DUBAI: A jump in U.S. Treasury yields in the last few weeks has raised a grim possibility for emerging market bond investors: a sustained backup in U.S. yields that could sink the value of bond holdings.
But compared to many other places in the world, the Gulf looks well-placed to weather such a storm. Because it has a big local investor base of cash-rich financial institutions, the region may quickly absorb any mass exit by foreign investors from its bonds.
And relatively high yield levels, especially for lower-rated bonds, give countries in the six-member Gulf Cooperation Council some protection.
“GCC debt markets will continue to grow and increasingly capture a higher share of international, emerging market and regional portfolios, regardless of the cycle of U.S. interest rates,” said Mohieddine Kronfol, chief investment officer for global sukuk and regional fixed income markets at Franklin Templeton Investments.
The yield on 10-year U.S. Treasurys has hit a high of 1.91 percent in January, some 30 basis points higher than its levels in early December. The yield was at a record low of 1.39 percent in late July.
The consensus among most banks and investment firms is that the yield is likely to reach 2.25-2.50 percent by the end of this year, depending on U.S. economic growth. A faster rise cannot be ruled out.
Investors bought heavily into Gulf debt last year; total bond and sukuk issuance from the region exceeded $40 billion, up from below $30 billion in 2011. So in theory, a backup of U.S. yields could expose investors to substantial losses.
The most highly rated, longest-term Gulf bonds have started to react to the U.S. move. For example Qatar’s $1 billion, 6.4 percent bond maturing in 2040 yielded 4.06 percent Thursday, up 8 bps so far this year and at its highest level since mid-October.
But yields on less highly rated Gulf credits have continued dropping to record lows. The yield on the $1.8 billion, 6.85 percent bond issued by Dubai’s DP World and maturing in 2037 is 5.40 percent, down 18 bps from the end of 2012. DP World is rated BBB-, the last level above junk grade.
The reason for the divergence seems to be that yields on lower-rated Gulf bonds are still far enough above U.S. Treasury yields that they look attractive – and would not necessarily back up sharply if U.S. yields rise further.
Georges Elhedery, head of global markets for the region at HSBC, the top arranger of bonds and sukuk in the Middle East last year, said that despite recent tightening, GCC bonds and sukuk still offered value compared to other emerging markets.
For example, Turkey, rated BBB- by Fitch Ratings, priced its debut $1.5 billion sukuk last year at a profit rate of 2.803 percent for a long five-year issue, well inside much higher-rated Qatari and Abu Dhabi credits.
The sukuk was yielding 2.49 percent Thursday, almost three percentage points below DP World with the same rating.
Bonds from Indonesia and the Philippines also priced tighter than top-rated Gulf credits, giving Gulf issuers more leeway in case of a substantial U.S. rate rise.
“Yield rather than spread continues to be the focus of the majority of fixed income investors in the region,” said Doug Bitcon, head of fixed income funds and portfolios at Rasmala Investment Bank in Dubai.
Another supportive factor for the Gulf is its large, rich investor base, which typically bids for more than 50 percent of bonds issued in the region.
Last year, Gulf issuers made a point of trying to diversify geographically, so Gulf investors sometimes ended up getting well under 50 percent of bonds on offer. But if foreigners were to pull out, Gulf buyers could be expected to step into the secondary market.
“Regional investors, especially the top financial institutions, are unlikely to switch their holdings to UST instead of high-grade or high-yield local paper, even if UST offer better yields than now,” said a Gulf-based analyst, declining to be named under briefing rules.
“Regional liquidity will still chase Gulf dollar-denominated paper.”
The Gulf still carries substantial risks, of course. One reason for its high yield levels is geopolitical risk, and it would be vulnerable to any large, sustained drop in oil prices.
But as long as oil prices stay high, the region’s economies appear set to continue growing robustly, supported by heavy government spending. This may set the Gulf apart from many other emerging markets, where growth and credit quality could be threatened if U.S. market rates rise too fast.
So the Gulf may outperform during any future crisis in the United States Treasury market.
“If there is a sudden jump in risk-free rates, we’re likely to see new issuance at tighter spread levels as cash prices lag – or do not fully reflect – rate movements,” said Elhedery.
Some investors in Gulf bonds will be willing to accept lower spreads above U.S. Treasurys as long as the yields they are obtaining match their portfolio objectives, he added.