KAMCO Research: MENA Fixed Income Report - January 2017

Some of the key events of 2016, particularly the Brexit and US elections are expected to have long term repercussions on world economic growth. Uncertainty is expected to be high, which could result in higher market volatility for all the asset classes. Moreover, the focus seems to be shifting from emerging markets to developed markets as seen during the year as investors tried to cash-in on the surge in US economic growth rates followed by the unexpected results of the US elections.

Moreover, economic growth rates have started picking up in Europe with declining unemployment and rising inflations level and the ECB now looking at tapering the quantitative easing programs. On the other hand, after driving world growth rates for more than a decade, Emerging markets are now expected to take a break before things improve, and especially in bigger economies like China, which is seeing higher accumulation of debt but with declining marginal impact on GDP growth.

The year 2016 was also in a number of ways a turning point for the MENA region in terms of the structure of the capital market. GCC, in particular, witnessed a great deal of volatility in its primarily capital market, the equity market, due to the decline in oil prices, whereas the sovereigns were compelled to turn to the largely untapped fixed income market to fund budget deficits giving a boost to the number of instruments in the fixed income space.

Global Fixed Income Market

2016 was a volatile year for US interest rates with the 10-year bond yield on US treasuries reaching an all-time low of 1.36% by mid-year only to reverse by the end of the year. Moreover, the impact of global events on US treasuries (for instance the Brexit, US Elections and Italian referendum) has affected the demand for these instruments. The US fed policy of raising rates once a year as seen over the past two years is expected to accelerate in 2017 and we expect at least two hikes this year based on higher inflation rates, firming wages and employment and higher economic growth rates.

In Europe, negative interest rates affected the profitability of European banks during most part of 2016. However, by the end of the year, the ECB reversed its policy of an enlarged bond buying program and lifted bond purchase restrictions. The new policy hint at an end to asset purchases and point towards a first ECB rate hike in 2018.

Global Bond Market continues to be dominated by developed countries and China that account for a lion's share of the market. On the other hand, in terms of type of instruments, fixed rate instruments is the preferred choice.

Corporate Fixed Income Instruments
Amount Outstanding by Country of Incorporation	Amount Outstanding by Coupon Type

Source: Bloomberg

In terms of high yield corporate bond issuances that has declined for the past four consecutive years, 2017 is expected to see higher issuance as M&A activity is set to increase, particularly in the TMT space. In addition, before the Fed raises its rates further during the year, corporates would be looking at refinancing their debt, particularly during the first half of the year. Moreover, as bond yields rise, it will have an opposite impact on prices, that could to investors looking at equity assets and move their holdings from bond funds.

MENA Bond Market

Source: IMF, KAMCO Research

Bonds constitute a miniscule portion of total assets in the MENA region as compared to other world economies. According the latest available number from IMF's Global Financial Stability Report (October-14) the global average of total debt securities as a percentage of total capital market size (total of stock market capitalization, bank assets and debt securities) was at 35%; however, for the MENA region, the share stood at merely 7%, the lowest in the world. In addition, the share of debt as a percentage of GDP was also the lowest for the MENA region, as shown in the below graph.

Source: Bloomberg, KAMCO Research

On the positive side, 2016 saw a rebound in bond issuances in the MENA region primarily led by sovereign issuances to fund budgeted spending. Total bond issuances for the MENA region during 2016 reached the highest level since the financial crisis and was recorded at USD 75.8 Bn resulting in a year-on-year increase of 81%.

MENA Sukuk Market

Source: Reuters, KAMCO Research

Sukuk market has declined consistently for the fourth year in a row. In terms of country of domicile, Saudi Arabia dominated the market in 2015, while 2016 belonged to Bahrain and Qatar as Saudi focused on international bond issuance as against previous focus on sukuks. In terms of type of instruments, Ijara is the preferred structure.

Source: Reuters, KAMCO Research

A decline in sovereign sukuk issuances in 2016 in favor of conventional international bonds that were aimed at tapping liquidity from international investors was the key reason for the decline in total sukuk issuances during 2016. However, we believe that there exists a vacuum for local investors in sukuk that would drive the attractiveness of future issuances.

Source: Reuters, KAMCO Research

We expect Malaysia to be the largest sukuk issuer in 2017, however, the country's share is expected to decline due to its central bank's policies. We believe that this decline would be more than offset by higher issuances from GCC countries that are expected to increasingly tap the Sukuk market in order to finance the budget deficits.

Debt instrument financing in the MENA region continues to account for a miniscule pie of the total capital market when compared to other markets globally. The share of the MENA region was the lowest when compared to all other regions in the world.

Despite strong growth, islamic finance still accounts for a miniscule portion of the total global financial assets. Total global commercial banking assets stood at USD 162 Trillion at the end of 2015 vs. merely USD 1.5 Trillion for Islamic banking assets. GCC continues to maintain its regional lead in with assets totaling USD 922 Bn as strong balance sheets allowed them to sustain the oil price shock.

GCC economies are increasingly looking at alternative sources of funding for the massive ongoing infrastructure projects in the region. Private sector participation is being encouraged which would require a well structured fixed income market as a source of funding. However, governments will have to lead the market in terms of issuing bonds for all maturities, so that there can be a 'yield curve' which can be used to price other fixed income securities.

MENA Fixed Income Market Outlook

With the expected hike in US Fed interest rates in 2017, the regulators in the MENA region would react in line with the Fed policies as a majority of the countries have their currencies pegged to the greenback. Low oil prices is one of the key reason for the decline in spending initiatives in the oil exporting nations. However, as the market visibility improves and as oil price moves north, the investment cycle is expected to get a boost with both government and corporate issues expected to tap the bond and sukuk markets.

Government's role is crucial in developing a broad-based fixed income market in the region. On a positive note, the fall in oil prices have triggered GCC governments to tap the international conventional bond market which we believe would serve as the triggering point for more local issuances. A higher institutionalization of the MENA fixed income markets would help to increase the breadth of the market in the region.