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As they were reviewing the bank’s funding needs recently, executives at HSBC Holdings decided to take a fresh look at sukuk, or Islamic bonds. Three years earlier the London-based bank had announced plans to issue up to $5 billion of sukuk under a medium-term financing program, but it never proceeded because the sukuk market, which seized up during the financial crisis, failed to recover. In recent months, however, a decline in yields and a revival of activity persuaded HSBC that the time was right to dust off its plans.

In June the bank’s subsidiary HSBC Bank Middle East sold $500 million of five-year sukuk priced to yield an expected 3.575 percent. It was the largest shari’a-compliant financing ever arranged by a non-Islamic institution. The deal saved money: ?At a yield of 155 basis points over midswaps, the cost was 15 to 20 basis points cheaper than the bank would have paid on a conventional bond issue. The offering also helped HSBC deepen ties with investors in the Gulf, an increasingly important market for the bank.

“We wanted to ensure we were capturing as much of the Islamic investor base as possible,” says Mohammed Dawood, head of global capital financing at HSBC in Dubai. “With this issue we ticked all of the boxes in terms of geographic distribution, Islamic accounts going into the transaction and overall successful secondary market trading as well.” About half of the deal was placed with investors in the Gulf, primarily family offices.

Once again, the sukuk market is open for business in the Gulf. In addition to HSBC, a number of regional entities have tapped the market recently. In May, Sharjah Islamic Bank, a leading Islamic lender in the United Arab Emirates, sold $400 million of sukuk yielding 4.75 percent and the Jeddah, Saudi Arabia–based Islamic Development Bank raised $750 million at 2.35 percent. Several other banks in the region are said to be considering entering the market later this year, and bankers say the Palestine Monetary Authority plans to offer its debut Islamic bond, worth about $50 million, this summer.

The market revival is part of the broader global economic recovery, says Afaq Khan, chief executive officer of Standard Chartered Saadiq in Dubai, the London-based bank’s Islamic banking subsidiary. “As the cost of capital has come down and adjusted to the new financial growth rates and companies are again looking at expansion, we’re seeing a growth in sukuk issues,” he says. “There is a lot of liquidity looking for a good credit, good management and a good growth story.”

In addition, the market upturn reflects some factors particular to sukuk. A lack of Gulf issuance over the past two years has created pent-up demand and lowered the yields available to borrowers, bankers say. Investor confidence has also recovered in the wake of defaults by two borrowers in 2009: Kuwait’s Investment Dar defaulted on a $100 million sukuk, and Saudi Arabia’s Saad Trading Contracting & Financial Services Co. failed to make payments on its $650 million issue after its owner, Maan al-Sanea, was hit with a multibillion-dollar fraud suit by Ahmad Hamad Algosaibi & Brothers Co., a Saudi conglomerate. Even Dubai, which roiled global markets in late 2009 when its flagship Dubai World conglomerate declared a standstill on billions of dollars in debt, appears to be on the mend following a bailout from the UAE.

“There are various sukuk maturities that are coming up this year and next. You have a dearth of supply,” says Yavar Moini, an executive director at Morgan Stanley in Dubai. “And Dubai credit is in better shape following the Dubai World resolution. There is a feeling amongst banks that the worst of the provisioning is behind them.”

Last month, Nakheel, the property arm of Dubai World, announced it would issue about $1.36 billion in sukuk to its contractors and other trade creditors as part of its restructuring plan. The company’s existing $3.52 billion sukuk, issued in 2006, remains the largest corporate issue ever. Markets indicate a growing confidence in Dubai’s fiscal health, with credit default swaps on Dubai debt trading at 335 basis points in mid-June, well below the peak of 702 basis points reached in 2009, when Dubai World declared its standstill.

“You can’t underestimate Dubai in developing the market and setting the benchmark for sukuk in the region,” says Adnan Hawari, head of fixed income at Zawya, a financial news and data provider based in Beirut.

The net result of these developments has been dramatic. Dollar-denominated sukuk issued by entities in the six-nation Gulf Cooperation Council (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE) were yielding about 4.6 percent in early June, down from about 6 percent three months earlier, according to the HSBC–­Nasdaq Dubai GCC sukuk index. By contrast, the GCC conventional bond index was yielding 4.9 percent in June.

Total sukuk issuance between January and mid-June reached $40.9 billion, nearly three times the year-earlier volume of $14.2 billion, according to Zawya data.

Malaysia continues to account for the lion’s share of the market. Borrowers and investors there suffered relatively few negative effects from the financial crisis. The market recovery in the Gulf has been dramatic, though. GCC issuers accounted for $12.8 billion of the volume through mid-June, compared with $6.9 billion for all of 2010.

Much of the Gulf activity reflects a single jumbo issue. In January the Qatar Central Bank issued $9 billion of three-year sukuk to local banks to mop up excess liquidity. Aside from that deal, however, the pace of Gulf issuance has picked up notably in recent months. The increase is all the more remarkable because it has taken place amid social and political turmoil following populist uprisings in Tunisia and Egypt. The Arab Spring protest movement has shaken regimes across the region and prompted a violent crackdown on Shiite protesters by Bahrain’s Sunni government, but it hasn’t impeded a recovery in the sukuk market. “Despite the tragic events in Bahrain, the market is optimistic about the situation in the Gulf,” says Zawya’s Hawari.

Sukuk adhere to principles laid out in Islam. The instruments cannot relate to businesses involved in practices forbidden by the religion, including gambling and the production or consumption of alcohol. Interest is forbidden, so sukuk are structured in such a way that investors receive rental income or profit-sharing instead.

The main source of demand remains Muslim investors in the Middle East, for whom shari’a-compliant investments have a strong appeal. However, conventional investors are also returning to the market as a diversification move, bankers say. “We’re seeing orders from all kinds of Islamic banks, takaful [Islamic insurers] and investment managers,” says Standard Chartered Saadiq’s Khan. “We’re also seeing pockets of orders from pension funds. It’s very broad-based. They’re looking at the risk-reward trade-off” and finding sukuk attractive.

As welcome as the recent revival has been, bankers and lawyers say more needs to be done to ensure a lasting recovery. “The money is now there, but banks are being more selective by way of the credit profile and the structures that are being used,” says Ayman Khaleq, managing partner at law firm Vinson & Elkins in Dubai. “You don’t have a high tolerance for risk anymore.”

A large portion of the sukuk issued in Dubai between 2004 and 2007 were real estate leaseback transactions. When the emirate’s debt crisis hit, many investors discovered that they wouldn’t be able to seize the underlying property if the borrowers defaulted, because the property hadn’t been registered in the name of the financing vehicle that actually issued the sukuk. “There was no true sale of the assets that transfers the assets from the balance sheet of the borrower to the sukuk issuer,” Khaleq says. “In the UAE you have to register the sale” with the authorities, or the sale can be considered void.

These days investors are being more diligent. “Now they’re spending more time going through covenants and making sure security packages are more enforceable,” says Khaleq. “It’s not enough to say, ‘Here’s a sale contract.’ There has to be a transfer of title in the [Dubai] land department.”

The sukuk market also needs greater diversity. Nearly 90 percent of this year’s issues have come from sovereign or quasisovereign entities, according to Zawya. There should be more corporate issues for a truly robust market to develop, says Khaleq. Eventually, he says, he would like to see the development of specialized desks at Islamic banks, much like those at international investment banks. “We need to create larger Islamic banks with energy, telecom, what have you, as opposed to smallish banks, so they can lead the syndicates like the Wall Street banks do,” he says.

The Gulf market continues to suffer from a lack of standardization of ?bond documents. Underwriters need to hire their own shari’a scholars and obtain a fatwa, or ruling, that their issues comply with Islamic law every time they bring a borrower to market; this adds cost and complexity to each deal. “It almost has to be bespoke each time,” Khaleq says. “Each deal is created differently, whereas Malaysia has standardized these documents.”

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