Sep 05 2012
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More corporate issuance and the entry of retail investors can power sukuk market ahead
2012 is already proving to be a bumper year for the sukuk market with nearly USD 68 billion in new issues in the first half alone, according to Zawya Sukuk Monitor data. This represents a nearly 56% increase year over year from the record-setting pace set in 2011.
Already, the third quarter of 2012 is off to a promising start with Qatar's dual-tranche USD 4 billion sukuk issuance and Emirates Islamic Bank and Emaar each issuing USD 500 million worth of sukuk. The sukuk market also welcomed the first issuer out of Kazakhstan in the form of the Development Bank of Kazakhstan's MYR 240 million maiden sukuk. While 2011 certainly set the bar quite high, 2012 promises to shatter the high water mark of USD 85 billion in primary sukuk issuance, with estimates of USD 123 billion by Zawya Sukuk Monitor squarely within sight.
The profundity of this moment should not be lost. In merely two years, the primary sukuk market will have outstripped the value of primary sukuk issuance over the previous 10 years. According to IIFM historical data, from 2001 to 2010 primary domestic and international sukuk issuance totaled USD 197.2 billion. At the current pace, the value of primary sukuk issuance in 2011 and 2012 will eclipse the USD 200 billion mark.
How Do We Capitalize?
Corporate Issuers - Where Art Thou?
With the credit crunch in 2008 and 2009, corporate issuers looked to deleverage their balance sheets. But nearly four years on, corporate sukuk issuers remain conspicuous by their absence. Corporate issuers made up only 14% of sukuk issuers in 2011 and so far only 13% in 2012 according to Zawya Sukuk Monitor data. Sovereigns have stepped in to help establish a yield curve for their respective domestic markets (more on that below), so now is the time for those corporate issuers to step forward. And, with sukuk yields at a seven year low according to the HSBC/Nasdaq Dubai US Dollar Sukuk Index, now is the time to jump in.
Yield Curve Doesn't Stop at 10 Years
The supply of long dated paper (tenor greater than 10 years) seems to flow exclusively through Malaysia and Indonesia. A few exceptions exist out of the GCC - the most prominent being 20-year issues by SABIC and SEC. That said, the Islamic bond market still makes up a small percentage of the overall sukuk market in terms of both value and volume.
In order for the sukuk market to continue to lay strong foundations, the full spectrum of the yield curve will need to be touched. This starts with sovereigns and quasi-sovereigns continuing to push the tenor of their sukuk issuances - domestic and international - coupled with an increase in volume. As corporate issuers return to the market they too will need to follow this lead and break through their seven- to 10-year ceiling.
The appetite for longer dated paper seems to be there and as long as that is the case and yields are low, it makes sense to take full advantage. Not to mention that longer dated paper will help shore up corporate balance sheets which often rely on short term liabilities to fund long term assets.
Return of the 'International' Issue
International issuance has long played a vital role in developing the sukuk market. From 2001 to 2010, international issuance comprised nearly 24% of the primary sukuk market according to IIFM research. Since the financial crisis though, the impact of international issuance has been muted. In 2010 and 2011, international sukuk issuance made up only 11% of the sukuk market and this despite the strong rebound of the sector in 2009. Green shoots seem to be developing this year as international issuance, particularly US dollar issuance, is finding its footing.
US dollar issuance is customarily a proxy for international issuance since the US dollar is the currency of choice when a sukuk issuer looks to tap the international market. Increasingly though, international issuance comprises non-Malaysian issuers tapping the domestic Malaysian ringgit market. Although this is a trend worth following, the focus squarely remains on the US dollar.
And this is for good reason. US dollar issuance tends to be benchmark-size issuance that attracts a geographically diverse investor base, including US investors via 144A issuance. Two of the most quoted benchmarks for the industry are the Dow Jones Sukuk Index and the HSBC/Nasdaq Dubai US Dollar Sukuk Index - the former tracks and the latter is comprised wholly of US dollar denominated issuance.
As the chart suggests, US dollar issuance is again playing a major role in the success of the sukuk market. So far in 2012, US dollar issuance makes up 19% of the sukuk market. In order for the sukuk market to maintain its momentum and show a trajectory which is in line with the past two years, the proportion of international sukuk, and US dollar denominated issuance in particular, will need to maintain a similar trajectory.
Calling All Retail Investors
It is common to find articles lamenting the lack of liquidity in the secondary sukuk market. There are many reasons expounded as to why - lack of international issuance, lack of issuer diversity, reinvestment risk, price discovery, lack of transparency. Most observers would admit that each of these factors plays a role in holding back the market.
There is a causal argument made by many that as the primary market develops this will lead to increased activity in the secondary market, which will in turn lead to increased issuance in the primary market. This may well be true, but what this argument fails to address is the reason there is limited trading activity within the USD 200-plus billion sukuk market today. I would suggest it is due to the type of investor currently in the market for sukuk.
In its 2010 Institutional Investment Report, the Conference Board found that the percentage of institutional assets as a percentage of US financial assets over the past 20 years ranges between 18.5% and 21.5% of total US financial market assets. This would suggest that the other 80% of the market is comprised of retail investors.
Institutional assets are those comprised predominantly of pension fund, investment company and insurance company assets. Pension funds and insurance companies generally tend to be long term investors, employing a buy and hold strategy. Investment companies tend to be more engaged in trading activities according to the report and generally serve as proxies for their retail investors.
I have yet to find such a study of the Islamic finance market. Anecdotal evidence suggests that the sukuk market is dominated by institutional investors. Primary issuance comes with high minimum investment amounts as do the growing class of sukuk funds, freezing out retail investors. For example, the Global Sukuk Plus Fund managed by QIB (UK) claims to be the largest such fund with more than USD 200 million in assets. The minimum investment is the USD equivalent of EUR 125,000. It is not surprising that 80% of the fund is comprised of institutional investors, and takaful or retakaful (Islamic insurance or reinsurance) companies at that.
This may be a contributing factor as to why the fund, and others like it, has done little to spur activity in the secondary sukuk market, with the fund reporting as little as 40% turnover in a single year.
This would not be as important if retail investors could simply purchase individual sukuk securities through their brokers on registered exchanges. Much of the sukuk market is traded over the counter, however. This includes even those sukuk 'listed' on regulated exchanges like the London Stock Exchange, which is home to the largest value of sukuk listings at nearly USD 25 billion, according to Zawya Sukuk Monitor data.
Listing in this sense implies an adherence to the listing requirements of the exchange, including the legal and disclosure standards imposed by the exchange for listed securities. While the sukuk is admitted to listing on the exchange, the next step of admitting to trading is usually not taken. Again, the retail investor is frozen out.
The problem is not only that retail investors are frozen out but that the Islamic fund industry is sorely lagging. Investment companies are major players in the global financial markets and serve as vehicles for retail investors to access scale when investing in the markets. As the Conference Board report mentions, investment companies tend to be more active in the secondary market, generating more trading activity on behalf of their investors.
Ernst & Young's Islamic Funds and Investments Report 2011 highlights this problem. According to this report, the Islamic funds industry accounts for 5.6% of the USD 1 trillion Islamic finance market, or roughly USD 58 billion in assets. In 2010, only 23 new funds were introduced while 46 were liquidated. In the fixed income space, the numbers are even starker. Fixed income funds represent only 12% of the Islamic fund industry, or USD 6.8 billion.
The E&Y report also emphasizes two key structural weaknesses in the Islamic funds industry: a lack of scale and over-dependence on a few institutional investors. Only 30% of Islamic fund managers have more than USD 100 million in assets under management and 64% have less than USD 75 million. The top 10 Islamic fund managers have 80% market share. In terms of institutional versus retail funds, the report finds that only 33% of the Islamic fund industry caters to retail investors.
While this may be an industry wide issue, the focus here is on the sukuk market. There is an obvious gap in the fixed income funds market that needs to be filled, sooner rather than later. Islamic fund managers should focus more of their efforts on introducing fixed income funds that cater to both retail and institutional investors. Mutual funds that provide daily redemptions or ETFs should be staples of the industry rather than floundering on the periphery.
The data on the equity ETF front is not encouraging and this is acknowledged. But this may have as much to do with investor sentiment on the market, limited product offering or any number of other factors as it is a reflection on the products themselves. There is an oft acknowledged lack of options in the Islamic fixed income space, so why not a family of sukuk ETFs or sukuk mutual funds accessible to retail investors? I believe that the introduction of these types of products - institutional investors in themselves - will provide a vehicle for retail investors to become players in the sukuk market and hopefully spur activity in the dormant secondary market. This may then ignite the causal link between trading activity and increased primary market issuance, helping take the market to its next level.
The sukuk market is a pillar of the Islamic finance industry and is one of the higher profile segments, if not the highest profile segment, of the industry. Its success or failure is a reflection of the success or failure of the industry as a whole. I hope that by addressing the issues identified above, we as practitioners can make the sukuk market more robust and build it for enduring, sustainable success.
Sherif Elkhouly is the executive director of investment strategy at Noriba Investing (NoribaInvesting.com), the first Islamically compliant online investment broker-dealer and investment advisor in the US. Prior to joining Noriba Investing, Sherif spent nearly six years with Kuwait Finance House Bahrain in both legal and investment banking roles.
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