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Monday, 10 July 2017

Opening up the sukuk market

Despite the challenges faced by the sukuk market, there have been a number of significant developments in recent months, including regulatory changes in the US and the inclusion of sukuk in a number of key indices. These could help change market dynamics, address some of the shortcomings and increase both issuance and demand. One critical issue that continues to be cited by investors is the lack of liquidity, particularly in the secondary market where trading is limited. 

A lot of sukuk investors, particularly Islamic banks, are hold-to-maturity investors not due to Sharia principals but because there is such a scarcity of sukuk assets.  This is in turn a consequence of the limited volume of issuance, with demand far outstripping supply. Investors know that, if they sold a sukuk, they might face difficulty finding a suitable replacement for their portfolio. Nonetheless, an upside of this demand/supply gap is that sukuk has in the past proven to be a usefully defensive stock compared to conventional bonds, not least for distressed issuers. The demand-supply gap is itself caused, at least in part, by the complexity of issuing a sukuk, particularly for those unfamiliar with this segment of the financial market. Whilst issuing a conventional bond might take just a few weeks, an initial sukuk issuance can take many months as identifying appropriate sukuk assets and finalizing the sukuk structure often takes longer than expected. 

That may explain why, after a wave of sukuk from new issuers such as the UK and Luxembourg in 2014, the number of new entrants to the market has dwindled. There are still some non-traditional markets where activity looks promising though, such as formosa sukuk in Taiwan – a number of large financial institutions from the Middle East and beyond have issued such instruments and other corporate issuers have looked closely at following them. The complexity involved in sukuks can also be off-putting for some investors, particularly the way that interpretations of what is, or is not, Sharia-compliant differ in different parts of the world, not least between the two key markets of Malaysia and the Gulf countries. 

Unfortunately, this is unlikely to change quickly, despite industry attempts to improve standardization, and investors will need to understand and be patient in the meantime. Such concerns are not eased by reports that highlight how interpretations within a country may change over time. An example of this is the ongoing efforts of UAE-based energy firm Dana Gas to persuade a court in Sharjah to rule that its $700 million sukuk is no longer Sharia-compliant and should thus be cancelled and replaced with a new instrument. 

Despite these concerns, investor demand is such that new issuance is almost always oversubscribed, even as the size of sukuks continue to grow. As a case in point, the market saw a $9 billion Saudi sovereign sukuk earlier this year, which became the largest issuance to date.  Increasingly, we see that sukuks have become a part of mainstream investments for fund managers, central banks, sovereign wealth funds and banks. The demand momentum is also being helped by ongoing developments in the regulatory environment. One significant change came with the Saudi sovereign sukuk – among the disclosures in the prospectus was one which stated that sukuks might be considered an asset-backed security under the Dodd-Frank regulations. The full impact of that has yet to be seen, but it may be followed by a similar approach from regulators in other markets, in which case it could reduce issuance. 

Another area of potentially great significance is the inclusion of sukuks in the EMBI and JACI indices published by JP Morgan. This is seen as a very positive development, as it brings sukuks onto the radar of many more investors and fund managers. It has already helped to bring the spreads on sukuks from the likes of Indonesia, Turkey and South Africa into line with their commercial bonds. With pricing relatively flat between conventional and Sharia-compliant bonds, issuers will need additional reasons if they were to tackle the complexity involved in a sukuk.  “Maybe there is some pricing benefit but it’s probably not enough in itself to be a reason to do a transaction. There needs to be something else out there,” said Michael Bennett, Head of Derivatives and Structured Finance at the World Bank, during the recently concluded Global Borrowers & Bond Investors Forum in London. We saw this played out with sukuk issued by the International Finance Facility for Immunisation (IFFIm). 

The World Bank worked with the organization to issue two sukuks in 2014 and 2015, raising $500 million and $200 million respectively. For the IFFIm, it was a way to diversify its investor base and raise its profile in the Middle East. Against the backdrop of sector-specific issues, wider geopolitical events also have the potential to prompt concerns. The diplomatic and economic standoff between Qatar and three of its Gulf neighbours – Saudi Arabia, the UAE and Bahrain – which began in early June may raise the caution against getting involved in instruments issued from some of those countries. However, the general view is that this should be a short-term concern and the market is fairly optimistic that a solution will be found before too long.If this situation, along with the others mentioned earlier, can be successfully addressed, then the prospects for continued growth for sukuks look bright. 

Nade Ali Shah Nade Ali Shah, Head of DCM Sovereigns and Supranationals at Standard Chartered

(Euro Money - 10 July 2017)
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