After years in which the growth of Saudi Arabia's bond market lagged its economy, the market is taking off as local companies rush to issue debt - though low returns are keeping foreign investors on the sidelines.
Traditionally, Saudi companies and other entities have relied on bank loans and retained earnings to finance their expansion. For debt market traders, that has made the Arab world's biggest economy a case of unfulfilled potential.
In recent months, that pattern has started to change as companies become more familiar with bonds, a wide range of investors demand them, and banks bump up against the limits of how much they can lend to individual companies.
This has caused a burst of riyal-denominated debt issuance. In Saudi Arabia, such issuance is entirely in the form of Islamic bonds, or sukuk, which are structured to obey Islam's ban on interest and instead pay returns on assets.
"Saudi Arabia had traditionally been considered the sleeping giant of regional debt capital markets, but this has certainly changed in the past 18 months as we have seen an upsurge in riyal sukuk issuance," said Stuart Ure, partner at law firm Clifford Chance in Dubai.
Bank loans are still growing rapidly in Saudi Arabia because of strong economic growth; lending to the private sector climbed 15.6 percent from a year earlier in February to SAR1.02 trillion (US$272bn).
But sukuk issuance is now expanding much faster. Last year about SAR27.2bn worth of riyal-denominated sukuk were issued, according to HSBC, up from SAR11.3bn in 2011. In the first quarter of this year, SAR10.3bn were issued.
Three sukuk deals have closed in the past week alone: a SAR1.3bn deal from construction giant Saudi Binladin Group, SAR1.3bn from dairy firm Almarai Co, and SAR7.5bn from Sadara Chemical Co, a venture between Saudi Aramco and Dow Chemical.
Some Saudi banks have run up against their internal lending limits for companies, an issue which is particularly acute for firms such as Saudi Binladin, which require large amounts of finance to undertake construction projects. This is pushing some companies towards sukuk.
At the same time, sukuk have advantages for companies; they often carry longer tenors than the short maturities commonly offered on Saudi bank loans, and they allow the borrower to diversify its funding sources.
"Of the various advantages of going for a sukuk, some of the key ones are a massive pool of liquidity to tap into and the diversity of funding sources," said Fahad al-Saif, head of capital markets and corporate finance at HSBC Saudi Arabia.
As Saudi regulators press firms to become more transparent, companies have gradually become more willing to disclose the data necessary to conduct sukuk issues. Growing familiarity with the instruments has made issuers more comfortable.
Ure dated the sukuk boom back to the successful issue in January last year of a mammoth SAR15bn by the government's General Authority of Civil Aviation (GACA).
New entrants to the market may include National Shipping Co of Saudi Arabia (Bahri), according to market sources, and Marafiq, a utility services provider to two industrial cities in Saudi Arabia, which has confirmed it is considering an issue.
Meanwhile, Saudi investment funds and insurers, some of them cash-rich in a booming economy, are keen to put sukuk in their portfolios and willing to accept low returns to obtain them - making them financially attractive for issuers.
Saif believes the market would be helped if Saudi Arabia could develop a local credit rating agency which understood the country's domestic dynamics. It is not clear when this might happen, however.
Beyond its growth in size, the Saudi sukuk market is becoming more sophisticated, moving beyond plain vanilla transactions to more innovative deals.
"A number of innovations were seen in the riyal debt market, including an increase in non-rated issuers coming to market, the sukuk by GACA that was guaranteed by the Ministry of Finance, bank capital-raising transactions and project sukuk," said Saif.
"Going forward, we could see seven or ten-year issues, with even longer tenors for project finance-related deals." In the past, sukuk maturities have tended to be shorter-term, of five years or less.
Some analysts think a future change in the market could be a shift from asset-based to asset-backed sukuk.
Traditionally, sukuk in the Gulf have been asset-based, meaning the assets generate returns for investors but the investors do not have direct recourse to the assets in case of non-payment. Asset-backed sukuk offer direct recourse, and are therefore seen by some religious scholars as closer to the spirit of Islamic finance, which emphasises investment in the real economy and spurns monetary speculation.
The recent Binladin Group sukuk, tied to a piece of land in Jeddah, broke new ground, Ure said.
"The sukuk doesn't follow a classic structure, but instead is quasi-asset-backed, with sukuk holders having recourse to both the credit of the obligor and a prime land bank, essentially using dual-recourse (covered bond) technology."
HSBC's Saif said he expected in the medium term to see more hybrid perpetual structures, which mimic some of the characteristics of equity because they lack a maturity date.
An irony of Saudi Arabia's sukuk boom is that foreign investors are largely sitting it out.
They are barred from buying directly in the primary market, and secondary market trade is too thin for them to get their hands on any paper - sukuk sales are placed with only around 20-30 local investors on average, most of whom hold onto their allocation until maturity, according to Saif.
The main problem, however, is the returns on riyal sukuk are low compared to what foreign investors can obtain in the international markets.
Domestic sukuk supply is still much smaller than demand, so risk-averse Saudi funds - reluctant to invest abroad because of volatility in global markets - are desperate to buy the paper and are bidding down profit rates.
"Although profit rates are determined by prevailing money market rates, the scarcity of riyal issuances means a further 30-40 bps contraction," said one regional sukuk investor.
The recent Sadara sukuk, which has a lifespan of 16 years, was priced at 95 basis points over the six-month Saudi interbank offered rate, making its profit rate just under 2 percent.
By comparison, Saudi Electricity Co, the Gulf's largest utility, priced a US$1bn, ten-year dollar-denominated sukuk tranche in the international market last month at 3.473 percent - a much more attractive return.