A lasting bond

By Angad Rajpal and Usman Ahmed

15 Jul 2011

The onset of the global credit crisis, a significant drop in domestic asset values and a subsequent decline in the banking sector’s risk appetite to extend credit have compelled Mena borrowers to adopt the fixed income market as a long-term funding alternative. The recent financial crisis highlighted the refinancing constraints of regional borrowers, who traditionally relied on short-term bank debt and equity financing to fund long-term infrastructure projects. The gradual development of Mena debt markets should enable regional borrowers to better align their asset and liability maturity profile besides providing the obvious benefit of diversifying their funding sources.

The evolving recovery in the region’s economy and a strong investment appetite for Mena credits have underpinned several successful benchmark-sized debt issuances in 2009 and 2010, most of which have seen their spreads tighten over the past few months. The HSBC/ Nasdaq Dubai Middle Eastern Total Return (MEAGTR) Index has successively outperformed, on a risk adjusted basis, its emerging market peers in recent periods and we expect, from a relative value standpoint, the Mena fixed income market to continue to offer attractive investment opportunities for regional and international fixed-income investors.

Evolving opportunity set

Not only has the number of outstanding debt issuances increased steadily in the past four years, the Mena debt market has begun to witness increasing issuances from borrowers outside of Dubai. More specifically, on-Dubai domiciled borrowers made up about 85% of the $30bn raised in 2010 as compared to only 60% of the $34bn raised in 2007. In 2009, we saw Qatar issue several tranches of debt that helped to create the region’s first sovereign yield curve and which helped establish a much-needed benchmark for other Qatari sovereign related and corporate issuers. The total market capitalisation of all outstanding debt underlying the HSBC/Nasdaq Dubai MEAGTR index stood at about $115bn, of which the UAE credits accounted for about 43%, followed by Qatar at 27% and Lebanon at 14%.

Despite the uprisings in North Africa and in parts of the GCC , which may be attributed to have caused risk premia to rise in the first quarter of this year, the region has witnessed year-to-date aggregate debt issuances of  $11bn (weightings as of January 31, 2011), the majority of which were issued by highly rated Abu Dhabi-based quasi-sovereigns. The GCC region’s infrastructure development plan over the next five years is well documented. Notably, Abu Dhabi, Saudi Arabia and Qatar have proclaimed the largest pipeline of long-term infrastructure development projects, a sizable portion of which is expected to be financed by long-term debt, which, when combined with the impending refinancing requirements of regional sovereigns and quasi-sovereigns, will provide significant tailwinds for increased bond market activity in the foreseeable future.

Meanwhile, a number of outstanding issues from oil importing, non-GCC countries with diversified exports, such as Egypt, Lebanon, Jordan and Morocco, offer an attractive opportunity set to investors seeking the benefits of attractive yields across the maturity and credit quality spectrum. At the same time, Mena fixed-income markets have begun to witness a structural shift from short-term papers to intermediate and longer-term debt issues, which make up about 38% of total outstanding issues, as measured by the Citigroup Mena Broad Bond Index. As the chart below shows, investment grade issues make up more than 70% of the Mena fixed-income investable universe. This is a reflection of the policies adopted by the region’s sovereigns which, along with quasi-sovereigns, made up the majority of debt issuances to date. Meanwhile, the high-yield universe continues to emerge and, in spite of the recent volatility, potentially offers an attractive level of risk adjusted total return.

Risk-adjusted performance

Between 2008 and 2010, the Mena fixed income universe steadily produced attractive absolute returns as compared to those generated by its emerging market peers. While the political upheavals in parts of the Middle East since the start of the year have caused an increase in bond price volatility in recent months, investors have sought safe-haven opportunities in selective credits within the GCC countries, most of which have not been noticeably affected by the regional unrest due to low political risks, a high degree of social stability and have rather benefited from higher oil price realisations further enhancing their overall financial profile. The Mena fixed income market, as measured by the MEA GTR Index, generated year-to-date returns of 4.6% as compared to 2.8% and 4.3% generated by the JP Morgan Emerging Bond Index and Barclays Capital Aggregate Bond Index, respectively. The rally in the GCC fixed income space has also mirrored a gradual tightening in the five-year Credit Default Swaps (CDS) spreads, particularly the spread linked to Dubai sovereign; which tightened by about20% to about 330 basis points year-to-date.

Since the beginning of the year, the debt default fears emanating from Greece and other peripheral countries in the Eurozone have resulted in a widening of global CDS spreads. The negative impact on the CDS spreads linked to Mena region debt obligations has been more pronounced as a direct result of an increase in risk aversion due to the unrest in North Africa. While the extent of the unrest was relatively muted in oil-exporting GCC countries, spreads on selective GCC sovereign and corporate issues have traded wider than those on similarly rated sovereign and corporate debt issues in the emerging market space. Having said that, GCC countries have benefited from higher oil prices and have efficiently used their fiscal muscle to enhance social spending and maintain stability. As the social unrest in North African countries recedes, investors who differentiate the issues during this period should potentially benefit from a fundamental readjustment of spreads in due course.