An attractive alternative: Islamic bonds are an increasingly popular means of obtaining financing

A survey of the most significant sukuk (Islamic bond) issuances of 2013 reveals that a diverse array of institutions have turned to the instrument in order to acquire capital. The first of the major deals came in March with the Saudi Electricity Global Sukuk II, a US-dollar-denominated offering worth $2bn. In May three issuances were made on a single day: the Power and Water Utility Company’s riyal-denominated sukuk of $666.5m; real estate firm Dar Al Arkan’s $450m offering, another riyal-denominated deal; and a US-dollar-denominated offer from IDB Trust Services worth $1bn that was carried out on behalf of the government. April brought a single issuance, in the form of the Sadara Basic Services $2bn riyal-denominated sukuk, which was followed in July by the $266.7m offering from construction outfit Saudi Binladin Group, priced in riyals. The final quarter of the year saw a flurry of activity in the sukuk arena: in September Almarai issued a $453m riyal-denominated sukuk; October saw the General Aviation Authority of Civil Aviation (GACA) successfully conclude its $4.1bn offering, priced in riyals; and in November Riyad Bank closed out the year with another riyal-denominated offering worth $1.1bn. In addition to the government’s sukuk issuance, therefore, the last year has seen firms from the financial services, food and beverage, construction and real estate, industrial manufacturing, and the power and utilities sectors tap the debt markets.

VALUE IN THE RIYAL: Another interesting characteristic of Saudi Arabia’s sukuk issues is the popularity of the local currency. Six of the 10 significant offerings in 2013 were priced in riyals, a continuation of a trend which saw 65% of issuances in 2012 carried out using the currency, according to a recent report by Saudi Hollandi Capital. During the early years of sukuk issuance, Saudi Arabian institutions favoured international offerings, usually placed in US dollars, and prominent issuers such as IDB Trust Services and Dar Al Arkan have become well known in the market for their internationally placed deals. Going global with a sukuk requires a slightly different approach to that for domestic offerings, such as the need to acquire a rating – either for the issuer or the instrument itself – in order to attract capital from investors who might not be familiar with the local economy. Many international issuances are listed on global exchanges, with London being one of the more popular destinations for local companies seeking international capital. Again, this provides a way for international investors who are not necessarily familiar with Saudi Arabian entities to access sukuk offerings in a low-risk manner, while by gaining a rating and listing on a foreign exchange the local issuer stands to benefit from the vast capital pool of the global investment community.

INCREASING POPULARITY: The increasing popularity of Saudi Arabia’s domestic sukuk market is a relatively new phenomenon. Just one domestic issuance was made in 2004, and the next sukuk was not offered to investors until 2006. Since 2008, however, issuances in the domestic market have been increasing in frequency, with the four offerings of that year followed by a further three in 2009. In 2011 local institutions offered a total of 10 sukuks to the domestic market, and both 2012 and 2013 saw a record 10 issuances each. Those denominated in riyal account for more than half of total offerings, which runs counter to a trend seen elsewhere in the GCC region, where less than 50% of sukuks are priced in the local currency.

The explanation for this is the straightforward matter of cost: ample liquidity in the domestic market has lowered borrowing costs to rates well below the levels seen for equivalent dollar-denominated bond and sukuk sales. Moreover, as interest rates on international markets inevitably rise after years of historic lows, Saudi Arabia’s more insulated market is likely to become even more attractive to issuers of sukuks. “There is a lot of liquidity looking for a good home in Saudi Arabia, and importantly, the Saudi market has developed comfort with long-term debt issues in Saudi riyals. We expect local debt market activity this year to surpass international bond sales by Saudi issuers,” Jamal Al Kishi, the chief executive officer of Deutsche Securities Saudi Arabia, told Reuters at the start of 2014.

FINE-TUNING THE SYSTEM: With momentum in the sukuk market gathering, the potential challenges to issuance growth are highlighted all the more starkly. Chief amongst these is the question of a yield curve by which issuers can benchmark their instruments – the lack of which is a problem facing many economies in the region. As ever, the market looks to the sovereign to provide a yield curve, and in Saudi Arabia’s case the $4bn government-backed sukuk issued by GACA in January 2012 has partially answered the need for sovereign issuances to lead the way. More sovereign issuances or, better still, the development of a government sukuk programme would greatly enhance the ability of issuers to benchmark the pricing of their future offerings – as demonstrated in the Malaysian market, where government sukuks are a frequent occurrence.

The offering of more sovereign sukuks might also help to give the local bourse’s electronic platform, introduced in 2009, a useful boost. Trading on the platform remains muted, with only eight sukuks active as of April 2014, and the resulting low liquidity has made it of limited interest to institutional and retail investors. As well as establishing a useful yield curve, government sukuks could act as anchor instruments in the secondary debt market and thereby generate liquidity for it. Other developments that would give the secondary debt market a much-needed fillip include the credit rating of sukuks and increased transparency in issuance and pricing.

The importance of credit rating extends beyond the secondary market and forms a third significant challenge facing Saudi Arabia’s sukuk market. The rating of issuances is a prerequisite for the majority of institutional investors these days, thanks in large part to the capital adequacy requirements of Basel II and III. From the perspective of issuers, gaining a credit rating usually enables them to secure better pricing, increase tenures and attract more investors. While the international sukuk issuances of Saudi Arabian institutions have been for the most part rated, the domestic offerings have more often than not been carried out on an unrated basis. Thanks to the large amount of liquidity and the appetite from well-informed local investors for government and corporate debt, the lack of a credit rating has to date not presented a problem. However, as issuances continue to increase in frequency, thereby enabling investors to pick and choose from a range of high-quality offerings, the lack of a credit rating may act as a disincentive to buy.

POSITIVE OUTLOOK: While these challenges still need to be addressed, the outlook for continued sukuk growth is nevertheless positive. Bank lending and equity funding remain popular methods of long-term financing for Saudi Arabian companies, but both have their limitations. The short-term nature of most bank lending in the Kingdom (with around 60% of all loans having maturities of less than one year) makes sukuks an attractive alternative for some issuers, while the mixed performance of stock markets around the world in the wake of the credit crunch has made equities a less dependable choice than they previously were.

Moreover, the demand for long-term financing is increasing after some years of economic uncertainty, with both corporates and the government drawing up spending plans aimed at infrastructural and industrial development. The Kingdom rolled out a record budget in 2013, announcing an ambitious programme of investment in health, education and infrastructure that represented a 19% year-on-year increase in spending, while for corporates Saudi Arabia is the largest project market in the region, with an estimated $600bn in development contracts awarded in 2013. This aggregate long-term financing demand alone is enough to support the optimism that surrounds the issue of future sukuk issuance.