Confident Gulf Bond Market Shrugs Off S&P Downgrades

Confidence that the Gulf oil exporting states can ride out an era of cheap oil supported prices of their international bonds on Tuesday after Standard and Poor’s cut its debt ratings or outlooks for several of the countries.

Taken together, S&P’s actions were the biggest move by a rating agency in the Gulf since the price of Brent crude plunged below $60 a barrel in December, from $115 last June.

S&P cut its outlook for Saudi Arabia’s “AA-/A-1+” foreign and local currency credit ratings to negative from stable, warning the oil-dependent kingdom’s finances could be damaged by the price drop.

It lowered the ratings of the two financially weakest states in the Gulf Cooperation Council by one notch – Bahrain fell to “BBB-/A-3”, and Oman to “A-/A-2” – while affirming the ratings of two of the strongest, Abu Dhabi and Qatar.

But Gulf bond prices barely moved on Tuesday. The spread of state-controlled Saudi Electricity Co’s U.S. dollar sukuk maturing in April 2023, one of the most liquid international Saudi credits, against 10-year U.S. Treasury bonds edged up just 1 basis point.

The spread of Bahrain’s dollar sovereign bond maturing in August 2023 against 10-year U.S. Treasuries rose 5 bps. Bank Muscat, Oman’s biggest bank, saw the spread of its 2018 dollar bond against five-year U.S. Treasuries widen 2 bps.

“I believe credit spreads for the region will increase over time, but maybe not markedly just because of these actions” by S&P, said Abdul Kadir Hussain, chief executive at Mashreq Capital in Dubai.

“Many regional investors tend to buy and hold, and hence these actions are unlikely to be followed by a lot of selling.”

SPREADS

Several factors are behind the bond market’s strength. One is the large base of cash-rich Gulf funds and institutional investors who are eager to invest their money and willing to buy into any selling of bonds by foreigners.

This is a powerful force, especially when combined with a recent drop in bond supply from other emerging markets and the European Central Bank’s launch last month of radical monetary easing, which is spurring European funds to hunt for yield.

“Long-only local investors are up to the gills in these regional bonds, and this is a lot of vanilla debt with government support,” said the debt capital markets head of a European bank in the Gulf.

“The oil price drop has been factored in with marginally wider spreads, and now the market is cheering increased European investor interest.”

More broadly, the market’s calm can be taken as a vote of confidence that the rich Gulf states have amassed enough financial reserves, and are deploying them effectively enough, to cope with low oil prices for a few years at least.

Saudi Arabia, for example, has projected a record state budget deficit of $38.7 billion for 2015, and the actual deficit may be much larger if oil stays below $60. But it can cover deficits with $245 billion of reserves at the central bank, excluding other assets and its ability to borrow.

In its statement on Monday, S&P signalled any Saudi rating cut might not come soon – it said ratings might be lowered over the next two years – and described the government’s current financial position as “very strong”.

Movements in bond spreads suggest the oil price slide caused a small increase in concern about Saudi credits late last year – Saudi Electricity Co’s spread widened from 108 bps last October to 146 bps in mid-December.

Since then, however, concern seems to have evaporated; the spread was back at 107 bps on Tuesday. This follows a stabilisation of the oil price since mid-January, and pledges by Saudi officials to keep spending heavily to offset the economic impact of cheap oil.

Bahrain’s bonds were hit much harder last year; its spread ballooned from 195 bps in October to 310 bps in mid-December. But it has since narrowed back to 220 bps, partly because investors think rich Gulf states will if necessary support Bahrain for geopolitical reasons.

Bank Muscat’s spread widened to as much as 119 bps in mid- December but is now back at 82 bps, near its October level of 80 bps.

In fact, Gulf bonds have outperformed the rest of the world in recent weeks. The S&P Middle East and North Africa bond index is up 2.61 percent year-to-date, against a negative return of 2.48 percent for the S&P/Citigroup International Treasury bonds ex-U.S. index.

Hussain at Mashreq Capital said Gulf bond spreads could widen later this year if the supply of regional paper increased. Bahrain, for example, may issue more bonds to cover an expanded budget deficit.

“Once new supply starts hitting the market, which I suspect will be in the next couple of months, then I think spreads would widen out to reflect the change in credit dynamics of the region.”

However, any widening may be minor, and some governments may turn to their liquid local currency markets rather than issuing bonds internationally. Saudi Arabia’s central bank chief has said the Saudi budget deficit may be covered partly by domestic borrowing, partly because of low domestic costs.

Sergey Dergachev, senior portfolio manager for emerging market debt at Union Investment Privatfonds in Germany, said he had used the small sell-off in Middle East credits on Tuesday to increase his exposure, buying Saudi Electricity bonds.

“I think yields on Bahraini papers could widen 5-10 bps more, but then will stay or marginally tighten. I do not expect a sell-off in Bahraini debt, mainly since their bonds have a very strong buy-and-hold investor base, and are strongly technically supported.”