In the past, sovereigns from the Gulf Co-operation Council (UAE, Qatar, Kuwait, Saudi Arabia, Bahrain and Oman) rarely needed to issue debt. However, the fall in oil prices and the need to fund their budget deficits has prompted these issuers to borrow in the international bond markets. The scale of this trend is clear as outlined in Figure 1: a quarter of all US dollar-denominated emerging market sovereign debt was issued by the GCC last year. Up until 2014, Bahrain used to be the sole GCC issuer of international debt.
Unless oil prices rise significantly from here, this trend is likely to continue for the foreseeable future. Given the size of the debt outstanding from these countries, it came as no surprise that major index provider JP Morgan decided to include it in its widely followed JPM Emerging Markets Bond Index Global Diversified (EMBIG, the EM USD Sov) index at the end of January 2019.Before this debt was tipped for inclusion, investors demanded a higher risk premium to buy bonds of GCC sovereigns. About a month before the index announcement, at the end of May 2018, investors were getting approximately 0.75% of additional spread premium for owning 10-year Qatar bonds (duration between 6-8 years) over a similar maturity bond from Chile, which is rated one notch lower. As investors have begun to flock to the GCC bonds ahead of their addition to the JPM index, the premium has fallen to approximately 0.35% bps as illustrated in Figure 2.
With the exception of Saudi Arabia, where the spread has marginally widened, the spreads of all other GCC countries have tightened. Index spreads have been widening over this period by 40 bps in comparison. In the case of Bahrain, the sovereign bonds have performed better than all other similarly rated countries. While the spreads of all other B-rated sovereigns have widened, Bahrain’s sovereign has bucked the trend and the bonds spreads have fallen by around 200 bps. Clearly on a relative value basis, bonds of GCC countries have considerably outperformed their peers.
While there has been growing demand for GCC debt, investors have been discerning in what they buy and focused on countries with better fiscal dynamics and consequently lower funding needs. More significant issuers, such as Saudi Arabia, have seen their bond spreads remain fairly stable since the end of May 2018, while those of other GCC sovereigns have tightened.
Even within the countries, bonds have performed differently, possibly driven by supply/demand dynamics. Several of the large ETFs that track the JPM EM HC Sovereign index (EMBIG Core) only include bonds with more than $1bn outstanding. The widely followed JPM EMBIG index itself has a lower $500m threshold for index inclusion.
So while 10-year Abu Dhabi government bonds and the 10-year bonds of the Abu Dhabi Crude Oil Company (ADNOC) are being added to JPM EMBIG, only the Abu Dhabi governments bonds are being added to the EMBIG Core index. Given the excess demand created by these large ETFs, Abu Dhabi government bonds have tightened by 20 bps to now trade 40 bps lower than the bonds of ADNOC. Nonetheless, we would expect this anomaly to be rectified as demand pressure from ETFs subsides allowing these bonds to revert to their previous fundamental fair value.
The inclusion of GCC countries in EMBIG should ultimately improve the credit profile of the universe. Kuwait, UAE and Qatar will join the index as the highest rated countries. The inclusion not only improves bond quality but also enhances the spreads and yields that investors will be able to earn.
As outlined in Figure 4, Middle East issuers have to date mostly borrowed in US dollars in response to investor demand and because their economies are oil-based. However, many sovereigns have set out plans to start issuing in their domestic currencies, thereby deepening their financial systems and tapping into new areas of potential demand. Oman has taken the lead with 86% of its debt issued in its domestic currency. This opening up of domestic GCC bond markets could present additional opportunities for GCC issuers and investors alike. One thing is clear: until now, GCC debt has been relatively overlooked in the portfolios of international investors, but with these trends firmly in train that is changing rapidly.
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