Gulf premium may vanish as views of region shift
Dubai, June 21, 2014
By Archana Narayanan
Long a key feature of the Middle Eastern bond market, the "Gulf premium" is fading and may vanish entirely as soon as this year if the region continues to gain ground as a mainstream investment destination.
The premium is the mark-up that issuers in the Gulf have to pay over developed-country issuers when they sell similarly rated paper. It has existed since the birth of a significant flow of international bonds from the Gulf about a decade ago.
It is attributed to a range of factors, especially the geopolitical uncertainties, unpredictable government policies, poor information disclosure and shaky corporate governance standards in the six-nation Gulf Cooperation Council.
And in the past, the premium was substantial; a decade ago, a highly rated issuer in an oil-rich economy such as Abu Dhabi or Qatar might expect to pay a premium of 200 or 300 basis points.
But it has been narrowing steadily over the past couple of years as the Gulf's bond market has deepened and foreign portfolio investors' concerns about the region have eased somewhat. In recent weeks the premium has almost disappeared - and some think it could do so entirely.
The Gulf premium "has shrunk and normalised over the past few years on the back of improving fundamentals as well as increased investor demand," said Mohieddine Kronfol, chief investment officer for regional fixed income at global asset manager Franklin Templeton Investments.
"Strong relative performance and rapid market development should support the GCC as an attractive investment destination for regional and international investors looking to optimise and diversify their portfolios."
The trend was underlined in dramatic fashion last week when UAE state telecommunications operator Etisalat sold $4.3 billion worth of US dollar and euro bonds in four tranches, the region's biggest corporate issue ever.
It also set a record for the cheapest pricing - it was the first time that any Gulf issuer, including governments, priced a bond in the double digits above mid-swaps. The Qatar government achieved 115 bps over mid-swaps with a five-year sukuk in July 2012, and a 10-year trade from Abu Dhabi National Energy Co in April 2014 was at that level.
Etisalat bonds have tightened in the secondary market since its sale and on Thursday, its $500 million of bonds maturing in June 2019 were bid at 2.32 per cent.
Dollar bonds from US telecommunications firm AT&T, maturing in March 2019, were bid at 2.24 per cent. Rated A3 by Moody's, AT&T is three notches below Etisalat, so a significant Gulf premium still exists - but it is small compared to what it would have been a year or two ago.
The gradual narrowing of the premium over the last few years can be seen in the spread between 10-year dollar bonds issued in October 2010 by Qtel International Finance, part of Qatar's state-run telecommunications firm, and South Korea's Export-Import Bank.
The spread of the yield of QIF, rated A plus by Fitch, over the AA minus-rated Exim Bank has shrunk to 15 bps from 45 bps at the end of 2010.
For pure sovereigns, the premium has shrunk even faster. The spread of Abu Dhabi's dollar bond maturing in April 2019 above Canada's December 2019 US dollar bond has narrowed to 16 bps from 28 bps at the end of last year, even though Canada at AAA is rated two notches higher than Abu Dhabi by Standard and Poor's.
Several reasons are behind the narrowing. One is outside the Gulf's control: the plunge in global interest rates and drastic easing of Western monetary policies over the last several years, including the European Central Bank's decision this month to cut its deposit rate below zero.
This left foreign investors hungry for yield and willing to bid up the prices of Gulf bonds in a way they had not done before. Some local institutional investors followed suit.
"Investors' hunger for fixed income assets, improving fundamentals and a supply-demand imbalance combined have caused the Gulf premium to shrink over the past few years - hence global and regional investors are having to accept the new pricing norm," said Chavan Bhogaita, head of alternative investments at National Bank of Abu Dhabi.
Other reasons are specific to the Gulf. The slow broadening and deepening of the region's bond market has made it more attractive for foreign investors by improving liquidity.
Meanwhile, the rich Gulf states have done well - surprisingly well, in the eyes of some foreign investors - in riding out the geopolitical and economic turbulence of the past five years.
Their treasuries swelled by high oil prices, they have banded together to prevent the Arab Spring uprisings in North Africa and the Levant from causing serious instability in the Gulf. So some foreign investors have cut their assessment of political risk, for the medium term at least.
The bond market's confidence in political stability has been evident in the past two weeks, as GCC spreads and credit default swaps have barely moved while insurgents threaten to dismember Iraq.
Meanwhile, the volatility in emerging markets over the past year has focused on countries with big current account gaps and budget deficits. Because of its oil earnings, the Gulf has huge surpluses in both respects, making it seem an oasis of economic stability in the emerging market universe.
Another factor is the Gulf's progress towards improving information disclosure and corporate governance. There is a long way to go, but authorities are working towards that goal in the UAE, Saudi Arabia and Qatar. The debt restructurings of Dubai's state-linked firms have revealed previously undisclosed data on how the emirate operates, though much remains secret.
"While significant improvements in the UAE's statistical base are underway, important shortcomings remain," the International Monetary Fund said in a report last month.
Some traders think the momentum of spread compression is strong enough for the Gulf premium to vanish in coming months - though others think that even if it does disappear, it could reappear when global economic conditions change.
Kronfol said further, sustainable spread compression would depend on the region addressing structural issues such as governance standards, capital market regulation and bankruptcy regimes. These issues still prevent pricing from being entirely in line with developed markets, he said.
One big risk for the Gulf, and all emerging markets, is the prospect of U.S. interest rates starting to rise next year, which could suck money back to Western markets.
The Gulf's currency pegs to the dollar should limit this risk, but even so, Gulf economies will for the foreseeable future remain heavily dependent on one commodity, oil, and they will be part of a volatile international environment.
"The supersized Etisalat corporate bond was issued with the lowest spread of any Gulf bond above mid-swaps ever. That is pricing for perfection, and fails to discount the political risk that is inherent in the region," said Daniel Broby, chief executive at Gemfonds, a global emerging market specialist.-Reuters