July 22, 2019 / 11:25 AM / a month ago

MIDEAST DEBT-Buyer beware as Gulf 'club' bonds risk eroding value

* Gulf banks still arranging bonds like club loans -sources

* Aim is to guarantee demand, but tends to inflate orders

* Unsatisfied demand for sukuk adds to ‘feeding frenzy’

* Bank, market sources say hard to assess real demand

By Davide Barbuscia

DUBAI, July 22 (Reuters) - The practice of Gulf banks clubbing together on debt issues to guarantee demand for major borrowers is in danger of eroding value for international investors, banking and market sources said, following a poor market run for Saudi Aramco’s debut bond.

Regional issues of hard-currency conventional and Islamic bonds, known as sukuk, have ballooned as Gulf Arab governments and corporates, seeking to offset the impact of lower oil prices, increasingly rely on external debt sales to raise funds and spur economic growth.

To make sure such borrowers get the funds they are after, several banks are arranging bond issues like “club” loans to guarantee those borrowers sufficient demand, often within a specific pricing range - perpetuating a traditional regional practice that undermines market transparency and dents competition.

With banks putting together groups of advisers as buyers in order to secure borrowers’ mandates, “some deals are half-cooked before going to the market,” said one banking source.

Given the level of demand already factored in, investors tend to overbid to secure a piece of the asset. Furthermore, sukuk from the region are oversubscribed almost by default because the supply of sharia law-compliant assets has traditionally been below Islamic investors’ demand.

Demand for conventional bonds can also be hyped up.

Saudi Aramco’s $12 billion debut bond issue in April received a record-breaking $100 billion in orders. The bonds depreciated when they started trading, signalling that part of the demand was inflated.

“It’s hard to assess the fundamental demand,” said Khalid Howladar, managing director of Islamic finance advisory Acreditus.

“It’s a bit of a chicken and egg situation. By updating the market on the investor ‘demand’ you artificially inflate demand as buyers up their bid trying to get their allocation.”

CROWDED OUT

While the ‘club’ system exists in other emerging markets, it is more widespread in the Gulf.

There, it exposes borrowers to the risk of concentrating debt in the hands of a few mostly local lenders, diluting the advantage of diversified financing sources.

“In the Gulf, the institutional buyer base is small, it’s the banks’ treasuries that buy large amounts,” said Howladar.

“If a bank is willing take down $50 million of an issuance through its treasury department, it probably gets a seat at the table as a distributor of those bonds.”

One downside is that banks that have less lending appetite and seek only an advisory role are crowded out.

Some banks use built-in demand to market a deal, giving potential buyers the impression they may miss out on allocations, thus “feeding the frenzy”, a fund manager said.

“Our job should be to sell bonds, not to buy them,” a Dubai-based debt banker at an international bank said.

This month, Dubai’s port operator DP World obtained $4.6 billion in demand for a $1 billion 10-year sukuk, while orders for Sharjah Islamic Bank’s $500 million sukuk last month went up to around 10 times the size of the bonds.

Aramco’s longest-dated debt tranche, a $3 billion bond, shed value for over a month with yields - which move inversely to prices - rising by more than 40 basis points. The bonds have since recovered and now yield around 30 basis points below their initial pricing, Eikon Refinitiv data showed. (Reporting by Davide Barbuscia; editing by John Stonestreet)

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