Abu Dhabi has launched two sovereign bonds with maturities of five and 10 years, priced to yield about 5.65 per cent and 6.85 per cent respectively, or put another way, at US treasuries plus 400 and 420 basis points. The bonds will raise as much as US$3 billion (Dh11.01bn) for the emirate. The issue has caught some market participants and observers a little by surprise. The first reaction is, why have the bonds been priced at this level? The second is, why does Abu Dhabi need to borrow in the first place?
The question of pricing is not very complicated, and the Government of Abu Dhabi should be commended on accepting terms that only a year ago would have seemed entirely unrealistic. The parameters are: ? Abu Dhabi's only existing bond, which matures in August 2012, has been trading about 350 basis points above comparable US treasuries; ? The credit default swap on Abu Dhabi has been trading between 350 and 400 basis points above US treasuries. In mid-January, in fact, it was as wide as 450 basis points; and
? Yields on GCC sovereign bonds, such as those of Qatar, have been trading about 400 basis points over US treasuries, albeit with different maturities. Based on these parameters a new issue of the size of the Abu Dhabi bonds, if they are to attract international investors, had to be priced around 400 basis points, plus or minus 50. So the pricing should not be a surprise. The bonds were priced to ensure success.
Now, the real significance of the issue is not whether Abu Dhabi is paying 50 or 100 basis points more than some might think it should. It is the fact that Abu Dhabi is making an effort to open up the international bond market to UAE banks, corporations and government-related entities. In the absence of a clearly defined federal entity backed by the full faith and credit of the UAE, and the market reality of limited access to other national entities, Abu Dhabi is assuming the de facto role of a national treasury. Policy makers have a decision to make on what form, if any, a sovereign/federal UAE institution will have in managing the issuance and repurchase of future government debt. For now, this is the best outcome we could have hoped for.
So even if Abu Dhabi itself has negligible external debt and no domestic debt, the emirate is acknowledging the implicit commitment to the large debts incurred by banks and companies in the broader economy that have been affected by the decline in real estate prices and the global economic downturn, the failure of which would affect the economic health and reputation of the UAE. The emirate is also being prudent by diversifying its funding sources. Rather than rely on sovereign wealth funds to plug short-term liquidity or budget needs, Abu Dhabi is avoiding asset sales at depressed levels and adding a significant measure of credibility to the UAE's fiscal policy at a time of low oil prices. I mention fiscal policy because it is only prudent to assume that in a setting of low oil prices, the revenues of the Government of Abu Dhabi would contract significantly and the emirate could run significant deficits.
This would be in contrast to the past four years when the emirate has run surpluses totalling more than $65bn. Revenues of government are not diversified, with 95 per cent coming from crude oil royalties and taxes on oil profits. Budget projections for this year are based on $50 a barrel for oil, so if we budget oil about $30, revenues would fall to $20bn, from $75bn last year. Recently, the UAE made a number of successful policy responses to the financial crisis. It has, among other things, guaranteed commercial bank deposits, provided liquidity to financial institutions, bailed out the mortgage industry, and set important precedents in dealing with the regulatory and legal challenges facing the economy. With all that behind it, the country is, through the Abu Dhabi bond issue, signalling that attention will be focused on reducing the cost of funding to UAE issuers, and making sure that access to international credit markets is achieved.
This bond issue needs to be successful because it will make sure the next Abu Dhabi issue is also well-received. With a positive history established, an issue by a bank and eventually large Dubai-based companies might then follow. In other words, Abu Dhabi is not borrowing with one objective in mind, but in order to open up the international capital markets to the country's companies and financial firms, to have the ability to run deficits in the medium term, and to materially improve the nation's financial infrastructure by initiating a bond programme.
For now, corporate bonds and sukuk prices are stressed and credit is expensive because there is little depth and diversity in secondary markets. An international bond should improve the UAE's standing in international markets and bring needed liquidity to the UAE's financial system, which, in turn, should develop interest in domestically traded bonds. Once this happens, spreads will come down to reasonable levels.
A liquid secondary bond market will allow investors to better balance their investments by allocating assets not only to equity and real estate, but also to debt. This can only strengthen the financial market infrastructure. The Abu Dhabi bond is significant because after six months of chocked credit when and primary bond markets almost shut down, the issue represents the beginning of a new phase in regional bond markets.
The finance community hopes this is only the first of many issues, and that banks and government-related issuers can access the market at reasonable levels later this year. Mohieddine Kronfol is managing director at Algebra Capital
