CAPITAL MARKETS

Tackling a triple-tranche

In an exclusive, Mohammed Khnifer, a debt capital markets banker at a supranational banking institution, suggests a pricing strategy in a triple-tranche deal and how debt issuers can lower cost of funding

One of the fundamentals in conventional or Islamic debt capital markets is determining the right pricing for your cost of funding. This vital issue is a deal-breaker for potential issuers. Some of the biggest emerging market issuers are gradually equipping themselves with former “debt capital market” bankers in order to master the art of pricing and create value for stakeholders.

One of the clearest examples of such a strategy is Saudi Arabia’s National Debt Management centre (NDMC). On 22 January 2020, the institution formerly known as Debt Management Office (DMO) priced a $5 billion multi-tranche bond. The story is not on the oversubscribed transaction (an order book of more than $23 billion) but rather on the implementation of the most aggressive pricing strategy since NDMC’s establishment. This led to the correction of the ‘yield curve’s distortion’ for the longer end of the tenor which (at the same time) created a ripple effect for the remaining tenors across the yield curve (which has been repriced as a result).

What we have witnessed out of this trade is that Saudi Arabia has taught us how to price sovereign debt strategically. Here is how they did it.

HOW THE CORRECTION ALL STARTED The distortion to the yield curve started two years ago when the 31-year paper was printed at a spread of 210bps (compared to a spread of 180bps a year ago). The spread then widened to 230bps in 2019.

In 2020, the 35-year bond was priced aggressively at 160bps over US Treasuries. This tranche saw a discount of around 65bps—the 35-year bonds were priced as if Saudi was issuing a 30-year maturity. The rationale behind this approach is to correct the longer end of the yield curve. Now there should be a ripple effect and we should see a repricing in the Saudi curve. This will be credit positive for new Saudi corporate issuers who will benefit from such pricing advantage.

LEAVING NOTHING ON THE TABLE NDMC took a particularly aggressive approach in terms of pricing after issuing the debt with no premium, not leaving anything on the table. Based on my hypothetical fair value for the new bond (after looking at the outstanding trading levels) the discount is in the range of 6bps to the seven years note and 23 bps to the 12 year one. The calculation is based on the last traded session that was on Friday, 17 January 2020 (as Monday was a holiday) and the deal was

KSA YIELD CURVE AND NEW BOND PRICING

KSA Yield Curve (Interpolated) KSA New US$ Bonds

1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 12Y 15Y 20Y 25Y

All three new US$ bonds were priced inside the existing curve which led to repricing of the yield curve 30Y

2020 2021 2022 2023 2024 2025 2026 2027

2028 2029 2030 2031 2032 2033 2034 2035 2036 2037 2038 2039 2040 2041 2042 2043 2044 2045 2046 2047 2048 2049 2050 2055 % Yield 4.25 4.00 3.75 3.50 3.25 3.00 2.75 2.50 2.25 2.00

RELATIVE VALUE: KSA NEW US$ BONDS vs EXISTING ISSUES

KSA New 01/55 35Y KSA 5.25 1/50 30Y KSA 5 4/49 29.2Y KSA 4.625 10/47 27.7Y KSA 4.5 10/46 26.8Y

KSA New 02/32 12Y KSA 4.5 4/30 10.2Y KSA 2.969 10/29 S 9.8Y

2.00 Yield to Maturity (%) KSA New 02/27 7Y KSA 3.25 10/26 6.8Y KSA 4 4/25 5.2Y KSA 4.375 4/29 9.2Y KSA 4.303 1/29 S 9Y KSA 3.625 3/28 8.1Y KSA 3.628 4/27 7.2Y

Source: Bloomerg/FAB

+0.7 +0.1 +0.6 +3.8

Additional yield spread (in bps) offered by existing bonds over the new bonds issued (which should be repriced/ corrected in secondary markets) +3.4 +5.9 +24.4 +26.2 +24.0 +10.6 +8.3 +16.1 2.25 2.50 2.75 3.00 3.25 3.50 3.75 4.00

~30 YEAR TENOR PRICING

Issuer year Tenor Spread over benchmark in bps Benchmark 30Y TY yield Effective pricing

2016 30Y 210 2.506 4.606 2017 30Y 180 2.860 4.660 2018 31Y 210 3.025 5.125

2019 31Y 230 3.010 5.310 2020 35Y 160 2.240 3.840

Source: Bloomerg/FAB

4.0 3.8 3.6 3.4 3.2 3.0 2.8 2.6 2.4 2.2 2.0 1.8 1.6

1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 15Y 20Y 25Y 30Y Yield Conventional (%) Years to Maturity SAUDI DEBT THE LONG END OF THE CURVE IS BEING PRICED AT PREMIUM TO SIMILARLY A-RATED EMERGING MARKETS Saudi Arabia Saudi yield curve at end of Dec. 2019

A-Rated EMs

Source: Bloomerg

announced on Tuesday. I did not take Tuesday's trading session in consideration because we knew that when a issuers decide to issue, usually their bonds will be under pressure on the same day.

JUSTIFICATION This approach is justified as most investors know that some GCC states are better rated than others in emerging markets (EMs). Those EMs can issue at a reduced cost despite their lower credit ratings. The road for correcting the pricing variance (for GCC issuers against their EM peers) is still long. NDMC and Aramco has shown GCC issuers the importance of how to price strategically.

Additionally, First Abu Dhabi Bank (FAB) has released a research note in which it explains the pricing difference with EMs. “At 3.84 per cent yield, the pricing of the 2055 35-year bond is the cheapest for Saudi Arabia as a borrower, while for investors it still offers substantial yield pick-up (against comparable peers) on a relative value basis. Indonesia priced its 2050 30-year bond on 7 January at 3.55 per cent yield and currently trades around 3.465 per cent. The KSA 2055 and 2050, rated three notches above Indonesia, still offer yield pick-up of more than 35 basis points over Indonesia 2050. Across the Atlantic, the Chile 2050 trades 60 basis points inside KSA 2055 for just one notch better credit rating.”

FINAL THOUGHTS Before 2020, the only Saudi entity that was very aggressive in the last four years was Saudi Arabian Oil Company (Aramco), which priced its bond offering inside the sovereign's yield curve. Saudi Arabia has demonstrated its sophistication (for an EM issuer) when it announced and printed an intraday trade, with no roadshow or investor call, against the backdrop of heightened geopolitical tension in the region.

Saudi’s latest issue—a smaller size for the sovereign by historical standards—has enabled the Kingdom to execute its aggressive pricing approach. This could signal a change in the market when it comes to the pricing strategy of jumbo deals above $9 billion.

With 16 per cent returns over the past year (compared to 12 per cent overall for the Bloomberg Barclays EM Sovereign index), the kingdom's sovereign debt has proven it is still in high demand.

Meeting the global demand

The region’s rising demand for Islamic finance calls for experienced international financial centres, says Faizal Bhana, Director for the Middle East and Africa at Jersey Finance

Faizal Bhana

Shari'ah-compliant wealth management is experiencing a period of growth with high penetration levels in the GCC. Given our longstanding presence in the market and discussions with partners and Jersey firms, alongside our research in the market, it has been highlighted that there is a shortage in supply of Islamic finance wealth management solutions and products, albeit the exact size remains unknown. What is clear, is that the demand for Islamic finance wealth management in the UAE, while still in its infancy, has enormous potential for rapid expansion from wealthy individuals and families in the predominantly Muslim countries within the Middle East, Asia, Africa and indeed worldwide.

Our recent report The Evolution of Wealth Management in the World of Islamic Finance—Views from the Islamic Finance Wealth Management Community, commissioned by Jersey Finance and Hubbis, revealed that almost 59 per cent of people aged between 50 and 70 currently use Islamic wealth management products and solutions. Nonetheless, 60 per cent of the increase in demand in the next five years will come from those aged between 25 and 50. These younger and largely Western-educated generation have more of a natural disposition for Islamic wealth management, as it tends to represent a more socially-conscious model. These individuals are expected to account for more than 55 per cent of this increase, compared to 33 per cent from family offices and 12 per cent from institutions. This is set to positively affect the already existing imbalance between supply and demand, presenting an excellent opportunity for reputable and experienced international financial centres (IFCs) to work with such individuals and offer their expertise.

The research shows that there is an increasing appetite for Shari'ah compliant wealth management solutions amongst wealthy and ultra-wealthy Muslims, especially in younger generations. However, most industry experts would agree that Shari'ah compliant financial products and Islamic finance solutions of any type are not simple to devise. Once such products and solutions are created, they are often subject to different interpretations amongst scholars, industry protagonists and clients about their religious compliance. While there might one day be an industry standardisation, the likelihood of this happening in the foreseeable future remains slim.

Other important challenges that must be addressed include the shortage of expertise available in the region, complex legal and Shari'ah interpretation issues, documentation concerns and the lack of scale—production costs of investment solutions have become significantly higher. In addition, returns on Islamic wealth management solutions are generally lower than conventional offerings, due to, amongst other factors, costs associated with documenting complex Shari'ah compliant structures. However, industry players and regulators recognise many of these challenges and are working to improve diversity, costs and returns.

The first step in meeting this growing demand is to attract and nurture the right expertise in Islamic finance wealth management. The offerings that IFCs provide are vital in supporting this demand. The opportunity ahead for IFCs is enormous, especially considering the region’s requirements for generational wealth planning.

IFCs with special purpose vehicles (SPVs) who have firsthand experience with Shari'ah-compliant Islamic capital market transactions will have an advantage in terms of bridging the gap in supply. Furthermore, product knowledge coupled with international expertise in Islamic finance wealth management solutions, alongside a healthy regulatory environment, equips IFCs with the necessary tools to answer the region’s high demand. Perhaps most importantly, a deep understanding of the local market requirements is necessary to ensure the smooth implementation of international Islamic finance wealth management solutions. Jersey Finance has long recognised this and its physical presence in the region allows for a better understanding of local market nuances such as the key themes driving client trends.

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ISSUE 118

INSIDE BISB’S SUCCESSFUL TRANSFORMA TION HASSAN JARRAR, CEO, BAHRAIN ISLAMIC BANK

A CPI Financial Publication Dubai T echnol ogy and Media Fr ee Zone Authority

INSIDE BISB’S SUCCESSFUL TRANSFORMA TION Hassan Jarrar , CEO, Bahrain Islamic Bank

PLUS:

16 ISLAMIC BANKING: The next generation of customers

24 INVESTMENT : A bullish view on US real estate

35 AW ARDS: A look back at the IB&F Awards 2019

Dubai T echnol ogy and Media Fr ee Zone Authority

ISSUE 117

TRA CING THE INDUSTR Y ’S POSITIVE TRAJECT OR Y DR BELL O LA W AL D ANBA TT A, SECRET AR Y GENERAL, ISLAMIC FINANCIAL SERVICES BO ARD (IFSB)

A CPI Financial Publication

TRA CING THE INDUSTR Y ’S POSITIVE TRAJE CTOR Y Dr Bello La wal Danbatta, Secr etar y General, Islamic Financial Ser vices Boar d (IFSB)

PLUS:

20 ISLAMIC BANKING: Saudi fundamentals

24 HALAL BUSINESS: Adapting to the needs of SMEs 40 SUKUK: Issuance rises for fourth straight year

ISSUE 116

LINKING GL OBAL V ALUE CHAINS ENG. HANI SALEM SONBOL, CEO, INTERNA TIONAL ISLAMIC TRADE FINANCE CORPORA TION Dubai T echnol ogy and Media Fr ee Zone Authority

LINKING GL OB AL VA L UE CHAINS Eng. Hani Salem Sonbol, CEO, International Islamic T rade Finance Corporation

Spearheading a digital future

In an exclusive, David Parker, Co-Chief Investment Officer of Bahrain EDB and Board Member of Bahrain Fintech Bay, shares his vision on technology in Islamic finance for Bahrain

How far has the Islamic fintech space come in the last few years? Not as far as we would like. We are interested in Islamic fintech from several different angles. First of all, we want to see more Islamic banks innovating. We’re starting to see banks such as Al Baraka Bank, for example, increasingly engaging with start-ups globally and are very focused on the fintech agenda. One of them recently joined the board of Bahrain Fintech Bay. We want to continue to work with the existing financial institutions in that space to help them embrace digital disruption and innovation.

Second, we’re very key to work with Islamic fintechs in different parts of the world and invite them to come to Bahrain and test their products and services here. We were delighted to welcome into our sandbox for example Wahed Invest, which is a Shari’ah-compliant robo-advisory firm.

The third area, in which I believe there is a lot of potential, is to what extent can we engage with companies doing interesting things in the conventional space which have the potential to develop a Shari’ah-compliant version of that product?

We worked with Rain in Bahrain, who were the first graduates from our regulatory sandbox, and were the first platform to become licensed for crypto trading in the country. They have now developed a Shari’ah-compliant focus in their product. We’re starting to see companies that are looking at the Muslim market and the Islamic fintech space as an opportunity. I think that’s where it gets really exciting from a fintech perspective.

This is an industry you could argue that Bahrain has always been at the forefront of. Bahrain pioneered Islamic finance decades ago, and we think fintech is the next phase of that. The only other location that we look at that we see do some interesting things is Malaysia. Something we’d love to do from a Bahrain perspective is see how we could tie in with the relevant authorities in Malaysia, as for us it’s all about building bridges. Malaysia frequently ranks number one in the world for Islamic finance. We know there are some interesting things going on in Malaysia and the Islamic fintech space. We are in different parts of the world—they are very much a part of the ASEAN economy, we’re a part of the Gulf economy. Could we build bridges? That question excites me.

David Parker

“ONE THING WE’RE VERY GRATEFUL FOR IN BAHRAIN IS THAT WE HAVE ONE SINGLE SUPER-REGULATOR, THE CENTRAL BANK OF BAHRAIN, WHO HAVE SHOWN REAL LEADERSHIP.”

— David Parker, Co-Chief Investment Officer, Bahrain EDB and Board Member, Bahrain Fintech

BANKER MIDDLE EAST | MARCH 2020 | ISSUE 228 We also are asking what else is going on in Pakistan, Indonesia, parts of Africa, London and Luxembourg, which is also looking at the Islamic finance and fintech space. We are trying to build bridges with those other hubs.

Could you tell me more about what your focus is? My personal brief covers four areas, all of which in some way or another link to Islamic finance and the Islamic financial sector. I’m responsible for financial services, so we do a lot of work with both the conventional and the Islamic players in Bahrain. I’m responsible for the ICT and start up sector. We’re very keen to attract more innovators, more fintechs, into Bahrain. We think the Islamic finance space is something that’s really ripe for innovation. If you take blockchain technology for example, if you look at the principles of blockchain it’s all about transparency that drives trust. Well, isn’t that one of the underlying principles of Islamic finance?

What are some of the challenges in getting traditional institutions to embrace innovation? I think that the main challenge in terms of getting traditional institutions to embrace innovation is to appreciate both the opportunities and the threats. From an opportunity perspective, obviously it’s a way in which institutions can become more efficient, drive down costs, and to go back to the point I made earlier, that they can further reinforce the principles behind Islamic finance through technologies like blockchain.

The threat, for me, is that they don’t one day find that other players have moved into the financial services space and eating their lunch so to speak. We’re seeing now the emergence not just of fintech but techfin—technology companies starting to develop financial platforms and financial services.

I was at an event recently and someone said: “people don’t need banks. They need banking services.” If you think about it, if new players start to come into this space and do things more efficiently and more effectively than banks, and I’m thinking technology companies for example, that’s a threat. What we don’t want to see is institutions in Bahrain that we have high regard for, that are important parts for our financial centre, starting to run into difficulties. We want to encourage a degree of disruption; we want to encourage more innovation. We want to shake things up a little bit. We don’t want, however, to lose those long-standing and trusted institutions.

They are looking at this space very aggressively. Bahrain Islamic Bank, thanks to the leadership of its chief executive Hassan Jarrar, have been leading the way. He and I recently visited Singapore recently attending the Singapore Fintech Festival, and we took the opportunity to visit some of the banks in Singapore to see what they were doing to embrace the digital agenda and what institutions in Bahrain could learn from that. There are opportunities, there are threats, and some are moving quicker than others.

We think the insurance space will start to move as well, and we will see Takaful and ReTakaful companies embrace innovation and digital transformation in the way that the banks have started to do. It’s a combination of the financial institutions, the innovators, and to some degree the investment community, but also the regulator.

What part does the Bahrain Central Bank play? One thing we’re very grateful for in Bahrain is that we have one single super-regulator, the Central Bank of Bahrain, who have shown real leadership. This is not an easy place to be if

you’re a regulator, because you want to embrace innovation but you also want to ensure consumer protection, anti-money laundering and all the things good regulators do.

That creates a problem. How do you get that balance right? How do you get the balance between driving innovation on the one hand and encouraging an environment that is innovation friendly while also ensuring that you have tight regulation and tight controls to protect consumers? The CBB stand up against any other regulator in the world in the way they’ve got that balance right.

Right from the outset, they have been driving this agenda. When we introduced crowdfunding regulations in Bahrain, they put in place Shari’ah-compliant regulations. They put Shari’ah-compliant crypto regulations with Rain. At each stage, they’ve been really very mindful of the Shari’ahcompliant agenda with all new innovations and regulations.

What percentage of Islamic institutions are pushing in innovation? It’s difficult to put a percentage on it because it’s almost like a conveyer belt. At the beginning, you have complete ignorance—banks who don’t appreciate the opportunities or the threats that this digital transformation presents to them. I’m not engaged with anyone anymore in the banking space who is still in that stage. They’re all in what I would describe as stage two which I would describe as curious. They appreciate that this is something that can’t be ignored, so they’re looking to learn. They have possibly identified key stuff and are starting to adapt accordingly. Then you have those who are actively engaged in the digital space, and following them are the ones who I would describe as outright pioneers in driving this agenda. I’m not going to go on record on which institutions those are, as I’d rather leave it for others to judge, but I’ve already mention one who has impressed me with vision and leadership in this space and that’s Hassan Jarrar from Bahrain Islamic Bank, and some of the initiatives coming out of Al Baraka.

How does the Bahrain Fintech Bay fit in? It gets exciting for me when we talk about all the different component parts of the ecosystem. We have the Bahrain Fintech Bay which has given us an ecosystem under one roof—the beating heart of conventional and Islamic finance and innovation in one space. When we set it up, we didn’t want it to simply be a co-working space—we wanted it to be an ecosystem. You can’t have an ecosystem without the incumbents. It’s great that some of the Islamic institutions are founding partners of the Bahrain Fintech Bay who are working with the Bay to contribute to the wider ecosystem. That, in this part of the world, stands Bahrain apart. The different players are working together to push this agenda, to drive the ecosystem and the future growth of the ecosystem through the Bahrain Fintech Bay initiative. The Bahrain Economic Development Board then intervenes to try to make this process go faster, as well. These are the key component parts of our ecosystem.

None of that would stand up if we didn’t have the skills and the talent. We have many years, many decades, of strength and talent as a financial centre. Next year we actually are celebrating 100 years of banking in Bahrain, as Standard Chartered set up shop 100 years ago in Bahrain. We’re very proud of that. We’ve been a pioneer in Islamic finance for 50 years, which is again something we’re very proud of. When we’re talking about fintech in terms of skills and talent, in

“WE WORKED WITH RAIN IN BAHRAIN, WHO WERE THE FIRST GRADUATES FROM OUR REGULATORY SANDBOX, AND WERE THE FIRST PLATFORM TO BECOME LICENSED FOR CRYPTO TRADING IN THE COUNTRY. THEY HAVE NOW DEVELOPED A SHARI’AH-COMPLIANT FOCUS IN THEIR PRODUCT. WE’RE STARTING TO SEE COMPANIES THAT ARE LOOKING AT THE MUSLIM MARKET AND THE ISLAMIC FINTECH SPACE AS AN OPPORTUNITY. I THINK THAT’S WHERE IT GETS REALLY EXCITING FROM A FINTECH PERSPECTIVE.”

— David Parker

terms of ‘fin’ we have talent, but in terms of ‘tech’ that’s one area that we’ve really had to adapt. We don’t have a longstanding track record as a country in technology. From many years, we made our revenues in oil, though we didn’t have quite as much of it as our neighboring countries of course. We’ve always had to diversify which is why we became a financial centre but we’ve never been a tech hub. In the emergence of Silicon Valley, you won’t see much mention of Bahrain. We want to be on the forefront of the fourth industrial revolution—the internet age. This is driven by the vision of his Royal Highness the Crown Prince who is also the chairman of the EDB, to embrace innovation as the new oil and embrace this digitalised economy.

So how do we address the talent gap? We’ve done a few things. We’re starting at grass roots, and we’ve started to take this into schools and colleges to work with our homegrown universities. Bahrain Polytechnic University and the University of Bahrain have been very active in this space. We’ve also reached out internationally to drive this agenda properly. Fintech Bay has partnered with Georgetown University in Washington DC USA to develop the national fintech talent programme, involving individuals not just going through development in Bahrain but taking secondments in other parts of the world using our partnerships in New York, Silicon Valley and Singapore so they can get more closely involved with the things that are developing this space. Hopefully this allows us to point young Bahrainis in the right direction in terms of the skills that they’re going to need to pursue their future career paths in this brave new world of fintech and digital transformation. That’s really exciting as well.