Dubai: Gulf Islamic bond yields fell for a third month as a scarcity of sukuk and Europe’s debt crisis prompted local investors to favour the oil-rich region.

Average yields on sukuk from the six-nation Gulf Cooperation Council slid 20 basis points, or 0.2 percentage points, last month to 3.18 per cent August 31, according to the HSBC/Nasdaq Dubai GCC US Dollar Sukuk Index. That compares with a nine basis-point drop to 4.74 per cent for emerging market bonds, according the JPMorgan Chase & Co’s EMBI Global Diversified Blended Yield index. Ten-year US Treasuries yielded 1.55 per cent on August 31.

Economic growth in the GCC, home to about half of the world’s proven oil reserves, will reach 5.3 per cent this year compared with a contraction of 0.3 per cent in the 17-country euro area, the International Monetary Fund forecasts. The Islamic finance industry is set to expand to $2.8 trillion (Dh10.2 trillion) by 2015, according to the Kuala Lumpur-based Islamic Financial Services Board. Gulf sukuk have also benefited from appetite for higher-yielding assets, according to Union Investment Privatfonds.

“On a regional level, the repatriation of GCC funds from European investments back home, along with the ample liquidity of Gulf-based Islamic funds, has revived the sukuk market in the Gulf states,” Apostolos Bantis, a credit analyst at Commerzbank AG in London, said on August 30. The imbalance between “strong demand and low supply have led to record-low sukuk yields and more attractive pricing.”

Record sales

Sukuk sales in the Gulf have surged to a record $17.7 billion this year, beating the 2007 total of $16.2 billion as the decline in borrowing costs encouraged issuers such as Qatar and Dubai-based Emaar Properties PJSC to tap the market.

Investor confidence in the region has improved since Dubai, the region’s financial hub, pledged to meet financial obligations and property developer Nakheel PJSC and state-owned holding company Dubai World reached agreements with creditors to restructure debt last year. Business park operator Jebel Ali Free Zone FZE and DIFC Investments LLC paid debt this year.

The “resurgence in risk appetite” has pushed yields lower in Dubai and “across the board,” Abdul Kadir Hussain, chief executive officer of Mashreq Capital DIFC, said on August 30.

Wealthy investors

The yield on Dubai’s 6.396 per cent Islamic bonds due November 2014 declined 40 basis points in August to a record low of 2.86 per cent. The premium investors demand to hold the emirate’s notes over Malaysia’s 3.928 per cent sukuk maturing in June 2015 dropped 26 basis points in the period to a record 117 on August 31.

Growth in Islamic banking assets and funds held by high-net worth individuals and institutions is helping drive the rally in the Gulf, Hussain said. In the UAE, total banking assets increased four per cent to Dh1.73 trillion at the end of June from December 2011, according to official data.

Inflows into emerging-market bond funds climbed $455 million in the week ended August 29, taking their total to more than $32 billion this year, according to the latest research from EPFR Global. Funds favouring so-called hard currencies such as the dollar saw the biggest interest, the Cambridge, Massachusetts-based company said.

‘Risk sentiment’

“Very positive global risk sentiment in July and August has pushed demand and in this sense also spreads and yields for emerging market debt further down, and GCC sukuk weren’t an exception,” Sergey Dergachev, who helps manage $8.5 billion of emerging-market assets at Union Investment in Frankfurt, said on August 31. “The supply of sukuks has been very low so far. There is a lot of money chasing too few deals and that is supportive for valuations.”

European bond funds posted outflows for the second straight week, EPFR said. An escalation of the euro area’s sovereign debt crisis could cap the rally in GCC sukuk, according to Mashreq’s Hussain and Commerzbank’s Bantis.

A “major threat would be a long-drawn and material global crises, for example Europe or bad data out of the US,” Hussain said.

The Federal Reserve last month reiterated a plan to keep interest rates near zero through at least late 2014, while the European Central Bank cut its benchmark rate to a record low of 0.75 per cent in July.

‘Good quality’

“Declining yields for conventional corporate and sovereign bonds along with limited good quality high-yield paper have shifted investors’ attention to sukuk,” Bantis said.

Saudi Arabia, the world’s largest oil exporter, is rated AA- at Standard & Poor’s, on a par with China and Japan. The government has no outstanding dollar-denominated debt, according to data compiled by Bloomberg. The yield on state-controlled Saudi Electricity Co’s 4.211 per cent Islamic bonds maturing in April 2022 has dropped 53 basis points this quarter to 3.15 per cent August 31. The kingdom’s largest power producer is rated the fourth-best investment grade at S&P.

GCC Islamic bonds have returned 7.6 per cent in 2012, according to the HSBC/Nasdaq index, while debt in developing markets climbed 13 per cent, JPMorgan Chase & Co’s EMBI Global Composite Index shows. The difference between average yields on Gulf sukuk and the London interbank offered rate, or Libor, narrowed 40 basis points last month to 212 basis points, according to HSBC.

“Sukuk yields are likely to continue falling a bit more as the strong demand-low supply fundamentals will persist,” Bantis said. “Any further yield declines will be at a more moderate pace than in the first half.”