Corporate bond issuance in the kingdom is the most active in the region, but it lags far behind its potential
As Saudi Arabian authorities prepare to open the stock market to direct foreign investment this month, they're laying plans for a fresh set of reforms: measures to expand and energise the corporate debt market.
Corporate bond issuance in the kingdom is the most active in the region, but it lags far behind its potential. There have been no conventional bonds sold in Saudi Arabia since 2013 while issuance of sukuk (Islamic bonds) in all currencies totalled $7.8 billion in 2014, down from $13.5 billion a year earlier, according to data from Zawya, a Thomson Reuters firm.
The 2013 sukuk total was inflated by a government-guaranteed 15.2 billion riyal ($4.1 billion) issue by a state agency, the General Authority of Civil Aviation.
So far the Saudi stock exchange has only six listed sukuk; most domestic issuance is through private placements, which rarely get traded, so pricing in the market is opaque.
The Capital Market Authority wants to change things under a five-year strategy that would encourage issuance of sukuk and conventional bonds as alternatives to bank loans, which currently dominate corporate fund-raising.
This would spread corporate risk beyond the banking system, making the financial sector more healthy, and provide more channels for Saudi Arabia's growing investment industry.
"Within this year we will have some initiative to improve and help the debt capital markets, both from the private sector and from the government," CMA chairman Mohammed al-Jadaan said at an industry conference in May.
He did not elaborate, but in its 2015-2019 strategy paper, the CMA said it would ease the regulatory approval process for debt products, regulate the listing of private placements on the exchange, and develop securitisation to improve financing options for issuers with low credit ratings.
The CMA plans to introduce rules for credit rating agencies in September and is developing guidance for special purpose vehicles, which are widely used in sukuk structures.
A key question is whether the Saudi Arabian government will start issuing debt, which would create a badly needed benchmark for corporate bond pricings, especially if the government designed its issues to build a yield curve across maturities.
The government last issued a development bond in 2007 and for the past several years it has focused on paying down debt, a policy which it may be loathe to reverse.
But the plunge of oil prices since last year has pushed the state budget deep into deficit. So far the government has drawn down its foreign reserves to cover the deficit - net foreign assets at the central bank have dropped by $58 billion since last August - but Finance Minister Ibrahim Alassaf has said domestic debt issues will also be considered.
"Technical studies on behalf of the Ministry of Finance regarding government debt issuance appear to have already been conducted," Jean-Michel Saliba, regional economist at Bank of America Merrill Lynch, wrote in a report last week after BoAML analysts met Saudi officials.
Even if the government does begin issuing debt, however, there will be other big obstacles to the growth of Saudi Arabia's corporate debt market - some of which are not under the CMA's control.
One is the kingdom's uncertain legal environment. At present it is not always clear to investors and issuers how cases of default or distressed situations will be handled, said Khalid Howladar, Moody's global head of Islamic finance.
Currently, foreign investors can only access listed Saudi debt products through swap arrangements, which can prove costly, said Mohieddine Kronfol, chief investment officer for regional fixed income at Franklin Templeton Investments.
Some fund managers think the CMA could eventually open listed corporate debt to direct foreign investment in the same way that it is opening equities, in the hope that the involvement of foreign institutions would add expertise and sophistication to the market.
As foreign institutional investors enter the stock market, they are likely to want access to corporate debt to balance their investments, said Yazan Abdeen, lead fund manager at Jeddah-based SEDCO Capital.
But on current form, the pricing of Saudi corporate debt may not be attractive to many foreigners. Since local institutional investors are so flush with cash, yields on riyal bonds may be lower than those on debt abroad - and that's not taking into account inferior Saudi trading volumes, which raise risks.
"One key challenge is for riyal issues to be accessible to foreigners - the other, more significant, challenge is that they be attractive," Kronfol said.
Saudi firms with lower credit ratings would tend to offer bonds with higher yields, so encouraging them to issue - rather than just the financially strongest firms - could attract more foreign investors. This would need a major shift in Saudi Arabia's risk-averse business culture, however.