Middle East Capital Markets Come of Age

Euromoney, August 2014 

Was this the quarter when the Middle East came of age in the capital markets? Issuance from the region is on track for an all-time record this year, and it’s not just volume that is eye-catching: there are new tenors, a fondness for lower-rated and debut credits, and an increasingly fervent bid for Islamic paper.

According to Dealogic, Middle East DCM hit US$30.46 billion equivalent in the first six months of this year, up from $26.2 billion in the same period of 2013 and just $13.13 billion during the first half of 2011. The market is already three-fifths of the way to the full-year record $50.79 billion set in 2012. “It’s tough to project,” says Salman Ansari, head of debt capital markets, MENAP at Standard Chartered. “We were looking at a record last year and then the markets shut for a few months. But if macro conditions and the rates cycle remain where they are, then things are looking positive.”

Record numbers are one thing, but one has to look a little deeper before making a claim of greater maturity in the markets. A closer look at the data reveals a number of nuances. One is that it hasn’t been so much a strong first half as a strong second quarter. About three quarters of the total came between April and June; the first quarter was actually disappointed. “Year to date volumes are the highest on record, but it has been very lumpy,” says Ansari.

The clearest example of this was Etisalat, which raised Eu3 billion equivalent, or more than US$4 billion, across four tranches of dollar and euro notes in June. This deal somewhat distorted volumes.  “We’ve seen some jumbo financings this year from Etisalat and Saudi Electric, which have accounted for a pretty big proportion of issuance this year,” says Samad Sirohey, CEO of Citi Islamic Investment Bank, and head of capital markets for Citi in Dubai. Those two deals raised about $6.5 billion equivalent during the second quarter.

Then there’s the fact that, even if we are on for a record year, the vast majority of issuance is coming from just two places: the UAE and Saudi, which have accounted for 85% of volumes, up from 76% in the first half of 2013. “If you strip out Etisalat, UAE volumes are actually down 20%,” rather than up 20% as they are with the deal included, says Ansari. “While MENA volumes may be strong, a few transactions are accounting for a significant share of volumes.”

Those facts argue against a sense of greater maturity, but other attributes paint a different picture.

The first is a clutch of new names. “On top of the jumbo financings there have been some new borrowers who have come to market this year who previously didn’t see an efficient cost of funding in the capital markets,” says Sirohey at Citi. “They have been attracted by the yield environment.”

And it’s not just debut issuers, but lower-rated names too. “Historically you’ve just seen investment grade names accessing the sukuk market,” says Mohammed Dawood, HSBC’s Dubai-based global head of sukuk financing. “You’re now seeing standalone sub-investment grade corporates, such as DAMAC and Dubai Investment Park, both BB-rated.” DAMAC raised US$650 million in April; Dubai Investment Park raised US$300 million in a sukuk in February. “Investors are becoming more comfortable going down the credit curve: the order books on those transactions suggest they were very well bid, regionally and internationally, by high quality accounts including in Europe and Asia.” Others agree. “Damac is the kind of transaction we would not have seen two years ago,” says Abdeslam Alaoui, director, debt capital markets CEEMEA at Barclays. “We expect to see more corporate issuance in addition to the usual double As and single As.”

Dawood hopes for more of this. “We expect to see major growth in this segment in the next 12 to 18 months,” he says. “It may develop in the high yield form, or maybe the Eurobond style with limited covenants in place. Either way we are excited about that opportunity.”

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It’s also worth noting that many of the issuers one would normally expect to have seen by now have not yet turned up. There has been no Mudabala, no IPIC, none of the big state Qatar enterprises; no QTel, no Bahrain sovereign, nor hardly any of the cash-rich banks. If they do, we really will see a record year.

“Traditional issuers have been quiet and absent from the market, particularly from the bank sector for senior funding, as well as regionally from Qatar,” says Sirohey at Citi.

So why are numbers up?

In one respect, the Middle East is simple enjoying the same dynamics as a lot of other places. “I see the phenomenon in the Middle East as similar to the emergence of a wider range of deals we have seen across the CEEMEA and LatAm regions,” says Simon Ollerenshaw, head of DCM for CEEMEA at Barclays. “The market environment has been created by persistently low rates, the search for return through the credit markets, and the opening up of the markets to a range of issuers who might not have had a competitive cost of funds from the bond market before.”

But there are other elements distinct to the Middle East. Ollerenshaw’s colleague Alaoui notes that “through the volatility we have seen this year, Middle East credit spreads have been strong. It has led to the region being considered a safe haven compared to other emerging market jurisdictions.”

Then there is the amount of cash seeking a home. “The main reason is that liquidity has been strong across regional and international investors,” says Fawaz Abusneineh, head of debt capital markets at National Bank of Abu Dhabi. “The drop in volatility combined with the high liquidity have made market conditions conducive for issuers. Interest rates are almost at all-time lows – we don’t expect them to go much further down – and at the same time absolute spread levels are tighter than at any time since the 2008 financial crisis.”

There’s timing, too, with Ramadan approaching. “You certainly saw a rush of issuance in June,” says Dawood. “Given the fact that Ramadan is coming in July and the market will remain shut in August, many issuers were trying to get to the market beforehand and take advantage of lower rates and very favourable market conditions,” he says.

Dawood summarizes the positive mood. “The conditions are very favourable here: you’ve got the banks in a strong position and under pressure to grow assets, you’ve got economies performing well, governments embarking on large and significant infrastructure projects,” he says. “The overall macro picture lends itself very well to credit conditions remaining favourable for the foreseeable future.”

The sense of renewed appetite is nowhere more true than in the sukuk markets. The Islamic form of debt issuance is no longer an afterthought, an alternative; it is, increasingly, the default form of financing in the region, and for many issuers is cheaper than conventional.

“Sukuk has increasingly become the cornerstone of MENA DCM,” says Ansari at Standard Chartered, who says sukuk volumes are up 8% year on year and stand at the second highest year to date level on record, after 2012. “It has become a much more relevant part of the DCM markets,” he says: sukuk, on average, have represented about 51% of total Middle East DCM volumes over the last three years, whereas in the prior six years, the figure was 26%. “Sukuk have almost doubled their contribution to the DCM market.” The sukuk figure is slightly lower than half the market this year, but that’s the distortion of Etisalat once again.

Moreover, sukuk are increasingly responsible for the market’s most innovative deals. This year we have seen Dubai bring a new sukuk duration to the Emirates with a 15 year maturity; debut borrowers like ICD, which launched a dual tranche sukuk and conventional; a very successful 10-year US$750 million sukuk from Emaar Malls; and, the real stand-out, a US$500 million tier one perpetual from Al Hilal. “The sukuk market leads the way in innovation,” says Ansari.

The Al Hilal deal shows what happens when bank capital regulation and Islamic finance meet: fertile ground for innovation. Al Hilal was the first tier one deal from the region designed to comply with the provisions of Basel 3, and specifically the language around non-viability. “The Al Hilal deal is structured for potential Basel 3 compliance, because in the context of the UAE, there are no Basel 3 guidelines as such yet,” says Sirohey at Citi. “But this has ticked another box, which involves having the point of non-viability loss absorption language in the document.” In the past, such deals simply included a clause about a possible change in the law one day; this, therefore, is an evolution.

The deal’s success was telling. “It went extremely well,” says Sirohey (Citi was one of the leads alongside Al Hilal, Emirates NBD, HSBC, NBAD and Standard Chartered.) The diversity of its distribution was striking: 31% Asia, 30% Europe, the rest Middle East; fund managers 32%, private banks 30%, banks 29%, pension funds and insurers 8%. “The book received orders of almost $5 billion. It was the lowest priced dollar tier one issue from the emerging markets ever, I believe.”

In fact, it was the pricing more than the innovation which struck the market. Dawood at HSBC notes: “It has helped to narrow the differential between senior and tier one paper. It’s important not only from an innovation perspective but also a pricing perspective.”

And how does pricing now stack up? “When you look at sukuk versus conventional, sukuk continue to trade inside conventional bonds,” says Alaoui at Barclays. “That is a function of the buy and hold nature of investors. Since investors hold on to the sukuk that they buy, this leads to scarcity of secondary market supply, driving spreads tighter.” Moreover, there’s a bigger buyer base than was once the case: in addition to the local, sukuk-dedicated investors, those further afield are now interested. “Historically, five or six years ago, most sukuk investors were based in MENA and a few in Asia,” Alaoui says. “Now we are seeing more and more investors from the UK and Europe who are familiar with the sukuk market. For any sukuk now you see more than 50% of demand from Europe.” He highlights Saudi Electric Company’s $2.5 billion deal, which raised $12.5 billion in orders, as an example of this demand.

Sirohey at Citi says “a sukuk can get funding levels up to 20 basis points tighter than conventional for some issuers because of the extra pocket of demand for their credit.” But the point here is the remark “some issuers”, because this isn’t a bonanza that applies to everyone; chiefly, it’s established regional GCC credits benefiting from local Islamic banking liquidity. “Will other outside credits be able to benefit from the same dynamic? My view is it is more of a regional phenomenon. Within the GCC, if you have a strong following among the Islamic banks here, you are able to access that liquidity, and hence generate better terms.” If you are not, that’s a harder sell.

At NBAD, Abusneineh agrees a distinction must be made. “Let’s put sukuk into perspective,” he says. “For highly rated regular issuers, we do not expect tighter pricing for a sukuk vis-à-vis a conventional offering at the same terms and conditions, because they are already issuing at very attractive levels on a conventional basis.” It’s not going to work for multinationals without a clear connection to the Islamic investor base, either. “But for companies that are not very highly rated and where the business is generally Shari’ah compliant in nature, sukuk could be priced tighter, simply because of the incremental demand from the Islamic accounts that are hungry for good quality Islamic instruments.” In those specific circumstances, he says, going Islamic could be worth a 10 to 15 basis point differential.

That said, the scarcity created by a buy-and-hold investor base is a mixed blessing. “One of the negative points some investors highlight about sukuk is that there is limited liquidity, because Islamic investors don’t tend to sell them,” says Abusneineh. “That could be positive in certain instances, because it makes sukuk instruments relatively less volatile. Hence they can withstand adverse market conditions. But investors who want to trade the market find it difficult.”

Be that as it may, there’s no question that sukuk have real momentum as a form of financing. “I don’t think there is a ceiling to sukuk growth,” says Ansari.

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So what does the market lack?

For a start, a wider range of issuing nationalities would help. The absence of Kuwaiti and Qatari borrowers this year has made the customary dominance of the UAE and Saudi Arabia (which is chiefly a domestic market in riyals anyway) particularly stark. (If Turkey is considered Middle East, then that’s an interesting issuer too. “In most of MENA, issuance has been more corporate or GRE,” says Ollerenshaw at Barclays. “Turkey has a much broader mix,” including, unusually given regional bank liquidity, the financial institutions. Recent examples have included Halkbank, Vakifbank, Isbank and Turk Telecom.) A sense of diversification to the broader MENA region, exemplified by recent issues from Morocco, is very welcome. “It is important that issuance is not dependent on one or two markets,” says Dawood.

It would also be useful to see funding used for a wider range of reasons. “I would like to see a lot more happening on the infrastructure side,” says Dawood at HSBC. “There is a significant requirement in the region:  all the GCC countries are embarking on large infrastructure projects, and it would be good to see some of those assets coming to market. Infrastructure is a very natural asset for the sukuk market.”

On the buy-side, there is scope for further evolution too. “The market clearly lacks a longer-term investor base,” says Dawood. “The region is still heavily dependent on banks and we do need to see a more granular investor market, with some of the institutional investors you see in more developed markets.”

And there is more to do in convincing corporates in particular that the capital markets represent a viable alternative to easy bank credit, though there is a sense that that is underway. “A number of issuers are considering diversifying funding away from the loan market into the debt capital market, because it offers some better terms,” says Abusneineh at NBAD, such as relatively lighter financial covenants, unsecured borrowing, and bullet repayment profiles as opposed to amortizing structures. “We expect more names to consider obtaining ratings, setting up and listing MTN programs.”

So there is further to go. But for the medium term, the outlook for issuance looks very positive. “Post-Ramadan, there is a line-up of issuers wanting to take advantage of these attractive rates,” says Abusneineh at NBAD. “Corporates tapping the investment grade and high yield markets, sovereigns attracted to the longer end of the curve, banks coming with capital instruments, in addition to senior funding in dollars and other currencies,” such as Australian dollars, where Abu Dhabi Commercial Bank, Emirates NBD, First Gulf Bank and NBAD have issued this year. “There is a multitude of issuance expected to come to the market.” Along the way are an expected US$40 billion of total debt maturities in the GCC that need to be refinanced.

One gets a sense of the rising opportunity by looking at how NBAD itself is staffing up. Andy Cairns, formerly of BAML and HSBC, now heads debt origination and distribution, with responsibility for bonds and loans; Jonathan Macdonald, preciously head of global syndicated finance for Europe and APAC at Barclays, joined this year to head loan syndications. It’s still adding staff to the eight DCM and two fixed income syndicate staff it has built up, alongside a growing credit sales capability in the region, Europe and Asia, and a powerful secondary trading capability.

Why? “I’m of the opinion that over the next several years we’re going to see an increasingly heavy utilization of fixed income issuance from Middle Eastern corporates and financial institutions,” says Cairns. We’re going to see disintermediation of bank financing, and a gradual evolution towards bonds, similar to what we have seen over the last decade in Asia.” If that’s true, it’s little wonder that houses are staffing up.