Price Discovery for Sukuk Looks Impossible with Illiquid Secondary Market: Saudi Case Study
Back in early April 2018, Saudi Arabia’s securities regulator announced that it had approved the listing of local currency government sukuk and bonds on the Saudi Stock Exchange. By October 2018, the total size of listed of Riyal-denominated government debt stood at more than the equivalent of $66 billion in the local exchange. Keep in mind that the government has raised a total of $52 billion in international notes, both Islamic and conventional, since it started tapping the international debt markets in 2016 as part of its efforts to diversify its oil-reliant economy
Qualified and approved foreign investors would be able to purchase that debt at floating, fixed, bond, sukuk, as well as with different tenors. This will give emerging market debt investors access to this untapped local debt which has been closed off for several years.
Local debt is becoming a trend in emerging markets and many investors are planning to increase their exposure to local currency debt. This especially given the fact that the SAR is pegged to the USD.
The Dutch Auction Mystery
In July 2018, Saudi Debt Management Office (DMO) introduced an issuance system (entails the use of Dutch Auction) which coincided with the yields on government sukuk soaring across all tranches. By the time DMO raised US$2 billion in international 10-year Sukuk (in mid-Sept 2018), observers were wondering on the reasons that led to the higher yields for July and August issuances. As a background, DMO has appointed five primary dealers, using the Bloomberg auction platform. To widen the investors base for the Saudi Arabian Government SAR-denominated Sukuk program, the appointed primary dealers purchase sukuk sold through a Dutch auction directly from the government, and subsequently place these securities in the secondary market for final investors, acting as market-makers for government securities.
Yields edge higher
While DMO succeeded in widening the investors base to reach more than 20 investors, we noticed a spike in the sukuk yields (clearly seen in the yields of the 6th offering (April 2018) and 7th offering (July 2018). On average, between the two issuances, the yield increased by 9bps across all tranches.
In fact, the yield on the five-year sukuk in July was the highest it has ever been since the start of the program. Essentially, under the new auction system (which is similar to that used by the US Treasury), the DMO gave the primary dealers a ceiling above which they could not price the sukuk – the final price had to be at that level or below. But over the last two issuances, we have noticed that investors have remained right at the top of that ceiling.
Conundrum: Price Discovery
There are three possible answers that might justify the increase in sukuk yields for two consecutive months. First is that this is a totally new experience for both the issuer and the investor (with the pricing of the instruments is conducted through new platform).
The second is that, despite the newly appointed market-makers, there is currently very little active tradability of government sukuk in the secondary market. This makes it significantly more complicated for the issuer to define fair market value for each tranche. Thus, actual price discovery is not determined yet.
The third reason, the issuer may have decided to be generous when it comes to pricing (as the Ministry of Finance tries to widen its local investors base). Note that over 20 participants have participated in the July issuance compared to the usual 12. Once you widen the investor base, you increase the demand for issuances and this should hopefully lower the cost of issuance for the government. We have not yet seen active trading, even though it is already two months after the appointment of the market makers, but hopefully this will happen in the near future.