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Convergence of factors to boost global sukuk funds

By Dr. Aleksandar Devic, Head of Fund Management at QIB (UK)

Overall growth of Islamic finance and tightening spreads bode well for sukuk funds, writes Dr. Aleksandar Devic, head of fund management at QIB (UK).
The global sukuk funds industry is still in its infancy. However, we see strong growth potential going forward.

In particular, we believe that, in the long-term, the most significant factor in this respect is the growth in the asset base of Islamic financial institutions, as it boosts the demand for both sukuk and related portfolio management services.

We also think that an important factor in future growth of global sukuk funds is the ability of the funds' sponsors to adjust their investment styles to the needs and expectations of the majority of global sukuk fund investors, which, in our view, has been happening to an increasing extent in the marketplace. Finally, we think that the USD-denominated sukuk offers good relative value in the current global environment of low absolute yields, which may boost the demand for global sukuk funds over the immediate horizon.

Looking at the current state of the market, MYR-denominated sukuk accounts for more than 60% of the total outstanding (USD145bn equivalent), whereas the USD-denominated sukuk's share is at about 17% (USD40bn). Most sukuk investors are still mainly buy-and-hold, which limits the liquidity of a number of names. Therefore, it is not surprising that a majority of the existing global sukuk funds have fairly small assets under management.

According to Zawya data, total assets under management of all USD-denominated sukuk funds are about USD 375 million, USD 205 million of which is accounted for by EFH Global Sukuk Plus Fund, managed by QIB (UK).

On the positive side, we note that the ongoing strong growth in the asset base of Islamic banks and takaful companies is likely to further boost the sukuk market growth in two ways. First, a growth in balance sheets of Islamic financial institutions increases the dollar-value of the sukuk demand. Second, Islamic banks in general have been expanding their fixed income trading books, which has helped improve liquidity in the secondary market.

The increase in high-grade sukuk issuance has also helped increase secondary market liquidity, as dealers find it easier to obtain risk approvals to hold inventories of high grade paper compared to sub-investment grade or unrated securities. Consequently, the bid-ask spreads in the secondary USD sukuk market have been halved over the last three years.

As for the impact of the selected investment style on the growth in a fund's AUM, we would like to use the aforementioned EFH Global Sukuk Plus Fund as an example. The fund was set up in March 2009 with USD 30 million of seed capital from our parent company, Qatar Islamic Bank . The AUM has risen nearly sevenfold over the following three years. The investment style that QIB (UK) has been applying is aimed at limiting the downside whilst capturing the market upside.

This has resulted in relatively modest drawdowns during the market downturns that have occurred since the fund's inception. For instance, the fund's drawdown during the Dubai crisis in November/December 2009 was 2.5% whereas HSBC Sukuk Index had a drawdown of 8.4% over the same period.

Limiting downside risks has not come at the expense of performance, as the fund has generated an annualised return of 6.8% over the last three years since inception, beating its benchmark of three-month USD Libor + 200bp by 4.4% annualised. According to our experience, this investment style has been received well by investors.

Spreads over swaps: HSBC Sukuk Index and BBB US corporates



Moreover, we see the recent secondary market dynamics and short-term market outlook as additional positives for the immediate growth prospects of the global sukuk funds. The sukuk spreads have tightened by about 55bp during the last two months, outperforming the BBB-rated US corporates, which tightened by about 30bp over the same period.

However, the former still trades about 65bp wider than the latter whereas this differential had come down to 50bp in mid-2011, just before the outbreak of another Greek debt crisis. Therefore, we believe that sukuk may still tighten by about 15bp relative to BBB US corporates.

Also, the BBB US corporates themselves are currently trading by about 35bp wider than in mid-2011. Therefore, we think that sukuk spreads could tighten by another 50bp over the course of this year. Considering the average duration of 3.6 years for HSBC Sukuk Index, that translates into short-term capital gains of about 1.8% based on spread tightening alone.

The global sukuk market has a way to go before reaching the depth and the breadth of the conventional credit market. However, the progress made over the last two-to-three years and the strong prospects for further growth of Islamic finance, in our view, bode well for the outlook for the global sukuk funds industry.

Dr. Aleksandar Devic spoke to Nader El Boustany, Funds Team Leader, Zawya.

© Zawya 2012

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