Investors have been dumping Middle Eastern bonds in recent weeks, thrusting the local fixed-income market into the headlines. A scan of the most-read stories on UAE Bloomberg terminals revealed just two Middle East business stories in past week's top 10. Both were about bonds.
The articles were referring to the sell-off in sukuk issued by Dar Al-Arkan, a Saudi property company. And the selling of bonds issued by organisations in Dubai, particularly government-related entities such as Dubai Holding Commercial Operations and Dubai International Financial Centre Investments (DIFCI).
Sellers of course fear the European debt crisis could cause a second credit crunch. A global financial crisis would make it tough to roll over bonds that mature in the next year or two. All valid concerns.
By contrast, opportunists see tempting yields. The Dar Al-Arkan sukuk is yielding about 14 per cent, with Dubai Holding and DIFCI up about 17 per cent.
I think the optimists have a decent case. Not necessarily for Dar Al-Arkan, a private company that will sink or swim on its own merits. But for issuers in Dubai that qualify as so-called "government-related entities", recent declines mean many bonds are cheap. And fund managers at EFG-Hermes have publicly pledged their faith in Dubai bonds in recent days.
Before we think about buying, we need to ask two questions: what's the worst that could happen? And what's the best that could happen?
The worst-case scenario doesn't look too bad. Just a couple of weeks ago we heard heartening words from Mohammed Al Shaibani, the Director General of the Ruler's Court in Dubai and chief executive of the Investment Corporation of Dubai. Mr Al Shaibani told reporters in the US that Dubai stood ready to support "strategic" investments, singling out "anything that's sizeable with a major benefit to the economy". We can surely place issuers such as DIFCI, Dubai Holding and Jebel Ali Free Zone in this camp.
Meanwhile, the real economy in Dubai is buoyant, with hotels, shopping malls and even some conference halls full of visitors arriving on chock-a-block Emirates Airline flights. The UAE economy is also strong, backed by oil at about US$100 a barrel. Globally, Asia continues to be the world's economic locomotive, while even the US is bearing up.
But we're looking at the worst-case scenario, so let's assume the worst. Greece, Spain and Italy default in some sense, inflicting huge losses on European banks and causing the financial system to seize up. The US slips into a second recession. China's property bubble bursts. If this happens, oil, trade and tourism will tumble, hurting the UAE and probably causing a national recession.
Then what? If the Dubai World restructuring is anything to go by, lenders will be OK. Bondholders got every cent on time, while bank lenders had to take a hit, agreeing to defer repayment for up to eight years, receiving a below-market interest rate in the process.
What if credit crunch 2.0 is worse than the first version? Maybe holders of Dubai bonds will be asked to take a haircut. But remember, the UAE is not Greece. Given the scale of the country's sovereign wealth, any haircut is likely to be limited. Let's be pessimistic and say 20 per cent. I can't see it, but even if it does happen, most of that risk is already priced in. These bonds are trading below 90 cents on the dollar, so we're buying them at a steep discount. If everything that can go wrong does go wrong, we walk away with a loss of about 5 per cent, and our money is tied up for a few more years than we anticipated. We'd all rather it didn't happen, but it's hardly the end of the world.
Now the second question. What's the best that can happen? Let's take the $1.25 billion (Dh4.58bn) sukuk issued by DIFCI, which matures next June. If we rush out this morning and buy bonds with a face value of $1m, we'll pay about $900,000, depending on the bid-offer spread. We collect the quarterly payments in December, March and June, which should add up to about $100,000, depending on what happens to the London interbank offered rate (Libor) between now and then. Then we receive $1m on June 13 when the bond matures.
If all goes well, our total return will be - in ballpark terms - $200,000 ($100,000 revenue plus $100,000 capital gain because we're buying at a discount). That's an impressive return of about 22 per cent in just eight months.
Of course, it's risky. The DIFCI bond earned an "A plus" rating from Standard & Poor's when it was issued in 2007. Since then, S&P has cut the rating to "B plus". This is not the kind of trade your financial adviser would recommend you put your entire pension into if you're planning to retire next summer. But as a side stake in a diversified portfolio for an investor with risk appetite, it could be worth a look.
If it sounds too good to be true, remember that we've been down this road before. Back in the dark days of late 2009 and early last year, after the Dubai World debt standstill, some brave investors bought Nakheel sukuk at close to a 50 per cent discount. They were repaid in full, making windfall profits by backing Dubai and the UAE to stand firm with bondholders.
* Richard Dean hosts Tonight on Dubai Eye 103.8 FM and is the author of Sink or Swim? How to Stay Afloat in Tough Economic Times: Business Lessons from the UAE