Top-tier companies in the Middle East's financial services, telecoms, real estate and transport sectors are increasingly turning to rights issues on regional stock markets, debt securities and sophisticated Islamic financial instruments for their medium and long-term funding programmes, although

Thus far, modest volumes of international bond financing in the Middle East & North Africa (MENA) region remains mostly the preserve of sovereign issuers (i.e., the governments), who accounted for more than four-fifths of global bonds outstanding at the end of 2003; the financial and corporate sectors represented only 14% and 4%, respectively, of outstanding bonds.

Although average yields are broadly in line with other regions, the duration of bond maturities is markedly lower compared with benchmark government bonds issued by the Organisation for Economic Cooperation and Development (OECD) countries. That, in turn, reflects investors' lack of appetite for longer-term exposures, like the US Treasury long bonds, UK gilts or German bunds, where the maturity date exceeds 30 years. As of September 2004, the average yield on MENA bonds was 5.8%, with an average maturity of just 3.5 years. The lack, or immaturity of secondary markets, too, deters investment in long-term fixed-income products.

Bond market activity is concentrated in the Gulf Cooperation Council (GCC) countries, notably Qatar, the United Arab Emirates--led by Dubai--and Bahrain.

Qatar issued sovereign bonds worth $2.4bn in 1999/2000 to finance liquefied natural gas projects operated by Ras Laffan Liquefied Gas Company (Rasgas) and Qatar Liquefied Gas Company (Qatargas) and tapped again the Eurobond markets during 2004.

Last year, the government of Dubai, acting through the Department of Civil Aviation, raised $1bn via an Islamic Sukuk listed on the Luxembourg stock exchange--with non-Islamic investors buying 70% of the sukuk.

This year, the combined impact of soaring oil revenues and 'twin surpluses' on state budgets and balance of payments current-accounts has reduced external capital requirements in the GCC countries, although Bahrain and Oman might require increased funds for industrial and infrastructure investments over the medium-term.

Outside the GCC bloc, Iran issued its first-ever sovereign debt paper since the Islamic Revolution in July 2002; worth 500m [euro] and carrying a maturity of five years. Egypt has been absent from global debt capital markets since 2001, while Lebanon and Morocco have occasionally issued bonds during the past three years.

First created in 2002, Islamic bonds (sukuks) comply with Shari'ah law, which prohibits depositing excess balances in short-term debt instruments or the inter-bank markets. Sukuks resemble highly rated corporate bonds that pay investors returns from the performance of 'asset-backed' investments, such as leased infrastructure or rented properties.

The income streams derived from the assets are structured into tradable securities, which are then issued on global capital markets as bonds. Total issues of sukuks are expected to reach about $7bn by end-2005--notably in the Middle East and Malaysia. Bahrain, the prime centre for Islamic finance, has so far issued over $1bn worth of sukuks. In 2001, the Bahrain Monetary Agency devised Shari'ah-compliant government bills called 'Sukuk Al-Salam', which are three-month, liquid asset-backed tradable instruments.

On the corporate side, high profile issuers of recent years, with disbursements running into many hundreds of millions of dollars, are the National Bank of Kuwait; Gulf Investment Corporation and Saudi British Bank. The Saudi British Bank (40% owned by HSBC) was the first Saudi entity to issue foreign currency-denominated bonds outside the kingdom and was rated "A-" by both Standard & Poor's and Fitch Ratings, which is one notch below Saudi Arabia's "A" sovereign rating.

HSBC's managing director and head of investment banking in Saudi Arabia, Timothy Gray, said: "Investors came predominantly from Europe, where the 20% risk rating for a Saudi Arabian bank [compared with 100% for other GCC countries] was particularly significant. The final distribution saw 54% placed in Europe--of which 40% was in the UK -22% in Asia and 24% in the Middle East."

Unlike conventional bank loans, debt securities are mostly unsecured assets, unless forming part of securitisation transactions or structured project financing. Securities--carrying a fixed or a floating rate of interest, or non-interest bearing termed zero-coupon--are used for short, medium or long-term financing. Securities with the shortest maturities (below one year) are referred to as 'commercial paper'. Whereas securities with longer maturities (up to 10 years) are called bonds or 'medium-term notes'. They have a fixed maturity and pay coupon interest on periodic dates.

There are many benefits for a company in raising capital by bond issuance:

Favourable pricing terms: by tapping the market directly rather than borrowing from commercial banks, a corporate often gains access to cheaper funding. This is known as 'disintermediation'--essentially cutting out the middleman (banker)--and is especially appealing to larger multinationals whose credit ratings in global capital markets may be superior to the banks from which they would otherwise seek funding;

Higher profile: an offering of securities to the market puts the spotlight on the issuing company, its corporate strategy and overall financial conditions, as well as medium-term projections for sales and pre-tax earnings. Thus, debt placements offer the issuer opportunities to enhance its public image and expand future market share;

Diversified funding source: the company can spread its debt widely around the market instead of relying on a relatively small number of banks, and;

Less onerous terms: covenants (formal agreements) are usually more straightforward than in loan documentation and hence less onerous for the company.

Prospective investors in debt securities focus specifically on the issuer's overall financial standing, i.e. the company's debt service capacity. But as with nearly all financial instruments, debt securities have few pitfalls:

Disclosure: commercial bank lending is based on prudent assessment of credit risks. Most bankers have an informed knowledge of a client's business. In contrast, investors in debt securities do not enjoy similar direct contacts and must rely on information supplied by the issuing company to the market. The process of producing and checking the document--a company's detailed description--is called 'due diligence'. This can be a time-consuming task both for the issuer and investors;

Higher fees: though interest rates on debt securities are generally lower than bank term loans, transaction costs are expensive. The issuer hires the services of an investment bank to help document and sell the issue. The fee structure reflects the tasks undertaken by advisers. A simple private placement involves a single arranging fee. A syndicated underwritten issue involves management/underwriting commissions. The fees are expressed as a percent of the securities' face value.

Other up-front costs--there are also additional expenses of printing the offering circulars, the lawyers/ accountants' fees and the production of the legal documents.

The international financial institutions (IFIs) highlight the benefits of bond markets for the real economy; they help foster macroeconomic stability, reduce inflationary funding, improve financial intermediation and assist the authorities in managing the adverse effects of domestic or external shocks.

The World Bank notes: "Local bond markets offer governments an effective tool for conducting and managing domestic monetary policy because issuing bonds can reduce the government's need to finance deficits by monetary means."

The vice-governor of the Saudi Arabian Monetary Agency (SAMA), Mohammed Al Jasser, explained that bonds and fixed-return Islamic notes will help to absorb a liquidity boom in the kingdom--fuelled by soaring oil export revenues, projected to reach $157bn this year, some 40% up on 2004. The IFIs noted: "Liquid bond markets can complement structured financing and stimulate healthy competition, not just in terms of market intermediation, but in financial products as well."

Thus matured capital markets mobilise savings by providing pension/mutual funds with longer-dated investment instruments. The infrastructure for building domestic debt markets, such as clearing/settlement systems and regulatory/legal frameworks, contributes to the "overall soundness of the domestic financial system", confirmed the World Bank.

The GCC debt capital markets should see more issuances from regional banks and companies in the coming years, partly because of increased demand for project finance and asset-liability management of the banking system. As in western countries, the use of sophisticated instruments, such as bond and rights issues could underpin the financial health of a country's corporate sector, thus enabling the Gulf region to achieve sustainable, long-term growth. Nick Edmondes, partner at the international law firm Trowers & Hamlins, said: "With the reliance on short-term debt diminishing, Gulf economies should be insulated from the kind of credit squeeze that crippled Asian economies in the 1990s."

During the Asian crises of 1997/98, highly leveraged and non performing loans (i.e., bad debts), contingent liabilities and unhedged exposures, coupled with a cyclical deterioration in investment returns, worsened the problems by adding to the liabilities of the public sector.

Khaled Fouad, a senior merchant banker, explained: "In the absence of a debt market, any crisis in the banking industry will have a spillover effect and would likely require the government to step in and assume the burden in order to prevent the financial system from collapsing."

The estimated costs of GCC mega projects over the next two years are about $166bn, with Saudi Arabia accounting for one-third of this total. Research by the SAMA (central bank) and National Commercial Bank indicated that local banks lacked capital to finance and/or underwrite forthcoming projects. Arab National Bank believes, "The bond market will become much more important. There are so many large, long term projects in the kingdom now it is unrealistic to see all the credit for them being provided by the banking sector."

In future, Arab banks are expected to issue floating rate notes on a regular basis and with longer tenors in order to diversify their sources of funding. A coupon on floating-rate notes is periodically reset, based on a predetermined benchmark, generally issued by banks or companies whose earnings are closely linked to interest rate fluctuations. This is a way to "adjust" how much they are paying for the money they borrow. Presently, most banks use customer deposits [mainly short-term] to fund retail/corporate lending operations. This could, however, lead to asset-liability 'mismatch' on their balance sheets--especially in the case of smaller banks.

The market for Saudi corporate bonds has recently taken off assisted by the country's new capital-market laws. The Capital Markets Authority, established by Royal Decree in mid-2004, has laid down stringent rules on public bond offerings--demanding full disclosure and transparency from prospective issuers. The Saudi debt market is open [only] to joint-stock companies, i.e., prime public listed stocks--notably Saudi Basic Industries Corporation (Sabic), Saudi Telecom, Saudi Electricity Company, Saudi Arabian Fertiliser Company and the Savola Group, among others, as well as 11 local banks. Hence, public bond issues will exclude sub investment-grade status firms, or 'junk stocks'. Sulaiman Al Gwaiz, of Riyad Bank agrees: "The bond market here will grow step by step and be limited to the largest issuers. Only those with a rating or a very well known background will be able to raise money in this way," he observes.

SAMA has recommended that companies--planning to issue bonds--should first solicit ratings from reputable international agencies. The trading of domestic corporate papers on Tadawul, the Saudi Stock Exchange, will be facilitated by new technologies. There are also plans for a secondary debt market that should boost liquidity. Buyers will enjoy the flexibility to trade post-issuance [bonds], rather than sitting on medium-term notes if market conditions change.

Saudi Hollandi Bank was the first company to issue a bond under the new capital-market laws. It raised $187m via a seven-year subordinated debt sold to Saudi investors, with the aim of increasing the bank's capital base. Subordinated debt ranks below other loans with regard to claims on assets or earnings. Thus subordinated debt (or junior security) is more risky than conventional debt because, in events of default, holders of the former do not get paid until after the senior debt holders are paid in full.

Sabic, the world's 11th largest petrochemicals company and boasting the biggest Saudi stock (by market capitalisation) is also issuing a SR1bn ($267m) Islamic bond and there are talks of greater recourse to local capital market in the future. Mutlaq Al Morished, chief finance officer, said: "The main aim of the issue was to help activate a domestic bond market. It is not because we need a lot of cash."

Sabic plans to invest $20bn on expansion projects over the next five years. However, the company has no immediate plans for Eurobond issues. "As long as we can get good financing locally, why go outside?" Morished said. Standard & Poor's assigned Sabic "A" long-term and "A-1" short-term ratings, reflecting its position as market leader, its access to cheap natural gas and its proximity to rapidly expanding Asian markets. Fitch Ratings, too, emphasised Sabic's robust earnings, awarding it an "A" rating and "F1" for short-term debt.

The company's net profits over the January-September period totalled SR14.7bn ($3.92bn), up 54% on the corresponding period of 2004.

It will take some time for the culture of bank lending to give way to tapping domestic debt markets on a regular basis as takes place in advanced OECD countries. Arab corporates have traditionally funded their growth through syndicated loans--which totalled $136bn for the 1994-2005 period, according to London-based Dealogic LoanWare. Also, the average investor has yet to grasp the mechanism of bond instruments.

Unlike initial public offerings (IPOs), bond issues are relatively new to the MENA region. There is no tradition of investing in corporate bonds, even among institutional investors, such as pension funds--who are heavily exposed to government debt. One Saudi banker put it: "The constraint will be the lack of natural buyers of bonds. Individuals in Saudi Arabia are not by instinct buyers of bonds or time deposits. They would rather leave their money in the current accounts--they will usually keep at least 20% there--and put some of the rest into equities."

The debt markets will be the new frontier for foreign portfolio investment. Fully developed GCC bond markets--underpinned by efficient settlement, clearing and custodial services, as well as regulatory frameworks--should appeal to foreign investors looking for greater regional diversification within their portfolios.

Looking ahead, the GCC local currency-denominated papers can provide higher returns and lower risks compared with other developing world regions, thus reflecting strong economic fundamentals, low interest rates and stable exchange rates. That being the case, there is considerable potential for growth of domestic debt market in the Gulf countries in the years to come.

Regional Foreign
Currency &
Bond &
[1 January 2004-23 May 2005]

Issuer Nationality   Amount [US$ mn]

UAE                      3,575
Lebanon                  3,313
Saudi Arabia               787
Qatar                      665
Kuwait                     500
Bahrain                    330
Egypt                      322
Oman                       250
Jordan                     145

TOTAL                    9,887

Sources: Dealogic BondWare and Dealogic LoanWare

Regional
Syndicated
Loans
[1 January 2004-23 May 2005]

Borrower Nationality   Amount [US$ mn]

UAE                       8,742
Iran                      6,832
Qatar                     5,836
Saudi Arabia              5,681
Bahrain                   3,912
Oman                      2,211
Kuwait                    2,085
Jordan                      109
Iraq                        108

Regional Project
Financing
[1 January 2004-23 May 2005]

Borrower       Amount
Nationality    [US$ mn]

Qatar          11,606
Oman            3,945
UAE             3,676
Saudi Arabia    2,915
Bahrain         1,503
Jordan            364
TOTAL          24,010