Saudi Arabia's Sukuk Success

(Bloomberg Gadfly) -- Saudi Arabia's $9 billion sale of Islamic bonds will be a landmark in the market's transition from niche to mainstream.  For an idea of how these new bonds from the world's biggest oil producer could perform, look no further than the latest environmentally-friendly bonds.

Less than six months after raising a record $17.5 billion in the largest conventional bond sale by an emerging market country, Saudi Arabia received a warm reception for its first dollar-denominated sukuk this week. Investors ordered more than three times the amount of securities on sale, according to the Finance Ministry.

That level of demand is a sign Islamic debt is increasingly being welcomed into the wider markets and potentially opens up the entire U.S. bond market universe to Middle Eastern governments and companies with higher credit ratings.

With the bonds covered by English law, available to U.S. investors and settled through Euroclear and Clearstream, there are few meaningful barriers for the majority of bond funds to hold these issues. Their exclusion from the major bond indexes, something that had held back their popularity, is changing.

JPMorgan added seven sovereign and corporate dollar sukuks to its bond indexes in October and has since admitted Turkey's Islamic bond, issued in March, broadening their appeal to funds that use the indexes as a benchmark. Saudi Arabia's offering will almost certainly be included as well.

For investors, Saudi Arabia is A1 rated by Moody’s, a decent rating for a bond that yields almost 140 basis points more than U.S. Treasuries of a comparable maturity. Many dollar bond funds will be underweight the region due to a paucity of supply and the bonds' exclusion from the indexes.

Granted, Saudi Arabia's sukuk was priced at wider spread to the benchmark than a conventional bond, but that can be explained by the larger-than-expected size of the issue. The country is also no doubt keen to woo international investors given it has a widening budget deficit to finance and a giant state-owned oil company to take public.

It is likely these bonds will follow the pattern of most Gulf Co-operation Council states and tighten to the conventional curve, helped by demand from Islamic finance funds that can only hold this format.

That would follow the pattern seen with green bonds, which increasingly trade tighter than the issuer's conventional credit curve.

The European Investment Bank was an early mover in issuing green bonds, raising money specifically to invest in environmentally sustainable projects. Due to the securities' novel status, it had to offer a yield premium, but as investors realized there were dedicated funds that would buy and hold them, the spread narrowed and, today, the EIB's green bonds trade at a tighter spread than their conventional counterparts.

So a petro-state's sukuk and a green bond could end up having something in common after all.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Marcus Ashworth is a Bloomberg Gadfly columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.

To contact the author of this story: Marcus Ashworth in London at mashworth4@bloomberg.net.

To contact the editor responsible for this story: Edward Evans at eevans3@bloomberg.net.