Can you have too much of a good thing? Islamic Business & Finance explores the dark side of Sukuk
Sukuk has been championing the Islamic finance industry for the last two years, grabbing the attention of conventional markets with record issuances and access to the GCC's ample liquidity. Every outlook for Sukuk reads with the predictability of the GCC region's weather forecasts: nothing but sunshine.
So imagine my surprise when a colleague returned from Coutts' Outlook in February this year with a warning for investors she'd been given: run from Sukuk.
WEALTH WARNING
"You can lose money on bonds or Sukuk," Gary Dugan, Managing Director and Chief Investment Officer (CIO) of Asia and Middle East at Coutts had said at the media gathering. "I know that in this region the Sukuk market has been performing exceptionally well - people have been seeing double digit returns - but I keep telling people that bonds do not give you double digit returns every year, they give them once in a lifetime quite frankly, and I think people got a little bit too excited about this asset class."
Dugan said that he was trying to reinforce a message to clients that while we think of bonds as a way of preserving wealth, bonds and Sukuk "can actually damage your wealth."
"The point to clients is to rebalance your portfolios away from fixed income like securities or Sukuk and into equities," he said. "If you really think the world is going to grow, why have this money in bonds or Sukuk in any case?
"If you don't think the world is going to grow, that we're going to go back into recession, you don't want credit where you're going to get damaged by a drop in global growth, which in fact is much of what you see at the bottom end of here and probably includes a loss in Middle Eastern markets, where CDS is very low and interest rates are incredibly low considering economic conditions."
"Beware of, in the Middle East, a significant sell off in Sukuk," warned Dugan. "I think there is a lot of leakage from emerging market bond funds looking for further sources of return in the Middle East, and they just quickly whip the money away leaving bond prices marked lower.
"What's also been seen in recent days is the massive illiquidity of the secondary market, which means that the spread for most of our clients have really widened ... people don't become aware of these things until they want to sell."
BUBBLE BREWING?
The massive demand for a limited supply of Sukuk has squashed yields to perhaps unsustainable lows; however, Abdul Wahab Al-Halabi, Partner at KPMG, believes this is reflective of the region rather than the instrument itself. "There won't be a [Sukuk] bubble per se, because how low can yields go?" he said. "Most of the demand will be macroeconomic-driven, rather than because of Sukuk; people may say after the event that there was a Sukuk bubble, but it's more likely to be an economic issue in a country or sector."
The biggest markets for Sukuk, particularly the GCC, are becoming increasingly attractive to international investors. "Governments and companies from Europe are issuing Sukuk to access Middle East capital," Al-Halabi explained. "Access to conventional financing is not as easy as it was. People want to access investors from these markets, because there are such huge surpluses of capital that need investing somewhere else. Some will only invest in Shari'ah-compliant products, and there's no easier way to convince someone that your product is good enough than by issuing a Sukuk."
However, Sukuk issuers have their own hurdles to face. "It is still much more expensive to issue a Sukuk than it is to issue a conventional bond," said Al-Halabi. "The profit rates you pay on a Sukuk are still higher than the interest you would pay on a bond. However, in recent years the difference in pricing between the profit rate on a Sukuk and the interest rate on a bond have narrowed significantly. We've seen recent issuances where it's been comparable, sometimes even lower, just because you have more demand for the instrument.
"However, the transactions costs involved with issuing a Sukuk are still much higher. There are many more lawyers and accountants involved as well as a Shari'ah board; there are typically many more companies and because Sukuk are asset-based they tend to involve transaction costs of moving assets around. These costs continue to make Sukuk issuance more expensive than bond issuance."
WORTH THE EXPENSE?
A costly issuing process does not translate into higher returns for investors. "Returns are comparable [with a conventional bond] - they're almost identical, frankly," said Al-Halabi. "As you would expect, if you were investing in Sukuk five years ago you would have done better than if you are investing today because pricing has tightened."
However, in the great scheme of things these costs don't mean much, according to Al-Halabi. "If you're issuing a $1 billion of Sukuk, quite frankly the costs aren't significant in the context of what you're doing," he said. "The advantages of issuing Sukuk are now increasing so much that the cost is becoming more worthwhile."
One of these advantages, Al-Halabi explained, is that investors and issuers allegedly have more security. "One of the most important things is that Sukuk tends to be asset-backed, so the owner tends to be more secure than a conventional bond which may be secured but often is not," said Al-Halabi. "I don't think they're necessarily more worrisome than conventional bonds - in theory - they should be less.
"In the past, there were fewer investors in Sukuk because the structures are so complex many people shied away from them, fearing what would happen in the case of a default. It was a specialty product. Now there is a process by which these things happen so people are much more comfortable."
While that works in theory, however, many Sukuk remain asset-based, a structure more akin to a conventional bond, rather than asset-backed; and laws that enforce ownership vary widely across the world. "So many countries have no trust law, so many countries have no ownership law - especially for properties - and many countries are against selling property to foreigners... These kinds of things do not help the industry, said "Muhammad Al-Bashir Muhammad Al-Amine, Group Head of the Shari'ah Assurance Department at Bank AlKhair.
"We must not be confine Sukuk to being a replica of the bond market," Al-Amine said, "It should move towards the securitisation market, which is more in line with Islamic finance principles than the bond market. Yes, the securitisation market will have issues that may not be compatible with Shari'ah principles, but these issues can be resolved more easily than with the bond market."
SOLID BASE?
However, in the mean time Al-Amine said that the market is still more willing to accept asset-based Sukuk. "This is one of the fundamental issues," he said. "To resolve this will take collaboration from different parties. Regulators need to make it easy for assets to be securitised. There is no securitisation in so many parts of the Islamic world. Shari'ah scholars need to be a little bit strict on their pronouncement of Sukuk, so we can move gradually, without undermining the industry, from bond to securitisation, and from asset-based to asset-backed Sukuk."
For anyone not put off the seemingly unstoppable industry, Dugan gave Islamic Business & Finance readers the following advice: "Be sure of the quality of the issuer and be aware that liquidity of many of the Sukuks tend to dry up after the Sukuk is issued."
However, having apparently had a change of heart when I contacted him, he also shared these words of comfort, "The market is well supported by domestic buying. We tend to find that the market for Sukuk is dominated by natural buyers, and we don't have a sense that there is a substantial amount of hot money in that particular asset class."
So, while there may be a few clouds on the horizon, the outlook for Sukuk remains generally sunny.
© Islamic Business and Finance 2013
