US rate cuts will help Gulf bonds but oil worries persist

September 16, 2024, 5:19 AM

US Federal Reserve chairman Jerome Powell. The yield on 10-year treasuries hit a 17-year high of nearly 5 percent in October 2023

Cut would benefit bonds and sukuk
Spreads on high-yield bonds will widen
Oil price likely to spur bond sales

Imminent US interest rate cuts bode well for Gulf bonds and sukuk, although declining oil prices could lead to higher spreads on regional debt.

Bonds are typically priced against 10-year US government treasuries and the difference between their yields is known as the spread. The yield on 10-year treasuries hit a 17-year high of nearly 5 percent in October 2023.

This reflected a sudden rise in US interest rates to a 23-year peak of 5.3 percent from near-zero in 2022 as the Federal Reserve sought to slow soaring inflation.

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Now, the Fed is widely expected to cut rates, beginning at its next meeting on September 17-18. Markets foresee rates falling by about 100 basis points this year and by a similar number again in 2025.

The yield on US 10-year treasuries has fallen to a 16-month low of about 3.7 percent ahead of the Fed meeting, which has helped the S&P GCC Bond Index gain about 4.5 percent this year. Bond prices and yields are inversely correlated.

“Rate cuts serve as a tailwind for all fixed income,” says Mohieddine Kronfol, chief investment officer for global sukuk and Mena fixed income at Franklin Templeton in Dubai.

“But a reduction in rates also indicates policymakers’ worries over economic growth … that presents a challenge for risk assets, which is everything from equities to commodities and spreads.

“We’re of the view that you want to be in higher quality bonds at a time when the economic growth outlook is so uncertain,” Kronfol says.

The volume of Gulf bond issuance increased steadily from 2015 as a precipitous decline in oil prices forced governments to issue debt to meet budget shortfalls.

This coincided with several de facto leadership changes across the Gulf, including in Saudi Arabia and Abu Dhabi, that heralded a renewed focus on developing capital markets. A key plank of this policy was deepening and broadening the fixed income sector.

In 2019, all GCC countries, except Oman, joined the JPMorgan EMBI Global Diversified Index, which is considered the leading emerging market bond index.

“That in and of itself created a much wider pool of investors and greater demand for regional debt that facilitated a sustained, significant increase in issuance,” says Kronfol.

The Gulf now has a 25 percent weighting on the JPMorgan bond index and a 13 percent weighting on JPMorgan’s emerging market corporate bond index.

To early September, new Gulf bond and sukuk issuance this year totalled $116.6 billion, according to Franklin Templeton. In contrast the full-year totals for 2023 and 2022 were $87.0 billion and $58.7 billion respectively following the sudden and sustained rise in interest rates; 2021 remains the record year for Gulf fixed income issuance at $126.2 billion.

“Gulf debt issuance in 2024 should be close to $150 billion,” says Abdul Kadir Hussain, head of fixed income asset management at Arqaam Capital. “Next year should be another $100-billion-plus year.”

He highlights the importance of oil, as the region’s top export, to GCC government finances. Brent has slipped to below $70 from nearly $90 in early July and further falls are widely forecast. This should spur both greater Gulf government bond sales and investor expectations for a bigger premium on such debt to reflect the heightened risk, says Hussain.

“Spreads on Gulf investment grade debt are tight and so are more sensitive to interest rate changes than higher-spread instruments,” he says. “Further declines in oil prices will probably lead to a greater divergence between investment grade and high-yield bonds. Spreads on high-yield bonds will widen to a greater extent. Even spreads on investment grade debt could widen slightly, although falling interest rates should largely offset this.”

The GCC has about $1.11 trillion in outstanding bonds and sukuk, Franklin Templeton estimates, based on Bloomberg data.

Of this, 43 percent is from Saudi Arabia, followed by the UAE (29 percent), Qatar (13 percent), Oman (6 percent), Bahrain (5 percent) and Kuwait (3 percent).

“If global economic growth is slowing and therefore a more challenging environment for risk assets, the GCC should be in a good position. The caveat is what happens geopolitically and to oil prices,” says Kronfol.

Foreign investment in Gulf debt is increasing, he says, although his company’s research suggests foreign investors remain underweight on the region.

“Gulf debt is an asset class to which investors should think about allocating money over the medium term because it's an important part of the emerging market landscape with excellent credit metrics,” Kronfol adds. “Now that we have a better environment for bonds, one should try to take advantage of it.”