A spectacular rally in Dubai-linked Islamic bonds is pushing yields to record lows and influencing prices in the entire Gulf debt market. Some investors think the rally has reached excessive proportions, potentially setting bonds up for a partial pull-back when the euphoria starts to fade.

Dubai’s $ 1.25bn sovereign sukuk, issued at a profit rate of 6.396% in November 2009 and maturing in 2014, was yielding just 3.2% yesterday, for example.

That is a yield plunge of about 2.35 percentage points since early February—an impressive gain for any credit and especially for Dubai, which until recently was seen as the ugly duckling of the Gulf because of its 2009 corporate debt crisis.

“Dubai Inc bonds have rallied significantly in the past few weeks and compressed spreads to ridiculously low levels,” a regional trader said, requesting anonymity because he was not authorised to speak publicly. “The market has been overbought for a while and now it’s just trading on sentiment.”

Dubai-related sukuk have been surging across the board.
Emaar’s $ 500mn, seven-year sukuk, issued at 6.4% last week, was bid at 5.78% yesterday.

There are some well-known and plausible reasons for the rally. Dubai’s property market, the source of its debt problems, has been stabilising and even picking up in some areas, while its state-linked firms have been moving aggressively to resolve their debt restructurings.

Dubai’s five-year credit default swaps, which represent the cost to insure against default, tightened to around 323 basis points this week, a nearly one-year low.

“Barring broader risk-off sentiments in global markets, the key to watch is whether Dubai CDS can break through the 300-320 bracket...that could well be possible if risk stays bid,” said Raza Agha, senior economist for the Middle East and North Africa at RBS in London.

In Emaar’s case, the company’s business appears to be recovering significantly; analysts polled by Reuters on average expect the big property developer to post in coming weeks a second-quarter profit of 516.3mn dirhams ($ 141mn), which would be a 106% increase on a year earlier.

Special, temporary factors also appear to be behind the Dubai sukuk rally, however, and the market could lose steam when these eventually fade.

One factor is an excess of idle funds, especially Gulf Islamic funds, searching for investment targets. This has been expanded by the maturing of several big regional bonds in the past few weeks.

A second factor is the approach of the Holy Month of Ramadan, which is expected to begin around July 20. Trading turnover tends to fall during that month, so investors are scrambling to get hold of bonds before that happens; the dramatic rally of the secondary market has made some of them desperate.

Although there has been heavy supply of new sukuk in the last couple of months - the government of Qatar issued a $ 4bn sukuk earlier this month, the largest dollar-denominated Islamic bond ever seen - there is no sign that it has satisfied investor demand. Oversubscriptions have prompted disappointed investors to buy the new sukuk in the secondary market, bidding prices up further.

And the global financial crisis continues to encourage interest in the Gulf, which to many is a safe haven compared to Europe and the US.

This factor is unpredictable, however. If the global crisis continues to worsen and oil prices resume falling, the Gulf could lose its safe-haven image. And if the global outlook somehow improves in coming months, investors will no longer need safe havens as much.

Some analysts also note that Dubai’s economic, fiscal and corporate debt outlook, while improving, still carries risks.