The market shows trends of broadening into local and otheremerging markets currencies, though. Last month, EmiratesBank Group closed its first bond denominated in the ThaiBaht, a $61.5 million issue that was lead-managed byStandard Chartered Bank, the same bank that had arranged GCCbond issues targeting other Asian markets by beingdenominated in Singapore and Hong Kong dollars.
Local investor hunger
In an example for companies responding to local investorhunger, Kuwait’s Global Investment House in late Aprilclosed a KWD45 million ($156 million) bond issue withfive-year maturity in two tranches, one paying 7% annualinterest and one with a floating rate. It is the financialfirm’s second bond and will be used to repay other debt andfinance investments.
Global’s senior vice president for marketable securities,Saidu Mohammed, told Executive that the investment bankdecided to issue the bond, which it also manages, todiversify and extend maturity of its financing tools, whichinclude funds and Islamic instruments.
It is not necessarily cheaper for companies to issue bondsthan obtaining bank loans, said Lotter, but by accessing thebond market firms can diversify their funding base and theirinvestor base. As a lesser motive, corporations also maywant to reap some benefits from the publicity associatedwith launching a massive bond and spreading the news of itsrating in the global financial industry.
Sukuk are bound to claim a greater role in regional fixedincome and are expected to penetrate global markets. Thatinfrastructure development is one major reason for theincrease in sukuk issuance creates a certain parallel in thegrowth of the asset-backed Islamic financial instruments tothe historic emergence of bonds in the debt markets ofEurope and North America. The plans of the UK and Japan, andalso of Germany, to issue new sovereign or government-backedsukuk will make sukuk again more palatable to investors.
To behave like bonds elsewhere, the Islamic andconventional issues need a liquid secondary market wheretrading of bonds stimulates further financial flows. Mostexperts agree that the region’s secondary bond markets arestill some time away, with the Dubai International FinancialExchange—where more sukuk are listed than anywhere else—andthe London Stock Exchange—which recently announced theestablishment of a secondary market for sukuk—being ahead ofothers in the attempt to grab the trading action.
Nakheel listed its sukuk on DIFX and LSE, and DubaiIslamic Bank has the same agenda for its new musharakasukuk. But trading in securities on DIFX is still somewhattheoretical and other contenders are in the race for hostingthe secondary market in Middle Eastern bonds. Thesecontenders include Bahrain and Kuala Lumpur, both placeswhere Islamic finance is strong.
Given the recentness of bond issuance in the GCC, theexperts would not estimate the timeframe for building aliquid secondary market. “It will take several years,”Lotter estimated. Afiouni noted that the investment behaviorof banks and other bond buyers in the Middle East was, untilrecently, still predominantly characterized by abuy-and-hold mentality. “They put them into the drawer untilmaturity,” he said, “but we expect this to change asinternational investors become more actively involved.”
In Kuwait, bond buyers are still holding to maturity,Mohammed said. While he expects the market to grow into moreissues, he sees the emergence of a secondary market for themoment as a wishful proposition. The market is “not thatliquid. If we want to see a liquid bond market, we will haveto be patient,” he said.
Harrison, however, claimed that a secondary market forover-the-counter trading of Middle Eastern bonds is alreadytaking off in Dubai. “It is starting already,” he said,referring to an active trading desk at HSBC.
With the latest announcements of bond projects, trends for2007 indicate that corporate issuance could well increasebeyond $40 billion this year and peak in a wave of growththat will continue at high rates well into the next decade.Besides the implications for development of a secondarymarket, the booming bonds imply that need for ratings andauxiliary services will increase in the next few years.Information on issuers, overall market conditions, anddetailed fixed-income trends and daily news will be a strongbusiness opportunity.