New directions: The growing popularity of Islamic bonds

The Islamic finance sector in Turkey received a powerful boost in 2012 as the government entered the market with its debut issues of sukuks, the Islamic equivalent of bonds. The successful debuts – one in the domestic market and another in the international Eurobond market – have set the stage for an expected boom in the issuance of sukuks by the government, state-owned companies, the construction industry and Islamic financial institutions.

The government’s entry into Islamic finance as an issuer was a milestone on the path away from strict secularism that Turkey has taken since the moderate Islamist Justice and Development Party (AKP) came to power in 2002. Although the government still prefers to use religiously neutral terms such as “leasing certificates” to describe sukuks and “participation banks” to refer to Islamic banks, the state’s issue of sukuks made a clear statement that Islamic finance has joined the Turkish mainstream.

Opening A Market

The government’s debut sukuk was a $1.5bn, 5.5-year issue that placed in September 2012 at a 2.8% profit rate, the equivalent of interest. The government initially planned to sell only $1bn, but an order book of nearly $8bn convinced the government to increase the size.

However, the purpose of the dollar sukuk was not simply to raise funds. The point was two-fold: to tap into a different investor pool, and to pave the way for later corporate issues by whetting investor appetite and establishing a benchmark.

Global Buyers

The biggest markets for international sukuks are Gulf Arab and South-east Asian countries, where there are large Islamic banking sectors. According to financial data vendor CB onds, 58% of the Turkish sovereign dollar sukuk was placed to Middle Eastern buyers, and 12% went to Asian ones.

Also, many US and European investors, most of whom are not Muslim, invest in sukuks. Due to their asset-based structure, sukuks perform particularly well when markets are risk averse. In the type of sukuk used in Turkey, known internationally as Al ijara, the issuer contributes assets to a special purpose vehicle, which leases them back to the issuer and pays out income shares. US and European buyers took 21% of the Turkish sovereign dollar sukuk, while 9% went to domestic buyers.

Bank Funding

Prior to the government issue, only two Turkish sukuks had been issued, both by Kuveyt Türk Katılım Bankası, the Turkish unit of Islamic banking group Kuwait Finance House. Soon after the government authorised issuance of leasing certificates in 2010, Kuveyt Türk issued a $100m, three-year sukuk at 5.25% in August 2010 and a $350m, five-year sukuk at 5.875% in October 2011. Kuwait Finance House was involved along with HSBC and Citigroup in placing the debut sovereign sukuk.

After the sovereign debut, Turkey’s three other Islamic banks moved to make their sukuk debuts. The country’s largest Islamic bank, locally owned Bank Asya, placed a $250m, five-year issue at 7.5% in March 2013. That same month, AlBaraka Türk, the Turkish unit of the Saudi-Bahraini Islamic banking group, passed a regulatory hurdle towards a $200m sukuk issuance, and in April it appointed BNP Paribas, Al Hilal Bank, Barwa Bank, Emirates NBD and Japan's Nomura for a possible Tier 2 issuance. In April 2013 Türkiye Finans, owned by National Commercial Bank, received permission to float a $500m sukuk. İbrahim Öğüdücü, a senior vice-president of Bank Asya, expects further growth. “The sovereign sukuk issues were a turning point for the Islamic banking system in Turkey. They will be followed by more public and private issues,” he told OBG.

Turkey’s construction sector, which has developed ties to Gulf Arab investors, is also likely to tap the developing sukuk market. In March 2013, Ali Ağaoğlu, president of Ağaoğlu Group, one of the main builders of the Istanbul International Financial Centre, told Arabian Business that his firm was planning to raise $2bn for the project through a series of sukuk issues.

Large state-owned firms are also likely to participate in this trend. Bloomberg reported in October 2012 that Turkish Airlines and Türk Telekom were both looking into issuing sukuks. Government officials have said Islamic bonds could be used to finance future infrastructure projects. Some in the financial sector are concerned that the state may be overdoing sukuk issues. As Reşat Karabıyık, managing director of Bizim Menkul Değerler, told OBG, “The recent sovereign sukuk issuance may set a standard that will facilitate further private distributions. However, there is a danger that this will encourage the Turkish government to become even more involved in the economy. Moving forward, further sukuks should come from the business community, with the state only getting involved on occasion, and in small amounts.”

Local Currency Sukuks

While Turkey’s debut sovereign dollar sukuk attracted the most attention, the government actually had greater success with its subsequent issue in October 2012 of a lira sukuk. The two-year, TL1.62bn (€699.5m) issue was placed with a 3.7% profit rate, a negative real yield, and about half of what Turkey’s benchmark two-year lira bonds were yielding. The government followed up in February 2013 with another two-year, TL1.52bn (€656.3m) issue, placed at 2.85%. By mid-April, it was trading with a 2.35% yield, while the first sovereign lira sukuk was trading with 1.8%, compared to more than 5.8% on standard two-year sovereign lira bonds.

Demand For Liquid Assets

The high demand for these bonds came mainly from Turkey’s Islamic banks, which had been starved of a safe, liquid security they could invest in to meet minimum liquidity requirements while holding down risk-adjusted assets. As Öğüdücü of Bank Asya told OBG, “The government’s lira sukuk issues were very important to us. We needed them, for the same reasons that standard banks hold conventional public debt issues. We needed some liquidity on our balance sheet.” Öğüdücü said that he expected more issues to come, with the volume increasing along with growing demand from participation banks. He added that rapid growth of Islamic pension funds would create additional demand for sukuk issues. Islamic pension funds may also drive demand for sharia-compliant equities, which mainly exclude standard banks and producers of alcohol and cigarettes. He told OBG, “The Islamic banking market isn’t deep yet. In five years we’ll have a much more mature market.”

Long-Term Funding

As of mid-April 2013, no private lira sukuk issues had yet been completed, but Kuveyt Türk and Türkiye Finans were each preparing TL100m (€43m) lira sukuk issues. These bonds are an alternative to short-term deposits, which made up 77% of Turkish Islamic banks’ funding as of February 2013, according to the Banking Regulation and Supervision Agency (BRSA). As Veysel Derya Gürerk, the CEO of Türkiye Finans, told OBG “Turkey has had a shortage of long-term funding for decades. Within this context, the recent public and private sukuk issuances represent potential sources of much-needed market liquidity.” According to Öğüdücü, encouraging Islamic banking is an important way to boost Turkey’s domestic savings rate. Islamic banks doubled the pace of asset growth of the overall sector in 2012: assets held by Islamic banks increased by 25.2%, while total sector assets grew by 12.6%, according to the BRSA. However, even after the lira sukuk issues, Islamic banking executives say their sector continues to suffer from the limited availability of liquid assets. Having few options for non-deposit funding also puts a damper on growth: Islamic banks accounted for 6.5% of total banking sector deposits as of February 2013, but only 5.3% of assets. Total assets held by Islamic banks amounted to TL74bn (€32bn). Turkey’s Islamic banks lag conventional banks, in terms of profitability.

Return on equity and assets were 14.7% and 1.47% in 2012, respectively, compared to 15.7% and 1.84% for the overall sector. According to Gürerk, the potential for Islamic banking is high, provided the required capital is sustained, as per the CBT's leverage ratio.