Gulf Bonds Diverge As Oil Plunge Separates Strong From Weak

Sovereign bond yields in the Gulf are diverging, as investors start to differentiate between countries that can cope comfortably with the plunge in oil prices and those which will find the cut to their export revenues very painful.

For two years, yields of the six oil exporting nations in the Gulf Cooperation Council converged as the regional economy boomed. Some investors even saw the GCC as a single credit.

That trend is now reversing as Brent crude, at $65 a barrel against $115 in June, drops below levels which most GCC members need to balance their state budgets.

The spread between Bahrain’s dollar sovereign bond due March 2020 and Qatar’s January 2020 sovereign climbed to 148 basis points this week from 95 bps in June.

Bond buyers aren’t panicking – credit default swaps are well below levels hit during the global financial crisis in 2008 and the Arab Spring uprisings of 2011. Foreign exchange forwards have edged up but aren’t near the 2008 highs that would imply pressure on Gulf currency pegs to the dollar.

But in investors’ eyes, the region is dividing into three classes. Kuwait and Qatar are the strongest class, since they are believed to be able to run budget surpluses even at current oil prices; Moody’s Investors Service estimates their break-even prices at $52 and $59.

The United Arab Emirates and Saudi Arabia, at $71 and $84, are the second class. They may run budget deficits next year but have such huge fiscal reserves that they could easily cover deficits for years.

Oman and Bahrain, with much smaller reserves and oil resources, are in the bottom class; with break-even prices of $97 and $117, they are likely to be deep in the red next year.

Moody’s figures suggest that if oil stays at $65, Oman will also become the only GCC country to run a current account deficit – a shortfall which, if sustained, could eventually put pressure on its currency peg.

“There’s definitely a divergence between the fiscally stronger economies and those which face higher budget break-even levels, which would include Bahrain and Oman,” said Doug Bitcon, head of fixed income funds at Rasmala Investment Bank.

Bahrain’s shorter-term debt is still performing relatively well since it is supported by Gulf investors, many of whom tend to hold until maturity, he said. Longer-dated Bahraini bonds are being hit particularly hard because they depend on support from international investors.

IMPACT

So far, selling of GCC bonds in response to oil’s slide has almost entirely focused on Bahrain and Oman. After the last oil price plunge in 2008, the bigger GCC economies built up financial reserves and strengthened their banking systems, so investors have more confidence in them this time around.

“We remain constructive on regional credits, as fundamentals remain very sound and market dynamics remain supportive,” said Mohieddine Kronfol, chief investment officer for regional fixed income at Franklin Templeton Investments.

Because the GCC views the stability of Bahrain and Oman as geopolitically important, the weaker states could almost certainly count on aid from their neighbours in a crisis.

So they may escape downgrades of their credit ratings and the Bahrain-Qatar bond spread may not snap all the way back to its 2012 levels of around 200 bps.

Moody’s hasn’t yet made any changes to its GCC credit outlooks or ratings in response to the oil price slide and has no timeframe for taking any actions, said Lucio Vinhas de Souza, managing director at its sovereign risk group.

Economies are strong enough that oil might stay near current levels for several years without necessarily forcing any GCC sovereign downgrades, he added.

Other rating agencies may not be quite as positive. Last week Standard and Poor’s cut its outlook for Oman’s “A/A-1” ratings to negative from stable, and its outlook for Saudi Arabia’s “AA-/A-1+” ratings to stable from positive. Weak oil was one factor.

Raza Agha, emerging market sovereign debt analyst at VTB Capital, predicted that if oil stayed so low, bond selling would eventually spread from the weakest GCC countries to regional credits in general.

He noted that when oil plunged in 2008 – a drop about twice the size of the current slide peak-to-trough – every $3 fall in oil caused the price of Qatar’s 2030 bond to drop by about one point.

Middle East energy importers such as Egypt, Morocco, Tunisia and Jordan could benefit greatly from cheaper oil. De Souza said this would not necessarily boost their credit ratings, which also depend heavily on political and policy risk.

But it could now make sense to buy North African credits while selling GCC ones.

Agha noted the spread of Bahrain’s 2022 bond above Morocco’s 2022 bond had expanded to 46 bps from 20 bps at the end of 2013; the spread could eventually climb to double its current level, he said.