17 January 2010
Fawad Hussain, CFA
Head of Islamic finance, RBS Global Banking & Markets, Middle East & Africa
International Sukuk issuance has made a strong comeback in the post-Lehman era as regional capital markets have gradually followed the recovery in global markets. Following a dry spell from late Q3 2008 to early Q2 2009, the Bahrain sovereign Sukuk issue of June 2009 finally broke the silence in international Sukuk issuance and has since been followed by a number of issues from sovereign, supranational and corporate issuers, thereby dispelling any doubts over whether this market is here to stay.
Why issue Sukuk?
What differentiates Sukuk from conventional bonds?
The most obvious answer is the incremental liquidity generated from the Islamic investor base. However, it is clear from empirical evidence that this is not the only difference since some issues have seen limited participation from Islamic-only investors. This proved that issuer preference is also a key aspect in the growth of this market, which has been supported by Islamic and conventional investors alike. Given that Sukuk have become acceptable across investor classes and geographies globally since the beginning of this decade this should make Sukuk the obvious choice over conventional bonds; however the reality is that conventional issues remain the preferred option for borrowers for longer-dated deals targeted at the US investor base as Islamic liquidity for longer maturities remains limited. Sukuk will therefore remain a viable option to raise liquidity at the shorter end of the curve unless the market evolves to a point where Islamic-only investors can also participate in longer-term issuance i.e. as we see increased participation from Islamic-only state institutions, asset managers, and more prominently from the longer-term investors such as Takaful companies and Islamic-oriented pension funds.
Stakeholder considerations
While looking at the drivers and obstacles relating to Sukuk issuance, it makes it easier to analyse the growth prospects of the Sukuk market if we look at the considerations facing each stakeholder in this market. In this analysis, it is important to focus on issuer and investor considerations but also to remain cognisant of the important role of certain other stakeholders including regulators, rating agencies, Shariah scholars, lead managers and law firms.
Issuers
Traditional Sukuk markets of the GCC and Malaysia continue to lead the way in Sukuk issuance. However some non-traditional names have been cited more recently with some European and Far Eastern sovereigns being quoted in the media as looking at potential issuance. Recently, the International Finance Corporation has announced a $100 million Sukuk which should elicit some interest from non-traditional issuers looking at tapping this market albeit for smaller issue sizes. For the well-established but non-traditional Sukuk credits from the US, Europe and Far East, such issuance will only ever take place if issuers can see either a tangible pricing benefit or a sizeable pool of Islamic-only liquidity that they have not been able to tap via conventional issuance. Since we will see growth in Islamic asset managers and Takaful companies only with the passage of time, it might well be the case that Islamic-only investors have to give up some relative yield upside to lure such well-known issuers to the Sukuk market in the short to medium-term. It will be important for investors to look at the lower yield in the context of the associated diversification benefit resulting from buying into international credits.
Investors
Typical Sukuk investors are split in varying ratios (depending on the nature of Sukuk) between conventional investors in the west and the conventional and Islamic-only investors in the GCC and South East Asia. These investors have always been looking for yield but are now increasingly focused on issuer creditworthiness. Conventional investors remain important from a pricing perspective as they drive the pricing for most international Sukuk issues due to the fact that they are collectively much bigger compared to the Islamic market. However Islamic-only investors are growing both in value and in number and the advent of investors such as Shariah compliant funds and Takaful companies and the growing allocation of such investors to Sukuk issues bode well for future Sukuk issuance.
Regulators
Regulatory and tax issues seem to be relatively straightforward when it comes to traditional Sukuk jurisdictions covering most of GCC and Malaysia. However they become relatively challenging in the case of non-traditional jurisdictions primarily due to the presence of a legal framework that does not recognise Islamic structures and thus impedes Islamic issuance. In Europe, the UK has been the first country to work on restructuring its regulatory framework to accommodate Islamic financial institutions and products and to offer them an at-par treatment and France has recently announced similar plans - it might be interesting to note though that the Saxony Anhalt Sukuk, arguably the first European Sukuk, was issued out of Germany which has not seen any follow-up issuance. Governments in the Far East such as Korea, Singapore and Thailand have been mentioned in the media as taking up similar changes to their regulatory framework to attract Islamic financial institutions and looking at potential sovereign issuance.
Rating agencies
Following the sub-prime crisis, there has been market talk about reduced investor confidence in the rating agencies. However ratings still remains a key requirement for all investors especially in terms of liquidity, marketability and capital considerations. The international Sukuk market is moving towards rated issuance and an increase in rated Sukuk should bring about increased transparency and comparability among credits from different sectors and geographies, thereby helping the market develop further.
Shariah scholars
It is often mentioned that standardisation is a key requirement for the Islamic finance market in general and the Sukuk market in particular to take off in a major way and, barring this, the market will remain fragmented. However it is a viewpoint of most experts that absolute uniformity in Shariah thought is not a practical expectation. It would be good to see the efforts of entities like the IIFM, AAOIFI and the IFSB, who have been working with their conventional counterparts, bear fruit by reducing the divergence on broader Shariah issues. Subsequently, the increased commonality of thought should give a boost to new issues.
Lead managers
Lead managers perform an important role in educating issuers on the myths and realities surrounding the Sukuk market and assisting them in positioning with the investor base. However they typically also perform an equally important role in market-making post-issuance. As lead managers continue to play an important role in educating issuers and reputed issuers continue to take the Sukuk route, liquidity in the secondary market should continue to grow with time. This should in turn help further primary issuance as investor confidence builds up.
Law firms
Lawyers play a very important role not only in drafting Sukuk documentation but also in assisting the lead managers in discussions with Shariah scholars to structure the transaction on a Shariah compliant basis. Their knowledge of Shariah law and their relationship with the Shariah scholars goes a long way in facilitating a smooth execution.
Other stakeholders
Stock exchanges, paying and clearing agents, trustees and various other parties also play a key role in Sukuk issuance. The track record and expertise of the key players in each of these segments with respect to Sukuk has helped in developing the Sukuk market and should continue to do so in the future.
Some pertinent issues
Certain general considerations such as which format of Sukuk to use, which currency to issue in, whether to issue under a programme or issue a stand-alone are common to all stakeholders. How these considerations are evaluated and decided upon will shape the trends in the Sukuk market as it grows. These are discussed briefly below.
Format
Although we have seen the second 144a Sukuk this year, it seems that the vast majority of Sukuk will remain either as locally focused private placements or in Reg S format. Which format is advised on by lead managers, selected by issuers and preferred by investors will be driven by issuer considerations and the availability of liquidity from the target investor base.
Currency
Malaysia and Bahrain have thriving local currency markets however they differ to the extent that the former is driven by pure corporate issuance whereas the latter is focused more on management of short-term interbank liquidity. Barring these, Saudi Arabia and the UAE are the two countries that have seen a significant amount of local currency issuance to date, primarily driven by captive local liquidity in the case of the former while expectations around revaluation have to some extent been seen in case of the latter. However with the exception of Malaysia, corporate issuance in the GCC has been hampered by an active local currency market. The CMA in Saudi Arabia has taken steps to facilitate trading of Sukuk on the Tadawul, while the UAE has also taken steps in this direction by opting for local currency issuance for sovereign issues. These developments should eventually result in country-specific Sukuk markets with limited initial liquidity which will only grow with time; however it should at least help in giving confidence to more issuers to come to market given that smaller issue sizes would be possible and issuance requirements may be less onerous.
Types
Fixed income Sukuk have been favourites since the advent of Sukuk. Notwithstanding this, there was a burst of activity in the equity-linked space during 2006-07 during which a number of convertibles and exchangeable Sukuk were issued both by GCC and Malaysia. Although this has died down in recent years, it should revive as issuers continue to debate the merits of potential dilution against cheaper cost of funding. International securitisation has not taken off in a big way in the Islamic space in the GCC due to the sudden disappearance of the key investor base from the scene post-sub-prime. However it is expected that they will return sometime in the near future for truly creditworthy originators as a genuine alternative investor base gradually builds up and actively evaluates the merit in taking asset-backed risk instead of investing purely on a corporate basis.
Programmes
The cost of establishing and updating Sukuk programmes needs to be weighed against the frequency of issuance. For regular issuers, establishing a programme makes a lot of sense as they can tap the market frequently and at short notice. A number of issuers have adopted this approach and the number of programmes is on the rise and should continue to increase as the market grows in depth and breadth and issuers are able to access the market at regular intervals.
Covenants
In some cases issuers have existing obligations which limits 'transfer' of assets even in a structural sense and therefore limits Islamic issuance regardless of the jurisdiction. Issuers could save a lot of time when undertaking any subsequent Islamic issuance by simply carving out purely structural transfers pertaining to Islamic finance in conventional financing documentation.
Defaults
Some of the defaults by Sukuk issuers seen in recent times will provide a much-needed precedent to the industry in evaluating future issuance. On a commercial level, senior unsecured asset-based issuance does not give Sukuk investors any preference over conventional investors regardless of the use of an asset for Islamic structuring purposes. Legal opinions do leave jurisdiction-related interpretations open to the extent that there is lack of precedent. This could prove to be the silver lining for future Sukuk issuances from these jurisdictions as decisions on the subject make this point very clear for future issuers and investors.
Ethical investing
Do conventional investors prefer Sukuk over conventional bonds due to their 'ethical' nature? Although asset-based Sukuk might not have won the hearts of these investors when compared to conventional bonds purely on the basis of 'form', they might increasingly become the instrument of choice for ethical investors if Islamic finance starts identifying itself with 'substance' and 'green' issuers start tapping the market. Carbon-credit-linked Sukuk anyone?
Fawad Hussain
-Ends-
Mr Fawad Hussain is observing and answering your comments and questions on this article over a period of a week, through a dedicated discussion we have set up within the Zawya Sukuk Community group.
If you are a member of the Zawya Sukuk Community, please access the discussion here.
If you are not a member of the Zawya Sukuk Community, we invite you to join by clicking here.
Fawad Hussain, CFA
Head of Islamic finance, RBS Global Banking & Markets, Middle East & Africa
International Sukuk issuance has made a strong comeback in the post-Lehman era as regional capital markets have gradually followed the recovery in global markets. Following a dry spell from late Q3 2008 to early Q2 2009, the Bahrain sovereign Sukuk issue of June 2009 finally broke the silence in international Sukuk issuance and has since been followed by a number of issues from sovereign, supranational and corporate issuers, thereby dispelling any doubts over whether this market is here to stay.
Why issue Sukuk?
What differentiates Sukuk from conventional bonds?
The most obvious answer is the incremental liquidity generated from the Islamic investor base. However, it is clear from empirical evidence that this is not the only difference since some issues have seen limited participation from Islamic-only investors. This proved that issuer preference is also a key aspect in the growth of this market, which has been supported by Islamic and conventional investors alike. Given that Sukuk have become acceptable across investor classes and geographies globally since the beginning of this decade this should make Sukuk the obvious choice over conventional bonds; however the reality is that conventional issues remain the preferred option for borrowers for longer-dated deals targeted at the US investor base as Islamic liquidity for longer maturities remains limited. Sukuk will therefore remain a viable option to raise liquidity at the shorter end of the curve unless the market evolves to a point where Islamic-only investors can also participate in longer-term issuance i.e. as we see increased participation from Islamic-only state institutions, asset managers, and more prominently from the longer-term investors such as Takaful companies and Islamic-oriented pension funds.
Stakeholder considerations
While looking at the drivers and obstacles relating to Sukuk issuance, it makes it easier to analyse the growth prospects of the Sukuk market if we look at the considerations facing each stakeholder in this market. In this analysis, it is important to focus on issuer and investor considerations but also to remain cognisant of the important role of certain other stakeholders including regulators, rating agencies, Shariah scholars, lead managers and law firms.
Issuers
Traditional Sukuk markets of the GCC and Malaysia continue to lead the way in Sukuk issuance. However some non-traditional names have been cited more recently with some European and Far Eastern sovereigns being quoted in the media as looking at potential issuance. Recently, the International Finance Corporation has announced a $100 million Sukuk which should elicit some interest from non-traditional issuers looking at tapping this market albeit for smaller issue sizes. For the well-established but non-traditional Sukuk credits from the US, Europe and Far East, such issuance will only ever take place if issuers can see either a tangible pricing benefit or a sizeable pool of Islamic-only liquidity that they have not been able to tap via conventional issuance. Since we will see growth in Islamic asset managers and Takaful companies only with the passage of time, it might well be the case that Islamic-only investors have to give up some relative yield upside to lure such well-known issuers to the Sukuk market in the short to medium-term. It will be important for investors to look at the lower yield in the context of the associated diversification benefit resulting from buying into international credits.
Investors
Typical Sukuk investors are split in varying ratios (depending on the nature of Sukuk) between conventional investors in the west and the conventional and Islamic-only investors in the GCC and South East Asia. These investors have always been looking for yield but are now increasingly focused on issuer creditworthiness. Conventional investors remain important from a pricing perspective as they drive the pricing for most international Sukuk issues due to the fact that they are collectively much bigger compared to the Islamic market. However Islamic-only investors are growing both in value and in number and the advent of investors such as Shariah compliant funds and Takaful companies and the growing allocation of such investors to Sukuk issues bode well for future Sukuk issuance.
Regulators
Regulatory and tax issues seem to be relatively straightforward when it comes to traditional Sukuk jurisdictions covering most of GCC and Malaysia. However they become relatively challenging in the case of non-traditional jurisdictions primarily due to the presence of a legal framework that does not recognise Islamic structures and thus impedes Islamic issuance. In Europe, the UK has been the first country to work on restructuring its regulatory framework to accommodate Islamic financial institutions and products and to offer them an at-par treatment and France has recently announced similar plans - it might be interesting to note though that the Saxony Anhalt Sukuk, arguably the first European Sukuk, was issued out of Germany which has not seen any follow-up issuance. Governments in the Far East such as Korea, Singapore and Thailand have been mentioned in the media as taking up similar changes to their regulatory framework to attract Islamic financial institutions and looking at potential sovereign issuance.
Rating agencies
Following the sub-prime crisis, there has been market talk about reduced investor confidence in the rating agencies. However ratings still remains a key requirement for all investors especially in terms of liquidity, marketability and capital considerations. The international Sukuk market is moving towards rated issuance and an increase in rated Sukuk should bring about increased transparency and comparability among credits from different sectors and geographies, thereby helping the market develop further.
Shariah scholars
It is often mentioned that standardisation is a key requirement for the Islamic finance market in general and the Sukuk market in particular to take off in a major way and, barring this, the market will remain fragmented. However it is a viewpoint of most experts that absolute uniformity in Shariah thought is not a practical expectation. It would be good to see the efforts of entities like the IIFM, AAOIFI and the IFSB, who have been working with their conventional counterparts, bear fruit by reducing the divergence on broader Shariah issues. Subsequently, the increased commonality of thought should give a boost to new issues.
Lead managers
Lead managers perform an important role in educating issuers on the myths and realities surrounding the Sukuk market and assisting them in positioning with the investor base. However they typically also perform an equally important role in market-making post-issuance. As lead managers continue to play an important role in educating issuers and reputed issuers continue to take the Sukuk route, liquidity in the secondary market should continue to grow with time. This should in turn help further primary issuance as investor confidence builds up.
Law firms
Lawyers play a very important role not only in drafting Sukuk documentation but also in assisting the lead managers in discussions with Shariah scholars to structure the transaction on a Shariah compliant basis. Their knowledge of Shariah law and their relationship with the Shariah scholars goes a long way in facilitating a smooth execution.
Other stakeholders
Stock exchanges, paying and clearing agents, trustees and various other parties also play a key role in Sukuk issuance. The track record and expertise of the key players in each of these segments with respect to Sukuk has helped in developing the Sukuk market and should continue to do so in the future.
Some pertinent issues
Certain general considerations such as which format of Sukuk to use, which currency to issue in, whether to issue under a programme or issue a stand-alone are common to all stakeholders. How these considerations are evaluated and decided upon will shape the trends in the Sukuk market as it grows. These are discussed briefly below.
Format
Although we have seen the second 144a Sukuk this year, it seems that the vast majority of Sukuk will remain either as locally focused private placements or in Reg S format. Which format is advised on by lead managers, selected by issuers and preferred by investors will be driven by issuer considerations and the availability of liquidity from the target investor base.
Currency
Malaysia and Bahrain have thriving local currency markets however they differ to the extent that the former is driven by pure corporate issuance whereas the latter is focused more on management of short-term interbank liquidity. Barring these, Saudi Arabia and the UAE are the two countries that have seen a significant amount of local currency issuance to date, primarily driven by captive local liquidity in the case of the former while expectations around revaluation have to some extent been seen in case of the latter. However with the exception of Malaysia, corporate issuance in the GCC has been hampered by an active local currency market. The CMA in Saudi Arabia has taken steps to facilitate trading of Sukuk on the Tadawul, while the UAE has also taken steps in this direction by opting for local currency issuance for sovereign issues. These developments should eventually result in country-specific Sukuk markets with limited initial liquidity which will only grow with time; however it should at least help in giving confidence to more issuers to come to market given that smaller issue sizes would be possible and issuance requirements may be less onerous.
Types
Fixed income Sukuk have been favourites since the advent of Sukuk. Notwithstanding this, there was a burst of activity in the equity-linked space during 2006-07 during which a number of convertibles and exchangeable Sukuk were issued both by GCC and Malaysia. Although this has died down in recent years, it should revive as issuers continue to debate the merits of potential dilution against cheaper cost of funding. International securitisation has not taken off in a big way in the Islamic space in the GCC due to the sudden disappearance of the key investor base from the scene post-sub-prime. However it is expected that they will return sometime in the near future for truly creditworthy originators as a genuine alternative investor base gradually builds up and actively evaluates the merit in taking asset-backed risk instead of investing purely on a corporate basis.
Programmes
The cost of establishing and updating Sukuk programmes needs to be weighed against the frequency of issuance. For regular issuers, establishing a programme makes a lot of sense as they can tap the market frequently and at short notice. A number of issuers have adopted this approach and the number of programmes is on the rise and should continue to increase as the market grows in depth and breadth and issuers are able to access the market at regular intervals.
Covenants
In some cases issuers have existing obligations which limits 'transfer' of assets even in a structural sense and therefore limits Islamic issuance regardless of the jurisdiction. Issuers could save a lot of time when undertaking any subsequent Islamic issuance by simply carving out purely structural transfers pertaining to Islamic finance in conventional financing documentation.
Defaults
Some of the defaults by Sukuk issuers seen in recent times will provide a much-needed precedent to the industry in evaluating future issuance. On a commercial level, senior unsecured asset-based issuance does not give Sukuk investors any preference over conventional investors regardless of the use of an asset for Islamic structuring purposes. Legal opinions do leave jurisdiction-related interpretations open to the extent that there is lack of precedent. This could prove to be the silver lining for future Sukuk issuances from these jurisdictions as decisions on the subject make this point very clear for future issuers and investors.
Ethical investing
Do conventional investors prefer Sukuk over conventional bonds due to their 'ethical' nature? Although asset-based Sukuk might not have won the hearts of these investors when compared to conventional bonds purely on the basis of 'form', they might increasingly become the instrument of choice for ethical investors if Islamic finance starts identifying itself with 'substance' and 'green' issuers start tapping the market. Carbon-credit-linked Sukuk anyone?
Fawad Hussain
-Ends-
Mr Fawad Hussain is observing and answering your comments and questions on this article over a period of a week, through a dedicated discussion we have set up within the Zawya Sukuk Community group.
If you are a member of the Zawya Sukuk Community, please access the discussion here.
If you are not a member of the Zawya Sukuk Community, we invite you to join by clicking here.
