* Companies traditionally rely on bank loans
* But limits of this strategy reached in some cases
* Riyal sukuk issuance more than doubled last year -HSBC
* Growing innovation in sukuk structures
* Low returns keep foreign investors away
By Mala Pancholia and David French
DUBAI, April 4 After years in which the growth
of Saudi Arabia's bond market lagged its economy, the market is
taking off as local companies rush to issue debt - though low
returns are keeping foreign investors on the sidelines.
Traditionally, Saudi companies and other entities have
relied on bank loans and retained earnings to finance their
expansion. For debt market traders, that has made the Arab
world's biggest economy a case of unfulfilled potential.
In recent months, that pattern has started to change as
companies become more familiar with bonds, a wide range of
investors demand them, and banks bump up against the limits of
how much they can lend to individual companies.
This has caused a burst of riyal-denominated debt issuance.
In Saudi Arabia, such issuance is entirely in the form of
Islamic bonds, or sukuk, which are structured to obey Islam's
ban on interest and instead pay returns on assets.
"Saudi Arabia had traditionally been considered the sleeping
giant of regional debt capital markets, but this has certainly
changed in the past 18 months as we have seen an upsurge in
riyal sukuk issuance," said Stuart Ure, partner at law firm
Clifford Chance in Dubai.
Bank loans are still growing rapidly in Saudi Arabia because
of strong economic growth; lending to the private sector climbed
15.6 percent from a year earlier in February to 1.02 trillion
riyals ($272 billion).
But sukuk issuance is now expanding much faster. Last year
about 27.2 billion riyals worth of riyal-denominated sukuk were
issued, according to HSBC, up from 11.3 billion in 2011. In the
first quarter of this year, 10.3 billion riyals were issued.
Three sukuk deals have closed in the past week alone: a 1.3
billion riyal deal from construction giant Saudi Binladin Group,
1.3 billion riyals from dairy firm Almarai Co, and 7.5
billion riyals from Sadara Chemical Co, a venture between Saudi
Aramco and Dow Chemical.
Some Saudi banks have run up against their internal lending
limits for companies, an issue which is particularly acute for
firms such as Saudi Binladin, which require large amounts of
finance to undertake construction projects. This is pushing some
companies towards sukuk.
At the same time, sukuk have advantages for companies; they
often carry longer tenors than the short maturities commonly
offered on Saudi bank loans, and they allow the borrower to
diversify its funding sources.
"Of the various advantages of going for a sukuk, some of the
key ones are a massive pool of liquidity to tap into and the
diversity of funding sources," said Fahad al-Saif, head of
capital markets and corporate finance at HSBC Saudi Arabia.
As Saudi regulators press firms to become more transparent,
companies have gradually become more willing to disclose the
data necessary to conduct sukuk issues. Growing familiarity with
the instruments has made issuers more comfortable.
Ure dated the sukuk boom back to the successful issue in
January last year of a mammoth 15 billion riyal sukuk by the
government's General Authority of Civil Aviation (GACA).
New entrants to the market may include National Shipping Co
of Saudi Arabia (Bahri), according to market sources, and
Marafiq, a utility services provider to two industrial cities in
Saudi Arabia, which has confirmed it is considering an issue.
Meanwhile, Saudi investment funds and insurers, some of them
cash-rich in a booming economy, are keen to put sukuk in their
portfolios and willing to accept low returns to obtain them -
making them financially attractive for issuers.
Saif believes the market would be helped if Saudi Arabia
could develop a local credit rating agency which understood the
country's domestic dynamics. It is not clear when this might
Beyond its growth in size, the Saudi sukuk market is
becoming more sophisticated, moving beyond plain vanilla
transactions to more innovative deals.
"A number of innovations were seen in the riyal debt market,
including an increase in non-rated issuers coming to market, the
sukuk by GACA that was guaranteed by the Ministry of Finance,
bank capital-raising transactions and project sukuk," said Saif.
"Going forward, we could see seven- or 10-year issues, with
even longer tenors for project finance-related deals." In the
past, sukuk maturities have tended to be shorter-term, of five
years or less.
Some analysts think a future change in the market could be a
shift from asset-based to asset-backed sukuk.
Traditionally, sukuk in the Gulf have been asset-based,
meaning the assets generate returns for investors but the
investors do not have direct recourse to the assets in case of
non-payment. Asset-backed sukuk offer direct recourse, and are
therefore seen by some religious scholars as closer to the
spirit of Islamic finance, which emphasises investment in the
real economy and spurns monetary speculation.
The recent Binladin Group sukuk, tied to a piece of land in
Jeddah, broke new ground, Ure said.
"The sukuk doesn't follow a classic structure, but instead
is quasi-asset-backed, with sukuk holders having recourse to
both the credit of the obligor and a prime land bank,
essentially using dual-recourse (covered bond) technology."
HSBC's Saif said he expected in the medium term to see more
hybrid perpetual structures, which mimic some of the
characteristics of equity because they lack a maturity date.
An irony of Saudi Arabia's sukuk boom is that foreign
investors are largely sitting it out.
They are barred from buying directly in the primary market,
and secondary market trade is too thin for them to get their
hands on any paper - sukuk sales are placed with only around
20-30 local investors on average, most of whom hold onto their
allocation until maturity, according to Saif.
The main problem, however, is the returns on riyal sukuk are
low compared to what foreign investors can obtain in the
Domestic sukuk supply is still much smaller than demand, so
risk-averse Saudi funds - reluctant to invest abroad because of
volatility in global markets - are desperate to buy the paper
and are bidding down profit rates.
"Although profit rates are determined by prevailing money
market rates, the scarcity of riyal issuances means a further
30-40 bps contraction," said one regional sukuk investor.
The recent Sadara sukuk, which has a lifespan of 16 years,
was priced at 95 basis points over the six-month Saudi interbank
offered rate, making its profit rate just under 2
By comparison, Saudi Electricity Co, the Gulf's
largest utility, priced a $1 billion, 10-year dollar-denominated
sukuk tranche in the international market last month at 3.473
percent - a much more attractive return.