Jan 27, 2015

The impact of lower oil prices on GCC budgets is much debated. But a fact that is ignored is the massive debt raising capacity most of these governments have. In addition to large SWF reserves, most GCC Governments enjoy very strong credit profiles and have under-utilised the capital markets. One could even argue that their capital structure is under-leveraged, or to use less kind words, misaligned.

Here are the reasons why GCC Governments should be issuing long dated foreign currency bonds right now:

1- Credit quality of the most oil-rich GCC countries is quite high: UAE, Qatar and Kuwait are rated Aa2/AA, and Saudi is only one notch lower at Aa3/AA- according to Moody’s and S&P respectively. These are strong investment grade ratings and the market is always very hungry for such strong sovereign credits.

2- GCC US$ denominated Sovereign bonds are considered a Rare Credit. In other terms, they have not issued enough bonds to satisfy the potential interest by investors. The only relatively active issuer has been Qatar and their last issue dates back by 2 years. They even redeemed a recent bond coming to maturity for cash rather than refinance it in the capital markets.

3- Interest rates are at historical lows. This is a great opportunity to take on debt at very low fixed rates and lock this borrowing cost for a very long time. US Government Bonds 10 Year yields are currently at around 1.75%, and the GCC Governments will be issuing at a reasonable spread above the US Government. This spread is likely to go UP when yields go up as investors will be less hungry for the yield pick-up if they can buy US Government credit at 3% or 4%.

4- Interest rates are expected to go up from current levels: US$ rates are indeed expected to go up as the Fed tapers its quantitative easing and eventually starts hiking short term interest rates. However, while US$ yields went up to 3% last year, they are now back below 2%, creating a fantastic opportunity for any long term borrower to lock in low borrowing costs.

5- GCC Governments can help develop their own debt capital markets by showing leadership and creating a benchmark yield curve: The opportunity to issue long term debt is also true for many corporate and other private credits from the region. Corporate credits will be better received and easier to price in the international capital markets if a Sovereign bond from their country of origin has been recently issued and provides a liquid reference for their own pricing.

6- Sovereign Bonds are the least expensive instrument for financing a budget deficit: GCC Sovereigns have multiple ways of dealing with the lower oil price. These include:

• Reducing budgets in line with reduced revenues
• Maintaining budgets and drawing on reserves such as those in the Sovereign Wealth Funds
• Increasing non-oil revenues by raising taxes (God forbid) or other Government income such as government fees

• . and of course, raising debt!

As we have already seen with most GCC budgets, Governments have, for the most part, taken the right decision of maintaining the budgets. Sovereign spending in most of these countries is key for economic and social development and this is probably the correct strategy.

With regards to financing the budget, drawing on the massive SWF reserves seems like a natural idea. But a good question is: what is the opportunity cost of drawing on the SWF reserves relative to issuing Government Bonds? And the answer to this lies in the cost of the government bond relative to the average return the SWF is generating. At the margin, if the opportunity cost is financially limited, there is still an argument for issuing bonds, based on a strategy of risk sharing and diversification, as well as the intangible benefits of developing the capital markets and getting the credit story out with investors, at a time where our region needs some positive stories making the international headlines.

Finally, and to pre-empt some of the obvious questions:

1/ Why not issue in the local currency markets? The local markets equally need the leadership of the Sovereign to be developed. And given the pegs to the USD, the financing costs should be similar. This is also a good idea, however, on the margin, we would recommend that the governments borrow in USD to ensure ample local currency liquidity remains with the local banks, which in turn can be transmitted to the private sector. USD denominated bonds are also a good way of replacing USD-invoiced oil revenues.

2/ Should Sovereigns issue Sukuk or conventional bonds? Both options are equally viable and achieve the same economic benefits of raising liquidity in a cost-effective manner. The best solution would be a mix of both instruments

In conclusion, rational economic theory, as well as capital markets development needs call for a wave of GCC Sovereign bond issuance. Let us hope we see some of that materialise over 2015.

About the author:

Ziad Awad is the CEO of Awad Advisory, an independent advisory firm specialising in M&A, Corporate Finance and Capital Markets. He has more than 20 years of Investment Banking experience and has advised on around half a Trillion Dollar of bond issuance, mostly for the European Sovereigns.

Picture Credits:

• United Kingdom, Federal Republic of Germany and Kingdom of Belgium Sovereign Bond tombstones. Source: Private collection
• US Government 10 year yield chart from 2011 to 2015. Source: Bloomberg
• Spiderman Camel. Source: Gabriel Poppa