Apr 28 2013

Sukuk: heading for the mainstream

By Jasmin Leitner Sukuk: heading for the mainstream

With more and more sovereigns and corporates looking to raise money through sukuk - in response to strong investor demand - Islamic finance is becoming increasingly mainstream. Are regional asset managers well positioned to take advantage?
The growth of the market for sukuk - Islamic bonds - over the last few years has been staggering and experts predict that 2013 will continue that trend, particularly in the Gulf Co-Operation Council (GCC) countries and wider MENA region.

Investors within the emerging markets space as well as internationally have had a taster and are hungry for more sovereign as well as corporate issues. Worldwide issuance was $138 billion in 2012, its fourth consecutive year of growth, and up 64% on 2011. Regionally, the GCC accounted for $24 billion of the total: in Mena, Oman and Egypt are among the governments issuing sukuk for the first time. Little wonder then that a recent report from Standard & Poors said that sukuk was fast becoming a "mainstream" debt instrument.

Many of the region's asset managers have been among the trailblazers in this investment space, but others have steered clear. Will the rapid current expansion persuade more conventional fund managers to make the switch to this specialised market?

According to Mark Watts, Head of Fixed Income at National Bank of Abu Dhabi ( NBAD ), the industry will see a number of managers moving into the Islamic finance space.

"On the conventional side there's a wealth of market, portfolio and bond-analysis experience and in my mind, it's easier to train someone in Islamic finance and the specifics of how the MENA bond market trades, than it is to take someone who's very well versed in Islamic finance and turn them into a portfolio manager or analyst," said Watts.

"I think there are a lot of people out there, maybe working in London, who would jump at the chance of coming into the region, following their own personal faith and investing in sukuk whereas they may be uncomfortable doing the job on the conventional market," he adds.

Watts says that this is already happening, but warns that investors should be wary of inexperienced managers jumping on the bandwagon - especially those coming from the ranks of ex-traders. "There are new managers coming to the party. Some of these managers will end up being credible competition and we welcome that, but some of them will be people who are a bit more opportunistic."

Watts argues that experience trading a certain asset isn't the same as managing that asset in a portfolio. "A trained trader is not the same as a trained fund manager. They actually approach the market in completely different ways, and that comes out in the risk profile. Our message to investors is always to have a look at the underlying experience, pedigree and resources of the fund manager."

NBAD has approximately 40% of its $800 million AUM invested in sukuk, making it one of the biggest players in the region, according to Watts.

Growing investor understanding

Investors do seem to have an understanding of products such as sukuk and this is one of the key factors behind increased issuance, according to Dilawer Fawazi, portolio manager of the Invest AD Middle East and Africa Bond Fund.

"Many international investors now have a better understanding of what a sukuk is, they understand the structures and appreciate that the structures in effect replicate the cash flows of a conventional bond," says Fawazi.

"There is a broader group of investors now willing to participate in sukuk issuance because of evidence that sukuk tend to have lower volatility characteristics than conventional bonds," he adds.

Fawazi believes this is down to a "dedicated Islamic investor base" that holds approximately 70% of sukuk issuance and tends to adopt a "buy and hold" approach, creating relatively low selling pressure in periods of volatility.

He also adds that a "demand-supply mismatch" ensures that new supplies tend to be mopped up easily and issuers, in most cases, obtain more favourable pricing than would be the case for conventional bonds.

Historically low yields

Yields for sukuk issuance are at historically lows, driven by realistic pricing and investors' acceptance of longer tenors. The S&P Ratings Direct report (entitled 'Investor Appetite is Pushing Sukuk Into the Mainstream') identified the recent $1 billion five-year sukuk of the Dubai Electricity and Water Authority (DEWA) as especially significant, noting that its dollar-denomination and low yield (3% compared to 6% on a previous bond) could "set the benchmark" for other strong credit quality government-related entity (GRE) credits in the region. Banks in Qatar and Saudi Arabia are predicted to lead more quality issuance in 2013, as they respond to increasingly rigid regulatory capital requirements, while the UAE could tap the sukuk market to boost its long-term funding profile.

The outlook for investing in sukuk looks favourable, according to Mohieddine Kronfol, chief investment officer of Global Sukuk and MENA fixed income at Franklin Templeton Investments.

"On the supply side it looks good, and on the fundamentals of the different companies it's looking good," says Kronfol. "It's also looking good with respect to the supply and demand imbalance; the market will continue to be underpinned by solid demand and that's going to help performance from a risk or volatility perspective."

The global firm has been making waves in Dubai since 2007 and as of 31 December 2012 manages over $1 billion in Shariah-compliant assets. They recently launched the UCITS-compliant Franklin Templeton Global Sukuk Fund, which Kronfol says could allocate between 40 - 50% of its assets to the GCC.

Kronfol stresses that although their latest product launch is a new departure in some ways, Franklin Templeton are not new to the space. "We've been doing it for a while and we have a leadership position. We have all the attributes to be competitive over the long run and that's why we're doing this."

So, while the trajectory of increased sukuk issuance is set to continue, fund managers who are new to this space will face stiff competition from the heavyweights as they try to get a slice of the pie.

© Zawya 2013

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