Creating a diverse bond market
In an exclusive mini roundtable, Banker Middle East speaks to Michael Grifferty, President of The Gulf Capital Market Association, Dr. Hansjörg Herzog, Member of the Executive Committee at Fisch Asset Management and Roland Hotz, Senior Portfolio Manager at Fisch Asset Management on the state of the debt capital market in the GCC
Describe the current debt capital market landscape in the region.
Michael Grifferty: It’s rapidly growing and there is a huge future in the next five years. Most of the issuance have been in the international dollar markets with minimal local market development. However, that is going to change as sovereigns seek to develop the local capital markets for their own funding needs and to complement their access to international markets—which was the story of 2016 and will also be the story of 2017, although probably more modestly than last year.
The local investor base is strong and diversifying but still oriented towards banks—they are predominantly the main investors due to relatively lighter weight of pensions and insurance companies in the region. They tend to have a preference for more plain vanilla products.
The region itself needs to further develop its investor base so that we are less reliant on banks as core investors. There is a lot of talk about retail but I think this could potentially lead us down a blind alley. This is because global markets are not driven by retail investors. And I think we need to develop regional institutions.
How do you view the pipeline for 2017?
MG: A majority of GCC sovereigns may come out again in volume. We have already seen Kuwait, Oman and Bahrain come to the market. While Qatar and Abu Dhabi are less likely, Saudi Arabia is likely to issue again this year. This is a wide expectation and they may issue in either conventional or Sukuk, or both.
I also think that the debt management offices now have had more time to evaluate their capacities to manage sovereign liabilities as well as to measure risk and develop a more strategic view towards markets. Therefore, I think sovereigns are consolidating in what they’re doing this year. Last year was marked by a bit of urgency. Now they’ve established themselves in the market. So I think we can see more regularity in terms of government issuance based on more a traditional and developed sovereign risk management.
Is there a difference between the level of sophistication amongst investors and issuers?
Dr. Hansjoerg Herzog: Our observation of the people we meet, the people who invest in bonds, is that they are very sophisticated in this context. For us as asset managers speaking to these institutions, it’s not that they do not understand the instruments—they do, they understand them very well.
Nevertheless, there is more likely to be a difference in the knowledge base of the instrument within each specific corporate. For example, there might be a gap when going for board approvals, or simply that the board may not be inclined towards more complicated products. Also, local regulations have not encouraged this or offered investors the full suite of products. We also have a perception that the investment bankers / advisors to the treasurers in this region put less emphasis on more complex structures such as convertible bonds.
Why are convertible bonds suitable for GCC issuers?
HH: Convertible bonds are usually put in a ‘too complicated’ product box, which in fact they aren’t. It is in essence a simple product. It’s not just about large billion-dollar issuance, but with convertible bonds you can go down to smaller issue sizes. We think that it is a very good instrument for the future in this region. Corporate bonds are usually used by large cap companies. Convertible bonds can be smaller and suitable for mid-cap companies. This could be an instrument to target smaller companies with in the region.
Historically, in industries such as biotechnology as well as smaller oil and gas companies in the US, convertibles have been a successful fundraising tool. There is a good opportunity for similar companies in this region to utilise it as a means of financing. The only issue is that the company needs to be listed, because convertible bonds involve the issuance of a bond with an option to convert it into the underlying shares over its lifetime. Therefore, if you do not have a listed share, this conversion is not possible.
Roland Hotz: Our view is that there are a limited number of listed companies to provide an opportunity for a large convertible bond market. However, this is only one side of the coin. We also see the possibility of entities who very often have shareholdings in companies throughout the world. They can use convertible bonds (or more specifically, exchangeable bonds) as an instrument to divest or reduce their shareholdings.
If they want to exit or reduce it over time, convertible bonds are an appealing instrument for them to do so. This is because in many cases the issuer itself has a very high credit rating and a perception in the market as safe and large.
Global investors are always looking for good quality issuers in order to offer comfort that the bond will be repaid at maturity in the event that the underlying company’s share does not rise sufficiently and the convertible does not convert into shares. The option to convert means that the issuer can pay a lower coupon than on straight debt. These coupons plus possible repayment of the bond if it does not convert is known as the bond floor, which provides the downside protection sought by investors.
Issuers are able to add a premium, perhaps 20-30 per cent above the actual stock price, at the time of issue. If the share rises above this level and the bond is converted, they achieve a higher sale price for the stock than if they were to immediately sell it in the market. This way, they do not immediately hit the market with a large number of shares which may put pressure on the share price. The good thing about conversion is that in such cases, the issuer doesn’t have to pay back the bond—they deliver the stock. The bondholder then becomes an equity holder. For large government entities, we regard this as a win-win situation.
HH: In summary, there is a lower coupon than on a straight bond, achieving a higher equity price than current levels if it is converted—these are the interesting aspects of convertible bonds from a treasury perspective. The downside is potential dilution for shareholders. This is because if the share price goes sharply up over the life of a convertible bond, then of course it may have been better to wait and issue equity. So it is a tradeoff between a lower coupon today and a higher equity issue price in five years than risk a dilution today. This is the name of the game.
For treasurers, it really depends on what is important for them. In recent times, with such low interest rates, the benefit of a lower coupon may not be so valuable for convertible bonds. However, if this secular trend of lower interest rate changes, then we expect to see more convertible bond issuance.
RH: Bear in mind that a dilution only happens if new shares are delivered via conversion. However, if these shares already exist, such as in the case of an issue converting into a crossholding, there will not be any dilution.
HH: Therefore, for state-owed institutions, if they are positive but not overly bullish on the outlook on their respective stock prices, then a convertible bond is a good option. It is an additional fund raising tool for these institutions beyond those they already have.
Do you think local investors would be interested in a convertible bond?
MG: Yes, in principle it is an easily explainable asset class. If they are offered the proposition, then they couldbe open to it.
HH: From our experience in Europe, we see that regional investors are much keener on having regional issues because they know how the market works. Therefore they are also willing to invest in smaller companies. We think the sentiment could be the same in this region as well. However, in general, the investor base on the convertible bonds side is more interested in having a diversified portfolio in terms of regional and sectoral spread. The convertible bond market is dominated by US and European companies, issuing approximately 80 per cent of the convertible bond universe. Ten per cent of the market is from Japan, with about eight per cent from the rest of Asia and others, which is a very tiny portion at about two per cent.
MG: This familiarity sentiment I believe fits well with the GCC. Some local investors feel less inclined to rely on ratings as they feel they already know the company in which they are investing.
What is the typical term of a convertible bond?
RH: Typically, a convertible bond is issued between a three and seven year term—an average of a five-year lifetime for the option of the underlying share to go well and to convert with a profit. If the shares do not perform, you rely on the issuer to re-pay your money. But this is a very long option. You usually cannot get pricing for a call option on the market for five years. And that is the reason why you often receive a cheaper annualised premium for this individual share via a convertible bond than if you’d bought it on a three or six-month basis and rolled it over all the time. This makes the convertible bond instrument attractive.
There are only a few outstanding convertibles in this region, for example NBAD at $500 million and DP World at $1 billion. We would like to see more convertible bonds coming out of regions other than Europe and the US.