Global debt capital markets were not for the faint-hearted in 2018. The year was one of turmoil in the global fixed income space, as the great bull-run in bond markets screeched to a halt.
However, MENA fixed income instruments provided a relative oasis of calm, according to a white paper titled MENA debt: an evolving world for fixed income investors. The numbers speak for themselves.
The GCC benchmark index returned 0.30 per cent in 2018 compared to -1.72 per cent for the emerging market benchmark JP Morgan CEMBI Index, and -1.20 per cent for the Bloomberg Barclays Global Aggregate Index.
MENA hard currency bond and Sukuk issuance reached $84 billion in 2018, with demand for new issues remaining high as regional debt was oversubscribed 2-2.5 times, according to the white paper by Emirates NBD Asset Management, KAMCO Investment Company and Fisch Asset Management.
The paper champions arguments to invest in GCC bonds in 2019. GCC bonds are now included in the JP Morgan EMBI index series and more outward-looking policies aimed at integration with global markets are increasing the breadth of financial instruments traded in the region, which is good news for foreign and domestic investors.
Faisal Hasan CFA, Head of Investment Research at KAMCO Investment Company, said, “Reforms being implemented across MENA make it an attractive destination for global investors—spending on infrastructure remains a priority for policymakers and expanding the non-oil sector to diversify economies away from oil dependence has received support from almost all governments in the region.”
Financial markets in the MENA region are evolving at a fast pace and catching up to other emerging economies by developing more advanced regulation, a supportive legal environment and a sophisticated investor community, the report says.
Furthermore, the GCC’s share of global GDP is expected to increase from 1.8 per cent in 2015 to two per cent in 2019, while its share of emerging markets GDP is expected to increase from 4.7 per cent to five per cent.
Debt-to-GDP ratios among most GCC issuers remain very healthy, especially when compared to similarly rated emerging market peers, despite some having risen sharply. On the equity side, the recent inclusion of Kuwait and Saudi Arabia in emerging market equity indices owned by MSCI, FTSE Russell and S&P Dow Jones comes on the back of a number of positive changes made to trading systems and regulations.
On the fixed income side, GCC bonds’ inclusion in the JP Morgan EMBI will result in increased foreign participation. Reforms have also been aimed at increasing transparency to boost investor confidence and at the same time provide ample supervision and oversight to protect investors.
These changes have helped, to a great extent, in limiting the impact of political events and decorrelating them from financial markets. An important driver for investors, whose demand encourages new supply, has been a widening of spreads as a consequence of rising interest rates in the US, according to the report.
Until a new equilibrium in the rate market is found, emerging markets remain attractive alternatives for allocation, with GCC countries among the most appealing of all. The report argues that the GCC fixed income space offers investors the best of both worlds, as it has characteristics of both developed markets and emerging markets.
In addition, traditionally attractive emerging markets such as Turkey, with twin deficits, are experiencing growing pressure—encouraging investors to reallocate to markets such as those in the GCC, where a relative ‘haven’ can be found.
GCC sovereign and quasi-sovereign debt will become eligible to be included in the JP Morgan Emerging Market Bond Index (EMBI) series from 31 January 2019. Both conventional bonds and Sukuk will be eligible for index inclusion, however Sukuk will need to have a credit rating from at least one of the three major rating agencies.
Approximately $300 billion worth of assets are benchmarked against the JP Morgan EMBI series, so this inclusion could translate into around $30 billion of additional inflows to GCC debt instruments.
Furthermore, the benchmark index inclusion provided a strong technical bid for regional debt in 2018, as active investors positioned ahead of the actual implementation date. “We expect to see a further boost as passive asset allocators follow suit in February 2019,” the report said.
“Saudi Arabia, United Arab Emirates, Bahrain and Kuwait are expected to have an approximate weight of 3.1 per cent, 2.6 per cent, 2.1 per cent and 0.8 per cent, respectively.” “As a result, after the additional emerging market index inclusion to attract inflows and improve transparency of these high-quality names, the average rating of the index is expected to improve.”
Oman is already in the index with a weight of two per cent. On an aggregate basis, the GCC is expected to represent about 13 per cent of the Index. With the inclusion of GCC countries, the average credit quality for the Middle East basket will move above the global emerging market sovereign bond universe average.
The risk premium will thereby turn in favour of the Middle East basket, and regional bonds will trade at lower credit spreads compared to average emerging market levels, according to the white paper.
The average credit quality for the Middle East sovereign universe at the end of 2018 was two notches lower than for global emerging market sovereign bonds, so these sovereigns had to pay an aboveaverage risk premium. The premium has increased by 50 per cent from 60 bps to 90 bps in the last five years.
If oil prices were to remain below $60/barrel for a three to five-year period, oil-exporting countries may face widening deficits, which would make a reassessment of credit quality by the rating agencies likely.
Additionally, the lower risk premiums for MENA credits would adjust to align with wider emerging markets. The volatility of current account balances, caused by oil price movements, make the region vulnerable, the report warned.
However, large foreign reserves in the form of sovereign wealth funds provide a cushion to ride out any short-term volatility.
The case for fixed income portfolio allocation to MENA is supported by the growing share of global GDP represented by the region, which for the GCC is expected to increase from 1.8 per cent in 2015 to two per cent in 2019, while its share of emerging markets GDP is expected to increase from 4.7 per cent to five per cent.
Less than a month into 2019, the GCC delivered $9.1 billon in issuance from both sovereigns and corporates, including the Saudi sovereign, First Abu Dhabi Bank and Dubai Islamic Bank, setting the scene for the rest of the year.
In addition, there are market-wide expectations that Saudi Aramco will issue debt in 2Q19 to fund its SABIC stake acquisition. Hasan said, “Regional gross government debt as a percentage of GDP increased from 29.7 per cent in 2014 to 44.4 per cent in 2018, after a series of issuances.
Fiscal deficits for most MENA countries have been the reason for an increase in government debt, and this trend is expected to continue in 2019—providing a fresh set of opportunities for investors.” The region carries a risk premium.
The paper also highlights that, while regional bonds look attractive on a rating adjusted basis against other emerging markets, there are a range of important considerations for investors: these include geopolitical uncertainty; possible rating downgrades, although in the case of most sovereigns this is mitigated by diversification initiatives; increased supply carrying the risk of a glut outstripping demand; and the region’s over-reliance on oil as a revenue source.
Banks and corporates are more exposed to downgrades, with the recent example of National Bank of Oman’s re-rating to BB+ by Fitch putting it into the high yield category. Credit events of this kind usually lead to repricing, as certain investors are forced to sell bonds due to rating constraints.
Overall, the white paper did not report a great deal of rating pressure for the region in 2019, but any downgrades that do occur could damage sentiment. Parth Kikani CFA, Director Fixed Income at Emirates NBD Asset Management, said, “Last year, GCC fixed income provided a safe haven during a sustained EM sell-off period. For 2019, we think risks are more balanced, and investors will need to be more discerning in credit selection.
While risks stem from further oil price volatility, increased issuance and geopolitical uncertainty, investors may benefit from attractive risk premiums, improving fundamentals and the benefits of index inclusion leading to efficient price discovery.
“Moreover, with most GCC currencies pegged to the US dollar, this reiterates an attractive relative risk premium amid weakening emerging market FX rates and a stronger US dollar.” Philipp Good, CEO and Head of Portfolio Management at Fisch Asset Management, concluded, “An important driver for investors, whose demand encourages new supply, has been a widening of spreads as a consequence of rising interest rates in the US.
Until a new equilibrium in the rate market is found, emerging markets remain attractive alternatives for allocation, with GCC countries among the most appealing of all. Most countries are pushing their reform agendas, and the balancing of the pace of reform will be one of the key drivers for stability in the region. Meanwhile, oil price performance remains crucial, and a key driver for credit.”