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Sukuk Backers Seek to Unite a Fragmented Market

Authorities strive to harmonize standards between the Gulf and Malaysia, which could push Islamic bonds into the investment mainstream.

  • By Matt Mossman

In October 2013, Prime Minister David Cameron stood before a crowd of mostly Muslim heads of state, bankers and investors at the World Islamic Economic Forum in London and announced that the U.K. planned to become the first non-Muslim sovereign to issue sukuk. “I want London to stand alongside Dubai and Kuala Lumpur as one of the great capitals of Islamic finance anywhere in the world,” the British leader declared.

Cameron soon found out he had company. Three months after the event, rival financial center Luxembourg declared that it too would sell sukuk and that it had already designated several properties to serve as the assets to underpin the issue. (As Islamic finance’s alternative to bonds, sukuk typically involve a claim on some underlying real assets.) In March 2014, Hong Kong announced that it too would join the party.

The Brits were first to market, selling £200 million ($315 million) in five-year sukuk in late June at a yield equivalent to the U.K. Treasury’s conventional 1.75 percent bond due in 2019. Luxembourg and Hong Kong followed in September with their own deals of €200 million ($250 million) and $1 billion, respectively; South Africa also tapped the market that month to raise $500 million.

The deals weren’t just about raising capital. All of the governments could have raised money more quickly, and usually more cheaply, through conventional bond issues. But Hong Kong, Luxembourg and the U.K. share a strong interest in promoting sukuk, which they regard as a growth area for their financial sectors and a means of diversifying their investor bases. South Africa, for instance, sold 59 percent of its sukuk to investors in Asia and the Middle East; by contrast, investors outside the U.S., U.K. and Europe took only 2 percent of the government’s $1.7 billion offering of dollar- and euro-denominated conventional bonds in July.

Taking advantage of the sukuk opportunity can be exceptionally complex, though. It took a minimum of five months for any of those countries to complete their sales. Resolving that complexity holds the key to unlocking the real potential of sukuk. If something can be done to reduce the cost and time required for issuance, sukuk could scale up dramatically, transcend its niche and hit the capital markets mainstream.

Sukuk offer exposure to countries and investment narratives that are otherwise difficult for many investors to access. They can add diversity and stability to a portfolio and sometimes offer a modest premium over conventional bonds, says Ihab Salib, head of international fixed income at Federated Investors in Pittsburgh. He manages the only shari’a-compliant fixed-income fund in the U.S., the $77 million Azzad Wise Capital Fund, on behalf of Azzad Asset Management, an Islamic fund manager in Falls Church, Virginia.

“In times of volatility sukuk generally perform better than conventional bonds,” Salib says. “There’s a lot less of it out there, and you can’t short it, so the hedge funds aren’t touching it.”

What’s holding sukuk back is the lack of a deep global market for the instrument. Instead, there are two main markets, in the Gulf and in Malaysia, with limited links between them. This fragmentation reflects the nonhierarchical nature of the Islamic religion. There are multiple schools of thought, and Muslims don’t agree on what it means to comply with shari’a, or Islamic law. This helps explain the long gestation period for a sukuk offering and why costs are usually higher than those of a conventional bond issue.

Proponents say these issues are just growing pains that will fade away with time — and some directed efforts. Leaders in the sukuk world have begun taking tentative steps to speed up the process and develop common standards for shari’a compliance. Malaysia, which would like to draw more outsiders to its sukuk market, has abandoned some local features that turned off foreign investors. Dubai, one of the world’s leading sukuk issuers, has convened a series of conferences to discuss ways to lower the cost and lessen the time of issuance. If that happens, sukuk could really grow, attracting a wider array of corporate issuers and a broader range of investors.

But as efforts to promote convergence are gathering pace, a new question has cropped up: Can sukuk thrive with lower oil prices? Much of the liquidity that has fueled demand for sukuk in the Middle East has ultimately come from oil revenues, and those have taken a big hit from the 30 percent-plus drop in crude prices since August. In the first six weeks of fourth-quarter 2014, sukuk issuance plunged 73 percent from a year earlier, a decline that many analysts attribute to the oil price drop.

The sukuk market has grown by leaps and bounds over the past decade. In part, the growth reflects rising wealth in the Middle East and parts of Southeast Asia. The global financial crisis also played a role, tarnishing conventional finance in the eyes of many investors in those regions and boosting demand for instruments backed by real assets, as sukuk are. Investors and issuers from non-Muslim countries saw sukuk as a way to diversify their portfolios and expand their investor bases.

Global issuance of sukuk rose from $20.2 billion in 2008 to a peak of $137 billion in 2012 before easing to $116.9 billion in 2013, according to Zawya, a Middle Eastern and North African business news service owned by Thomson Reuters. The market recovered in the first 11 months of this year, with volume rising 14 percent, to $114.3 billion.

Malaysia accounted for nearly two thirds of that volume, or $75.3 billion. The government and Bank Negara Malaysia, the central bank, are the big issuers, selling seven types of sukuk, including regular auctions of so-called monetary notes used by banks to manage liquidity, Treasury bills and savings sukuk aimed at retail buyers. The average issue size is $181 million. Most sukuk offer a modest yield premium to conventional bonds: In early December the government’s ten-year sukuk was trading at a yield of 4.11 percent, 23 basis points more than its ten-year conventional bond, according to Winson Phoon, a fixed-income analyst for Maybank Investment Bank in Kuala Lumpur.

Saudi Arabia had the second-largest market share, with issuance of $12.1 billion through November. The government has never sold debt, so the 15 sukuk issued in that period were all corporate; the average size was $808 million, far larger than Malaysia’s average corporate deal size of $164.2 million. Other key sukuk sources included the United Arab Emirates ($5.7 billion), Indonesia ($5.2 billion) and Turkey ($4 billion). The most active non-Muslim market was Singapore, where six sukuk were issued, raising a total of $590 million.

Going forward, Dubai plans to rely heavily on sukuk to finance another round of infrastructure and real estate development in preparation for Expo 2020, an industrial and cultural exposition that the emirate will host. Dubai has not yet provided specifics, but both the government and quasi­governmental corporations such as Dubai World and property developer Nakheel are likely to sell sukuk to finance projects. In 2009, Nakheel required help from neighboring Abu Dhabi and the UAE government to meet its debts. Earlier this year the company repaid its outstanding bank debt early; it still has a $1.2 billion sukuk outstanding that matures in 2016.

Financial services firms are the most active issuers outside of governments, providing 10 percent of overall volume in 2013, according to an annual review by Rasameel Structured Finance Co., a Kuwaiti specialist investment firm. The Basel III bank capital accord explains much of this issuance: The pact’s standards consider funds raised through sukuk sales as tier-1 capital if the sukuk are subordinated, perpetual and cannot be called for the first six years. Abu Dhabi Islamic Bank was the first institution to offer this type of sukuk, in 2012, selling $1 billion of perpetual notes at a projected yield of 6.375 percent. Several others followed. Some significant corporate outsiders tapped the market in 2014, including Goldman Sachs Group and Bank of Tokyo–Mitsubishi UFJ, suggesting that the instrument holds broader appeal.

Demand for sukuk of any type currently exceeds supply. The U.K. offering was more than ten times oversubscribed, for example. Many investors are buy-to-hold players. A Zawya survey of investors found that 43 percent of respondents, mostly Islamic banks, hold their sukuk to maturity. That feature limits secondary trading, curbing the appetites of some non-Muslim investors. “If you have huge market liquidations like a 2008 event where there are no buyers of anything, then of course less-liquid stuff is going to get hit more,” says Federated Investors’ Salib. “But in a normal market, it’s never a problem to sell.”

Demand for sukuk is underpinned by Islamic banks. To comply with shari’a law, these banks must manage their liquidity with Islamic instruments. So when Islamic bank assets are growing — and they grew at a rate of 19 percent a year from 2007 through 2012, according to the Islamic Financial Services Board, a Kuala Lumpur–based regulatory body — demand for sukuk does too. “Islamic finance thrives on having a trapped market of liquidity seeking yield,” says Mahmoud El-Gamal, a professor of Islamic economics, finance and management at Rice University. “It relies on having this pool of savings sitting with Islamic banks that can’t buy other assets.”

That captive pool of buyers means that a sukuk’s coupon, called a profit rate, can sometimes be slightly lower than yields on conventional bonds. In October, for instance, the Dubai International Financial Center, a free zone for financial services in the emirate, sold $700 million of ten-year sukuk with a profit rate of 4.325 percent.

“If your target is local investors, you don’t have to pay extra, and sometimes you pay less,” Salib says. “If you’re global or an issuer from outside of the region, you’re still going to pay that premium.”

The choice of structure can be critical for attracting a specific group of buyers or facilitating secondary trading. One common type of sukuk, known as ijara, is a sale-and-leaseback arrangement in which a company puts an asset in a special-purpose vehicle and makes payments to use it that are then disbursed to sukuk holders as the profit rate. By creating a revenue stream that investors can trade, the structure gets around the shari’a prohibition on trading debt.

The most common sukuk structure is murabaha, a type of cost-plus financing typically used for trade finance in which an entity seeking cash agrees to buy goods from another party and pays for them later at a higher price that includes a profit margin, the sukuk’s effective coupon.

For issuers murabaha can be preferable because it does not require securitizing an asset on the seller’s balance sheet. “If we were to do a sale and leaseback of one of our buildings, there would be tricky tax and other legal implications,” says Michael Bennett, head of derivatives and structured finance at the World Bank’s treasury department in Washington. “You can’t overestimate what a hurdle this can be for first-time issuers.”

In November the World Bank sold $500 million of murabaha, its largest-ever sukuk, on behalf of the International Finance Facility for Immunization. The three-year paper pays a floating rate of Libor plus 15 basis points.

On paper the Gulf and Malaysian markets are a great fit. Selling sukuk is fast and relatively cheap in Kuala Lumpur thanks to standardization, and the Gulf countries have investors with more capital than ideas for deploying it. But as of September foreigners accounted for only 2.3 percent of Malaysian sukuk ownership, according to Maybank’s Phoon.

The sell side tells a similar story. CIMB Group Holdings and Maybank dominate the underwriting league tables in Southeast Asia, with 2014 market shares of 28.4 percent and 21.9 percent, respectively, as of November 17, while HSBC Holdings and National Bank of Abu Dhabi rank first and second in the Middle East, with shares of 17.6 percent and 10 percent, respectively, according to Dealogic. The only banks that rank among the top ten underwriters in both markets are HSBC, Standard Chartered and Emirates NBD Bank.

Malaysia has built a deep market for corporate sukuk by developing common standards for shari’a compliance. The local regulator, Securities Commission Malaysia, provides a template prospectus for sukuk that is certified as compliant by the one body in the country authorized to do so, the central bank’s Shariah Advisory Council.

By contrast, the Gulf market and other non-Malaysian issuers rely on shari’a scholars who are versed in finance to approve each and every issue. Their opinions vary in degrees both large and small. “Even within the Gulf countries, transactions are accepted in one and not in others,” says Mohamed Damak, Paris-based global head of Islamic finance for Standard & Poor’s. “If the market reaches a stage where there’s a certain number of transactions agreed upon globally, this would really help.”

Malaysia’s standard format lacks the density of detail found in sukuk prospectuses from the Middle East, but it saves plenty of time and money, says Sayd Farook, global head of Islamic capital markets for Thomson Reuters. The average cost of shari’a compliance for a Malaysian sukuk is $20,000, he says, compared with $50,000 to $200,000 for an issue in the Middle East. That’s on top of normal issuance costs such as underwriting fees and legal expenses, which generally amount to about 1 percent of the value of the offering.

Even in Malaysia standardization can only go so far, and the need for scholars to rule on specific issues generates greater costs than a conventional bond issue. “Once you need to consider the transfer of specific assets, unique issues are bound to crop up,” says the World Bank’s Bennett.

Malaysia recently has taken steps to bridge the gap with Gulf countries on sukuk standards. In July 2013 it abandoned a controversial sukuk structure known as bay al inah, which the central bank had used for its regular issuance, that was at the heart of the divide. The structure resembles murabaha, but Islamic scholars in the Gulf consider it to be a thinly disguised form of conventional debt and not shari’a compliant because the resale of goods or assets by the financier to the borrower is done at a fixed price.

That change in stance is expected to encourage more Middle Eastern issuers to tap the Malaysian market. In April 2013, Al Bayan Holding Group, a construction conglomerate, became the first Saudi company to make a Malaysian issue, offering 200 million ringgit ($60 million) of three-year sukuk with a 5.75 percent profit rate. In July, Türkiye Finans Katilim Bankasi, a Turkish lender majority-owned by Saudi Arabia’s National Commercial Bank, sold 800 million ringgit of five-year, 6 percent sukuk. Other entities that have announced plans to tap the Malaysian market include Abu Dhabi’s First Gulf Bank; Emirates NBD Capital, the investment banking arm of Emirates NBD Bank; and Kuwaiti-controlled Kuveyt Türk Katilim Bankasi.

Although convergence is making progress, a lack of standardization remains an obstacle to deeper links between the Gulf and Malaysian markets. Tacking that issue would mean disrupting the small and lucrative world of shari’a scholars, which has a strong interest in preserving the status quo. Demand for the services of these scholars has made them millionaires multiple times over, and they have resisted attempts to reform the system.

With the exception of Malaysia, where the central bank’s shari’a board settles the major technical issues, shari’a scholars are crucial to the issuance process. “You want a recognizable scholar to reduce legal risk because shari’a compliance is not a well-defined concept,” says Rice’s El-Gamal. “The scholars are the brand names, and without them the credibility of the whole operation is in question.”

Scholars are hired on an annual basis to serve on three-member compliance boards at each Islamic institution. Disclosure isn’t mandatory or regular, but anecdotally the going rate to retain a scholar starts at $50,000 a year. On top of that, the scholars usually receive fees for each product that they approve.

There is currently no licensing process, code of conduct or governance system for scholars. Their backgrounds vary but generally include postgraduate study in both finance and Islam.

The definitive study of the scholars’ market was conducted in 2007 and updated in 2011 by a German research outfit called Funds@Work. It found that the top 100 scholars held 953 of 1,141 shari’a board chairs then in existence across all forms of Islamic finance, for a market share of 83.5 percent; the top ten alone accounted for 39.5 percent of the chairs. The study estimated that each of the top ten scholars sat on an average of 45 Islamic boards; at the going rate of $50,000 a seat, that implies the ten pulled in an average of $2.25 million a year in retainers. The most prominent is Nizam Mohamed Saleh Abdul Rahman Yaquby, who sits on 79 boards, including those of the Central Bank of Bahrain and Malaysia’s CIMB Bank, and has approved 401 sukuk.

One risk with this system is that a single scholar could affect the market with an unconventional or unexpected opinion. In 2007 a leading Pakistani scholar named Sheikh Taqi Usmani declared that roughly 85 percent of sukuk outstanding at that time were not shari’a compliant because the investors didn’t really share in the risk of the underlying businesses or assets. The market plummeted, but as the global financial crisis was unfolding at the time, it wasn’t clear to what extent Usmani’s pronouncement triggered the decline. Because shari’a compliance is subjective, such an incident could happen again. “It would have major repercussions,” says Thomson Reuters’ Farook. “This is where governance and scholars’ own code of conduct come into play. Every one of those scholars might make that judgment call.”

Efforts to change the system have failed thus far. In 2010, for example, some scholars spoke out against an attempt by Islamic banks in the Gulf to impose a ceiling on the number of board memberships that any one scholar could have.

However, frustration appears to be on the rise. In a roundtable discussion hosted in Dubai in April by trade publication Islamic Finance News, industry leaders admitted that issuers often hide some details from their shari’a scholars to smooth the process. In some cases disagreements among scholars lead sellers to abandon their sukuk plans, in particular for syndicated deals in which multiple shari’a boards — typically, with three scholars each — must agree.

One way to eliminate this problem would be to establish a global shari’a board, an idea that the Jeddah, Saudi Arabia–based Islamic Development Bank endorsed in 2013 but few experts regard as feasible because of Islam’s inherent diversity. The Malaysian model of appointing one shari’a board for a whole country, which would allow for standardized products and reduce the role of company-level scholars, is another alternative. Bahrain, Indonesia, Oman and Pakistan have elevated the importance of their national shari’a boards but haven’t given them the exclusive right to approve products. A handful of industry bodies are seeking to promote greater standardization but have yet to make an impact. They include Kuala Lumpur’s Islamic Financial Services Board and the International Islamic Financial Market and the Accounting and Auditing Organization for Islamic Financial Institutions, both based in Manama, Bahrain.

Efforts to standardize sukuk terms almost inevitably must take on the vested interest of the Islamic scholars. “If scholars approve these contracts to the point that boilerplate forms develop, then they would be out of business,” says Rice’s El-Gamal. “Scholars have a vested interest in the current system and could poke holes in any new one.”

Another possibility is that some shari’a scholars might disrupt their own model with a new structure, perhaps similar to that of a law firm: Junior scholars could do most of the work, with the scholars at the top signing off on it, for example. “A model along the lines of a law firm would give these young people a career path while still giving market players the comfort of being able to rely on names they trust,” says the World Bank’s Bennett.

Shari’a risk is primarily an issue for Muslims, but for outside investors the important point is to know where adjudication would occur in the event of a default, says London-based Farmida Bi, who heads law firm Norton Rose Fulbright’s Islamic finance division in Europe. There have been only a handful of cases that have proceeded to bankruptcy, and therefore there is little precedent. “Most Muslim countries have conventional courts and a shari’a system,” Bi says. “Some shari’a courts have not seen complex commercial contracts, and their approach could be a bit of an unknown. But if you can get to an English court or in international arbitration, the documents will be clear.”

Given the green shoots of Arab participation in the Malaysian market and the race among sovereigns to tap the sukuk investor base, the convergence-and-standards movement seemed to be progressing — at least, until oil prices interrupted. Now an additional question about sukuk’s efforts to go global is whether it can survive a crude bear market. This could certainly hurt demand for sukuk from banks in the Gulf Cooperation Council, where government revenue is a significant source of deposits. In the UAE, for example, 26.8 percent of deposits in the banking system came from government or quasigovernmental companies as of June 2014, according to central bank statistics.

Malaysia is less vulnerable to a slide in oil prices, though. The country is a net oil exporter, but it boasts a more diversified economy and its corporate sukuk market has less direct exposure to oil prices.

In Dubai sukuk will be a core part of the emirate’s plans regardless of crude prices. Expo 2020 will require another wave of real estate and infrastructure projects by many of the same quasigovernmental developers that built up the emirate during the 2000s. The Dubai government and companies it has stakes in still face big debts from that period; restructurings have simply pushed their maturities into the future. In July 2014 the International Monetary Fund estimated the emirate’s debt, including that of quasi­governmental entities, at $141.7 billion, or 141.1 percent of GDP. Annual debt repayments range between $7.3 billion and $17.9 billion from 2014 to 2017, then jump to $40.3 billion in 2018.

Dubai is betting that some reforms to the system will prevent another crash. Concentration-­risk regulations are now in place to avoid overreliance on the banking system to finance these projects, and more sukuk — as well as equity sales — are expected.

The sukuk pipeline in late 2014 also included planned first-time issues from countries such as Azerbaijan, Morocco and Tunisia, as well as a return to the market by Pakistan. On the corporate side, bankers expect Malaysian budget airline AirAsia to offer a perpetual sukuk by early 2015.

With steady demand from issuers and increasing efforts to bridge the gap between Malaysia and the Gulf, is sukuk ready to become a major instrument in the international capital markets? For many investors cautious optimism remains the order of the day.

“It’s still a relatively young market, and liquidity is still improving,” says Anupam Damani, a New York–based portfolio manager in charge of global fixed-income strategies for TIAA-CREF. “We agree there needs to be a standardization, but perhaps with increased issuance and demand these issues will be fleshed out over time.” • •

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