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Sukuk market offers an attractive alternative going forward

By Nick Stadtmiller, Head of Fixed Income Research, Emirates NBD
The GCC sukuk market has begun the year on a high note. Regional entities have sold USD 8.5bn of Islamic bonds so far this year, compared to USD 7.3bn for all of 2011. In fact, more sukuk have been sold out of the region in 2012 than was issued in each of the entire four previous years. There are now about USD 60bn of sukuk outstanding from GCC entities, about half of which are international bonds.

Sukuk issuance has increased in popularity among regional issuers for several reasons. First, it has helped entities to access new funding sources. Historically Western financial institutions have been important buyers of global bonds sold out of this region. European banks are in the midst of dealing with their sovereign exposures there, and are under pressure to deleverage and reduce exposure to non-core markets. This has led some European banks to pare demand for assets in this region. On the other hand, the majority of recent sukuk sales have been placed in the Middle East and Asia, allowing issuers to reach a new set of investors outside of Europe.

Although many 'conventional' investors do invest in sukuk, of course Islamic financial institutions are the primary target for sukuk placements. Islamic financial institutions in this region are relatively liquid compared to their conventional counterparts and are actively seeking suitable investments. As an example, the two largest publicly listed Islamic banks in the UAE had a combined loan-to-deposit ratio of 84% at the end of 2011, leaving them with excess funding to deploy into Islamic-compliant assets. In contrast, the UAE's five largest conventional banks had a combined loan-to-deposit ratio of 105%.

Furthermore, Islamic banks are less connected to the problems in Europe and have been less impacted by the deterioration in conditions in the financial system there, leaving them positioned to expand with the broader growth of the Islamic financial industry.

There is strong demand for sukuk among Islamic institutions, but the supply of Islamic bonds remains limited. The global sukuk market is worth about USD 180bn; in contrast, the size of the conventional bond market is around USD 100,000bn. To be sure, part of the size disparity reflects the fact that the sukuk market is still young and developing. For the time being, however, Islamic banks are faced with a shortage of investible financial assets. In the short run, that means that these institutions tend to be more active bidders for new sukuk. Over the medium term, it suggests there is sufficient demand to absorb an increasing supply of sukuk.

Nevertheless, the regional sukuk market must overcome several challenges to break through into its next phase of development. A wider base of issuers would widen the pool of sukuk available and allow investors to build more diversified sukuk portfolios. Currently most GCC entities issuing sukuk are either sovereigns, government-related entities (GREs) or banks, and issuance from private companies is minimal.

One recent development may encourage private companies to consider selling sukuk, however. Majid al Futtaim, an entirely privately owned UAE company, sold USD 400mn of sukuk in January. The success of this sale demonstrates that sukuk investors have appetite for private companies with a strong standalone credit profile.

Increased sukuk issuance by private companies in the region would also help to balance their funding sources. According to IMF data, capital markets in the Middle East and North Africa are more heavily reliant on bank financing than other regions. Bank assets make up over 60% of total capital available in the MENA market, while bonds represent just 10% of funding. For emerging markets as a whole, banks provide half of total capital raised, while the bonds provide another one-fifth. More issuance of bonds and sukuk from private companies would be a major step to diversifying regional capital markets away from their historic reliance on bank funding.

Placing a larger portion of new sukuk with investors abroad would help deepen the market and open up additional demand. Investors in the Middle East bought about half of global sukuk sold out of the GCC this year. Asian investors have been a key destination for GCC sukuk, but there is room to increase the region's footprint there.

Malaysia is the oldest and largest sukuk market in the world and offers significant potential for regional issuers looking to tap overseas capital markets. Islamic banks in Malaysia have total assets of over USD 110bn and are highly liquid, making them potentially an excellent source of funding. Issuers looking to tap this market should also consider selling local-currency sukuk in Malaysian ringgit, in addition to the dollar issues that currently dominate the market. Abu Dhabi-based Taqa placed MYR 650mn of sukuk in Malaysia in March, and there have been a handful of similar deals from Gulf issuers in recent years.

The regional sukuk market has witnessed remarkable expansion over the past 10 years and looks set to continue its momentum. As the market looks to capitalise on a promising start, it is important to see more participation from new issuers and a wider set of investors. Companies in the Middle East have historically looked to banks for financing, but the sukuk market may offer an attractive alternative going forward. Regional entities should look abroad to expand their investor base, particularly the Islamic financial market in Malaysia.

Nick Stadtmiller is head of fixed-income research at Emirates NBD, covering global interest-rate and regional credit markets. Before joining the bank, Nick worked with a department of the Government of Dubai. Previously Nick was at Merrill Lynch in New York as a strategist on the fixed-income proprietary trading desk and remained with the team after they spun off into an independent global macro hedge fund.

© Zawya 2012

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