Bright future: The market for Islamic bonds is promising

Bahrain is among the world’s focal points for Islamic finance and sukuk, a sharia-compliant bond, which has been among the most important and visible Islamic instruments worldwide. The outlook for sukuk markets was increasingly positive in early 2013, as the asset class distanced itself from the 2007-08 global financial crisis. The upswing in confidence has come about thanks to a number of factors.

The European debt crisis is a major contributor: investors in fixed-income securities have fewer good options than they usually do, making sovereign-issued sukuks more attractive in comparison. Another victim of Europe’s shaky economic outlook is that European banks are less willing to lend to customers on the Arabian Peninsula, some of whom may turn to sukuks as an alternative method to raise capital.

LOOKING TO ALTERNATIVES: In the GCC region, institutional and large-scale investors may have additional incentives to own sukuks or sukuk funds because real estate is no longer a preferred option for safe investing after a glut of projects introduced in the past 10 years has left a supply overhang and underperforming assets. “With the real estate market closed to many banks with their balance sheets remaining burdened with ‘underperforming’ legacy real estate assets, lower-risk sukuk investments became the natural asset of choice for many,” Eric Swats, the head of asset management at Dubai-based Rasmala Investment Bank, told local media in February 2013.

However, the optimism for sharia-compliant debt is based on more than merely the current global economics or the struggles of other asset classes. For instance, sukuks simply look better now than they previously did. Reasons for this include the asset class’s survival through its first exposure to a serious financial crisis and first defaulted issues, the increasing activity of government issuers located outside the Arabian Peninsula and Malaysia, and innovations that are expanding the range of possibilities for those who want to use the capital that can be raised with a sukuk.

RECORD GROWTH: Sukuk markets in the GCC were near dormant in the wake of the financial crisis, but have roared back and are now growing at record levels. The $46bn in sukuk sales worldwide in 2012 bested the previous annual high set in 2011, and issuance in 2013 is expected to be greater still. Kuwait Finance House has predicted a 30% increase. Meanwhile, for GCC countries, HSBC forecast a 33% jump in issuance, reaching a total value of some $35bn. Sales in the GCC almost tripled in 2012, jumping to $21.3bn from $5.6bn in 2011, according to Dealogic, a capital-markets-focused data provider.

Part of sukuks’ increasing appeal is that global investors now know more about these types of assets. Sukuks were popular until the financial crisis, and, more specifically, until the first high-profile issuer ran into trouble. Dubai World, the government-owned investment company, struggled in 2009 to make payments on $4bn in sukuks issued for its property arm, Nakheel. A default was avoided with a restructuring, but because of the timing and due to Dubai’s very high profile among foreign investors, the episode served as a lightning rod for outsider scepticism and for the subsequent greater awareness among investors about what they are purchasing.

Investors are no longer likely to assume that since a sukuk is issued by a government entity it may come with a de facto sovereign guarantee. And they are also paying closer attention to the specifics – such as what sharia-compliant mechanism is used to securitise the assets underpinning an issue, and how they are accounted for in records by the issuer, said Ijlal Ahmed Alvi, the CEO of the International Islamic Financial Market (IIFM), a standardisations body specialising in capital-markets instruments.

DEFINING TERMS: Whilst the financial crisis may have helped lead to the temporary halt in sukuk markets several years ago, many in Islamic banking feel that an internal dispute within the practice was a bigger problem. In November 2007 sharia scholar Sheikh Muhammad Taqi Usmani, the chairman of the Sharia Board of the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions, said at a conference in Bahrain that as much as 85% of certain types of sukuks may have sharia compliance issues. Whilst he was referring to only mudaraba ( profit-sharing agreement) and musharaka (joint venture), media covering the conference interpreted this to mean 85% of all sukuks may be problematic, and the mistake was repeated from there.

Now there is a greater understanding of what types of sukuk are most appropriate for specific types of circumstances, Alvi told OBG. Sovereigns issuing to fund infrastructure projects, for example, are using ijara (Islamic leasing bonds) or wakala (agency contract) structures to securitise assets and sell sukuks, according to Alvi. Meanwhile, murabaha, a type of sales contract, is better suited to domestic markets. As of the end of the third quarter of 2012, ijara and wakala accounted for 47% and 12%, respectively, of international sukuks, according to IIFM figures. Murabaha accounted for 42% of domestic ones. Mudaraba and musharaka are less used these days.

SPREADING OUT: Sovereign sales have become a larger part of the mix: in 2007 sovereign sukuks accounted for about 10% of total issuance, whereas now that number is 50%, Alvi said. The increased proportion of sovereign sukuks in the overall mix is a reflection of investors’ increased caution with corporate debt after the crisis, but also of the growing number of governments in Muslim countries that are now embracing sukuks as an option.

Two of the higher-profile ones in the past few years have been Turkey and Indonesia. Both are Muslim countries, both have recently graduated to investment-grade ratings from the international credit ratings providers, and both are increasingly minded to sell sukuks. Other new markets may include Kazakhstan, where a government development bank sold sukuks in 2012 denominated in Malaysian ringgit, in order to target investors there – and later in the Arab countries of North Africa. Islamic financiers reason that in Egypt and Tunisia secular governments have been replaced with ones open to allowing Islam to influence policy, and that may translate into sukuk sales – Egypt said in 2012 it plans on issuing one. However, these are more likely to be deployed in emerging markets in the longer term and not 2013, given the present political instability in the country.

Bahrain has for years been a regular issuer of short-term sukuks and sells long-term debt on an ad-hoc basis. Such a sale in early 2011 likely contributed to the kingdom’s economic resilience in the past several years. A conventional bond sale had been cancelled in early 2011 given the uncertain economic conditions. Instead, the Central Bank of Bahrain, which issues all sukuks on behalf of the sovereign, opted for an offering in November of that year of $750m in seven-year sukuks. It was Bahrain’s fourth sukuk sale in international markets and the first with a seven-year tenor. It was oversubscribed by investors, providing a boost to Bahrain’s standing with investors at home and abroad and shoring up the economic outlook.

Sovereign sukuks for the financing of infrastructure are likely to be common in the GCC in the coming years, providing opportunities on both sides of deals for Bahraini investors and banks. Saudi Arabia has been a common issuer given that the size of its population – more people live there than in the rest of the GCC countries combined – mandates the biggest need for new infrastructure. Bahrain, however, could end up an issuer as well, as the GCC has set up a $20bn fund to support it and Oman, the two members of the group with the least oil wealth. The plan calls for $10bn to be funnelled to both through $5bn donations from each of the other four countries: Saudi Arabia, the UAE, Qatar and Kuwait. The money would be spent on housing and infrastructure. In addition to that money, sukuks are likely to be used to raise additional capital to finance these projects.

CORPORATE MARKET: Although the corporate sukuk market has taken a back seat to sovereigns as of 2013, innovations in that segment of the market may also provide new opportunities. In 2012 Abu Dhabi Islamic Bank issued $1bn in sukuks that were a hybrid of common structures and were meant to be a perpetual issue: as the sukuk is structured, there is no specific maturity date and the lender can pay back bonds on certain dates from 2018 if it chooses to do so.

This was the first sukuk issue by a corporate for the purpose of raising Tier 1 capital, and was conducted in accordance with the new standards set for bank capital by the Basel Committee on Banking Supervision. It qualified because of features that make the debt behave more like an equity product than debt, for accounting purposes, and as a result is was able to qualify as Tier 1 capital under Basil III’s rules. The lender had issued similar debt in 2009 in a private placement, however, this public sale will likely lead to similar ones across the region. Indeed, the Dubai Islamic Bank announced a similar plan in March 2013.