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Wednesday, 15 October 2014

Portfolios: GCC Sukuk Attractive Amid Rising Rates Prospects

While the ongoing conflict in the Middle East raises concern over the outlook for the sukuk market, the Islamic equivalent of bonds, portfolio managers remain positive both on fundamentals and technicals for sukuk, which also offer a potentially attractive alternative amid prospects of rising interest rates.

Issuers from the Gulf Cooperation Council emerge as the most popular.
As the Federal Reserve prepares to exit its zero interest rate policy, but with the "new normal" promising a still low-rate environment that could continue to starve investment managers for yield for some time, sukuk are considered as an attractive option for those whose mandate allows to test new boundaries.
At Franklin Templeton Investments, Mohieddine Kronfol, chief investment officer of Global Sukuk and MENA fixed income, told MNI that "the lower duration and persistent strong demand from Islamic financial institutions should continue to support the market and allow it to perform well relative to other fixed income sectors, particularly those that have higher average durations."
In a written commentary, he had also argued that "the volatility of Sukuk has historically been more subdued - something that could prove important in a rising interest-rate environment."
He added in his commentary that, "Sukuk provide exposure to some of the fast-growing and most financially sound economies in the Gulf Cooperation Council."
Similar to conventional bonds, the rising interest rate environment is definitely challenging the sukuk market, acknowledged Lim Say Cheong, Executive Vice President, Head of Investment Banking Group Al Hilal Bank.
"Escalation of interest rates/benchmarks over the next 12 to 18 months is inevitable but issuers will still need to borrow to diversify one's source of funding and investor base," he told MNI.
Besides, rates are unlikely to "go over the roof at a rapid pace."
At Azzad Asset Management, Ihab Salib, the lead portfolio manager for the firm's sukuk fund, the Azzad Wise Capital Fund (WISEX), argued that despite the prospects of rising interest rates, "due to the specifics of the sukuk market and the fact that most of the securities are closely held, one could argue the effects of rising rates may not be as pronounced in the sukuk world."
For mandates allowing portfolio managers to invest in sukuk, the GCC region is particularly in demand.
Konfrol is "constructive" for the sukuk market overall, "with the GCC serving as a strong anchor."
He told MNI that while all GCC countries are attractive, "we believe that the UAE, Saudi Arabia and Qatar present the most opportunities at the moment."
Developments in the Middle East, notably the coalition's bombings in Syria and the potential for a worsening of global geopolitical tensions have, however, put stress on the sukuk market.
Still, Kronfol expects a "very limited" impact overall.
"The unfortunate events in Syria have had very limited impact on financial securities in the region and this is expected to remain the case," he told MNI.
"Highlighting this insulation from regional geopolitical issues is the fact that at the height of the Syrian conflict in 2013, three of the worlds' best performing stock markets were in the GCC, led by the Dubai Financial Market," he argued.
Azzad Asset Management's Salib told MNI he particularly sees value in non-conventional issuers.
"As maiden issuers in the market, they need to price the sukuk generously so as to tempt investors," he commented.
Salib sees "some value in the Dubai complex" despite the spread tightening since the beginning of the year, especially the hospitality and retail sectors.
More generally, from a fundamental standpoint, the GCC, which includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates, "offers the market the greatest support," he commented.
"Being a low population, hydrocarbon rich region whose governments run fiscal and current account surpluses, the economic backdrop is extremely conducive," said Salib, who also pointed out the solid balance sheets of individual issuers, many of them government owned.
Sukuk are increasingly catching global investors' attention, especially as non-Muslim countries - such as the UK government in June and Luxembourg at the beginning of October, which was the first EMU sovereign to issue in a sukuk structure - are joining the pool of issuers.
Going forward, investors are expecting both demand and supply to increase.
From a portfolio standpoint, GCC and Southeast Asian countries "are often underrepresented in many traditional bond indexes and funds," Franklin Templeton's Kronfol said.
He told MNI that in a global bond portfolio, depending on investors' objectives and risk tolerance, "a single digit percent allocation may be reasonable, complemented by improving emerging market allocations in South East Asia and an increasing selection of credits that are diversified by geography, sector and capital structure."
When surveying opportunities within the sukuk market, "broadly speaking, we envisage the primary sukuk supply pipelines as still very much originating from sovereigns - we may see one or two new names from Africa - government-related entities (GREs) and corporates," said Al Hilal Bank's Lim.
"We may still witness a selective range of issuers from the GCC," he predicted.
"From the GRE and corporate perspectives, it may encompass the transport, property development, construction, and utilities," he added.
Lim cited a range of factors supporting demand.
"From the buyer and investor perspectives, the abundance of liquidity resulting from, among others, upcoming maturities, heavy redemption profiles across loans, bonds and sukuk originating from 5 years ago across the GCC/MENA regions, certain geopolitical tensions that have encouraged further inflow of funds seeking relative safe havens, new investment homes, as well as declining loan-to-deposit ratios of local and regional banks - as opposed to 4-5 years ago - creates a stronger momentum among investors as they continue to search for new investment opportunities," he told MNI.
So clearly, new supply would be welcomed and likely absorbed.
In fact, Salib stressed the lack of issuance altogether.
"Compared to our colleagues in the conventional bond market, sukuk issuance is understandably much lower, and with issues such as the recent Indonesian sukuk issue being in the region of 8 times oversubscribed, this is another challenge managers face when constructing a portfolio," he said.
He said it is estimated that Islamic financial assets globally are expected to exceed $2 trillion by 2016.
"The Islamic finance industry is expected to continue growing at nearly 20% per year, and the pool of investors interested in Shariah-compliant securities is expected to rise along with it," Kronfol said in his Beyond Bulls & Bears commentary titled "Sukuk: An Asset Class Goes Mainstream."
Citing research from Kuwait Finance House, Kronfol said the sukuk market topped US$269.4 billion at the end of 2013.
Zooming in to the sovereign sector, Moody's estimated in a September report that sovereign sukuk issuance would rise by $30 billion by the end of this year to $115 billion, with both Islamic and non-Islamic governments tapping the market.
"Moreover, we expect demand and liquidity in the market will improve as the sector attracts more global investors," the rating agency said.
The arrival of major non-Islamic countries this year - the UK, Hong Kong, South Africa, Luxembourg - indicates "a significant change in the potential size, depth and liquidity of this market," it added.
By Moody's estimate, the total sovereign outstanding accounted for 36% of the $296 billion outstanding sukuk as of July 2014.
"Demand from global investors will grow as they become more comfortable with this asset class and it will support their search for yield and portfolio diversification," Moody's also predicted.
On the issuer's side, Al Hilal Bank's Lim pointed out the increasing level of sophistication in the market, citing senior secured and amortizing Sukuk-type transactions and perpetual/hybrid capital type Sukuk instruments issued or structured by "pure corporates" in addition to the more traditional financial institutions.
In fact, his own institution, Al Hilal Bank, issued "the first of its kind Basel III language-compliant Tier 1 Sukuk" that was largely oversubscribed.
Azzad Asset Management, for its part, hopes "to be given a green light soon to use profit rate swaps which swap a set of fixed profit rate cash flows into floating rate cash flows."
"We are also looking to introduce a whole new asset class into the fund in the not so distant future," Salib said.
While issuers and the investor base are diversifying, maturities are increasing, Lim noted, from the 5-year "sweet spot" to 7- to 10-year or even 15-year instruments.
(Deutsche Borse Group / 14 October 2014)
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