Sukuk: can 2012’s successes be repeated?

Driven by breakthrough deals and tightening spreads, Islamic finance had a record 2012. But sceptics worry that the appeal of the asset class is merely as a transitory haven from the chaos of the Eurozone. Dan Alderson examines whether the sukuk market can grasp the opportunity to build on its momentum.

  • 21 Dec 2012
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Record-breaking volumes of sukuk issuance were the most visible sign of the extraordinary year that Islamic finance had in 2012. Borrowers issued more than $127bn of sukuk globally, according to EuroWeek’s Islamic Finance Information Service, well above 2011’s $93bn. Of this, $21bn was international issuance, almost double the $11bn seen in 2011.

As growth rates go, this is impressive. But in real terms the international market remains small. Sukuk is so far mainly a Malaysian domestic product: such issues accounted for more than 75% of 2012’s volume.

And it is dwarfed by the conventional bond market. It needs a decisive spark or years of steady momentum to change that balance.

That spark may be difficult to identify, but there was no shortage of landmarks in 2012, with debuts by Turkey, Qatar, Saudi Electricity Company (SEC) and the sovereign proxy Development Bank of Kazakhstan. Dubai made a storming return with its first issue since the Gulf’s 2009 financial crisis, while Banque Saudi Fransi proved that a conventional bank can issue sukuk. Malaysia’s Axiata, meanwhile, blasted open the doors of the dim sum market.

All these deals pushed back the frontiers of the sukuk product, either geographically or in terms of demand and tenor. Those working in the market hope this will encourage more expansion in 2013.

South Africa’s debut sovereign sukuk is expected soon, for example. Its government will have noted that since Turkey embraced sukuk and set a $1.5bn tight liquid benchmark in September, more issuance looks set to follow from that country’s corporate borrowers. Turkish Airlines and phone company Turk Telekomunikasyon are tipped for 2013.

"The overwhelming success of the Turkish sukuk, the Axiata dim sum sukuk and the Qatar sukuk before that have elevated the profile of the global sukuk market," says Mohamad Safri Shahul Hamid, deputy CEO of CIMB Islamic, an Islamic bank based in Kuala Lumpur. "2012 is already the best year ever for global sukuk. Potential issuers from new jurisdictions are mulling sukuk issuances and the success of the mentioned trades — from the level of oversubscription achieved — will inevitably help reinforce the interests of those new kids on the block."

Sovereign fanfare

The fanfare around sovereign deals has certainly not been lost on countries affected by the Arab Spring. Oman has already changed its rules to allow Islamic banking and Egypt is making moves to issue sukuk.

Interest in Islamic finance has spread around the Middle East and North Africa, prompting other countries to level their financial playing fields. Most recently, Morocco and Tunisia have been trying to change their legislation to encourage Islamic banking.

Strong macroeconomic currents are propelling this shift. The continuing easy money policies of global central banks have left many investors chasing yield. Much of this has found its way to emerging markets and, in turn, the focus of Islamic financial institutions and conventional buyers has turned to sukuk.

By December 2012, the HSBC/Nasdaq Dubai Sovereign Dollar Sukuk index had narrowed to a global average of 2.74% from 3.75% at the start of the year, aided by excess demand, ratings upgrades in Turkey and Indonesia and a brighter outlook for the UAE — particularly the impressive recovery of Dubai Inc. Corporate sukuk has also rallied, with yields falling on average from 5.3% to 3.3% during the year.

The extent of this rally raises the concern that 2013 sukuk could suffer because of the successes of 2012. Yields have tightened so much that there may not be enough juice left, which may deter investors.

"One fears that all this good performance from GCC corporates may be running out of steam as investors take a step back and look at the fundamentals for growth going forward," says Martin Westacott, treasurer at Gatehouse Bank, a London-based Shariah-compliant bank. "This, coupled with the ongoing political turbulence, may just take some wind out of the sails, although the course still appears to be straight."

Counteracting that, there is still a dearth of issuance — relative to conventional bonds — and a lot of liquidity. But the influx of international players to the sukuk market has also made it less certain that new issues will see a stable performance in the aftermarket.

"Despite book orders far exceeding issuance, prices for many sovereigns such as Islamic Development Bank and Turkey did initially trade below par," says Westacott. "All this is a sign that there is some hot money looking for quick profits — perhaps a caveat emptor for 2013."

The fourth quarter of 2012 did see some erosion of the price advantage of sukuk over conventional bonds. But this is not because sukuk have performed badly, argues HSBC syndicate official Souhail Mahjour. He sees it rather as a reflection of the liquidity that has become available for their conventional counterparts.

Sukuk were still tighter than conventional bonds at the start of December, but only by an average of around 10bp. In the third quarter the advantage was more like 25bp. Things can change quickly, however: 18 months ago it was the other way around, with sukuk trading at a premium.

Returns compressed

The excess liquidity for both sukuk and bonds in the GCC, along with its improving economic backdrop and company metrics, has hit the return expectations of high yield investors. With the exception of the early November sukuk default by Dana Gas, there have been few causes for concern in the region since Jebel Ali Free Zone and DIFC successfully refinanced their respective sukuk in June.

"Yields have compressed so much that it’s difficult to find good opportunities in the Middle East or even adjacent areas," says Gus Chehayeb, director at boutique investment bank Exotix. "We are now looking wider afield to Africa to find high yielding situations above 10%."

The hunt for yield has encouraged investors across the spectrum to lengthen the tenors for which they are willing to lend — with the traditional GCC sukuk five year sweet spot giving way to seven (for Jafza) and 10 year tranches (Qatar, Dubai, SEC). SEC is interested in trying for even longer tenors if possible — 15 or even 30 years — and a 2013 deal already looks to be in the works. This could prompt other well known borrowers to follow, notably utilities and project financing vehicles.

"For that, however, we will need 144A documentation in place and a greater sponsorship from the global duration players such as those in the US — asset managers and insurance companies," says HSBC’s Mahjour. "Many of them may not be as familiar with the sukuk asset class just yet, but duration is unlikely to come from the regional investors and therefore there is a need for greater promotion of this product."

The project finance requirements of the GCC and other areas — Indonesia for example — could run up against limitations set by the wider market, however. Regulation will be more stringent and the whole banking sector has to look at how much capital it needs to provide against specific assets. Banks are looking ahead and modifying their business strategies accordingly.

"Regulations could have a big impact in 2013," says Saad Rahman, head of global Islamic banking at Crédit Agricole. "For example, Saudi Arabia has committed to $500bn of genuine new infrastructure. How are we going to finance all of this? The state is not infinite, but banks are going to be under constraints for longer dated paper. We need pension companies and asset managers to step in."

Whether they are in a position to do so, however, will depend greatly on whether rising interest rates come into play and how many Islamic investors have the capacity to hedge. The problem could be twofold — firstly because the concept of Shariah compliant derivatives is still new to many of them and secondly because the same Basel regulations could place a curb on banks providing longer dated hedging tools.

"If we find that banks become reluctant to provide the hedging facilities due to capital constraints, it will become difficult for corporates and other investors to manage their risks," says Doug Bitcon, head of fixed income funds and portfolios at Rasmala Investment Bank. "At the moment, regional bond and sukuk investors are happy running interest rate risk, up to 10 years and many on a leveraged basis," he adds. "We don’t even need rates to rise — just the threat of it. When interest rate expectations change, it has the potential to be ugly."

This is a concern that other participants share. "When Wall Street raises interest rates, you will be wiped out if you can’t hedge," says Rahman. "P&L could be in genuine trouble within 12 months. Whether you believe it’s this year or 2014 or 2015 — it’s going to happen."

On the face of it, this problem is compounded by the fact that HSBC — perhaps the biggest conventional player in the GCC Islamic market — recently pulled back from the regional Islamic market on both the retail and the institutional services side. However, some observers think this means that there’s an open opportunity for other banks, like Standard Chartered, for example, to step in.

Regulatory driver

Basel regulations could also spur the issuance of new sukuk products, however. November and December 2012 saw banks begin to raise regulatory capital through sukuk, and this should continue in 2013. As well as ADIB issuing a first ever Basel III-compliant subordinated sukuk, there have also been tightly priced tier two issuances from Saudi Hollandi and Banque Saudi Fransi in riyals.

"With Basel III fast approaching, we fully expect others to follow the lead of ADIB and watch this space closely," says Westacott. "GCC issuance, particularly from financials, has performed exceptionally well, perhaps highlighted by the recent ADIB perpetual sukuk, which since issue in October has rallied five points."

The icing on the cake for UK Islamic banks remains the possibility of sterling issuance, or, even better, some kind of issue they could use within their FSA-eligible liquid assets buffer.

"We currently can only use Islamic Development Bank sukuk [for FSA liquid assets], which, I know from talking to the other UK Islamic treasurers, creates a problem with currency and liquidity," says Westacott.

Islamic finance is still beset by formidable obstacles, the biggest of which is the lack of global oversight and co-ordination. But the list of areas where it could take the place of conventional borrowing is expanding: new countries, non-government backed corporates, conventional borrowers, Chinese renminbi or infrastructure financing.

Any one of these could provide the spark for continuing record sukuk volumes. In all likelihood, though, all of these areas will need to grow if 2013 is to surpass 2012.


Conventional lenders join the rush to capitalise on rapid growth in Islamic loan volumes

  Shariah-compliant loan volumes have doubled globally in the last two years and now Middle Eastern banks not traditionally associated with Islamic lending hope to take a share of the growing market, writes Michael Turner.

"We see a big potential for Islamic financing regionally," says Saad Azhari, chairman and general manager of Blom Bank in Beirut. "In Saudi Arabia [...] we are developing Islamic products and plan to have them running this year."

Egypt has also been earmarked as a place of growth for Shariah-compliant lending, adds Azhari.

By the end of November 2012, $18.1bn-equivalent of syndicated Islamic loans had been signed in the year, according to EuroWeek’s Islamic Finance Information Service. This is more than double the $7.24bn loans signed for all of 2011 and more than the $15.5bn of deals closed in 2010, according to Dealogic.

"Islamic finance in Lebanon is gaining ground," says Samir Hanna, chairman of the executive board and chief executive of Bank Audi in Beirut. "There is plenty of opportunity in Islamic finance and we could look into it seriously in the future."

The reputation of murabaha facilities — the most common type of Shariah-compliant loan, according to the Institute of Islamic Banking — was helped last year by the successful restructuring of Islamic debt, say bankers. Dubai World real estate firm Limitless restructured its $1.2bn murabaha facility in October after repeatedly extending the repayment deadline from 2010. In total, 92% of the company’s trade creditors were repaid, with the rest agreeing settlements with Limitless.

Saudi hot spot

Saudi Arabia remains the largest market for Islamic facilities globally, racking up $8.23bn-equivalent of Shariah-compliant loans as of November 28 — just under half of total Islamic loans signed in 2012. The second largest market last year in the Middle East was the UAE, with $3.39bn-equivalent of deals.

"To have the [market] size required, we must go to the Gulf," says Azhari. "We plan to open a branch for Islamic finance in Lebanon, but people are used to conventional lending."

As well as having the highest loan volumes, Saudi Arabia also hosted the largest Islamic financing of 2012. Saudi Arabian Mining Company (Ma’aden) signed an oversubscribed SR7bn ($1.87bn) five year murabaha revolving credit facility from regional banks. Like the vast majority of Shariah-compliant deals in the Middle East, Ma’aden’s was signed from a syndicate of regional banks that remain awash with liquidity.

And Saudi banks proved their bilateral lending firepower in 2012 too. In the final quarter, Saudi engineering firm Abdullah AM Al-Khodari Sons Co signed two Islamic financing facilities totalling SR1.14bn ($303m) from two domestic banks. National Commercial Bank provided a range of Islamic finance facilities totalling SR736m, while Riyad Bank provided the remaining SR400m.

But it’s not just the Saudi banks that have cash that’s ready to be used, according to Hanna at Bank Audi. "Lebanese banks have substantial liquidity," he says.

Bank Audi, which is funded by deposits, had a loan to deposit ratio of 34.66% in 2011.    
  • 21 Dec 2012

Bookrunners of International Emerging Market DCM

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 Citi 22,359.08 123 7.61%
2 JPMorgan 21,917.68 109 7.46%
3 HSBC 21,403.26 169 7.29%
4 Standard Chartered Bank 17,273.41 119 5.88%
5 Deutsche Bank 12,010.87 66 4.09%

Bookrunners of LatAm Emerging Market DCM

Rank Lead Manager Amount $m No of issues Share %
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1 Citi 4,325.33 16 11.99%
2 Bank of America Merrill Lynch 4,224.27 16 11.71%
3 JPMorgan 3,818.54 15 10.59%
4 Morgan Stanley 2,844.36 8 7.89%
5 Santander 2,639.35 13 7.32%

Bookrunners of CEEMEA International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 JPMorgan 12,528.53 43 12.52%
2 Citi 10,614.23 37 10.61%
3 Standard Chartered Bank 9,665.29 37 9.66%
4 HSBC 6,899.03 31 6.90%
5 Deutsche Bank 5,013.13 10 5.01%

EMEA M&A Revenue

Rank Lead Manager Amount $m No of issues Share %
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1 JPMorgan 195.08 50 10.55%
2 Goldman Sachs 162.26 37 8.77%
3 Morgan Stanley 141.22 46 7.64%
4 Bank of America Merrill Lynch 114.20 33 6.18%
5 Citi 95.36 35 5.16%

Bookrunners of Central and Eastern Europe: Loans

Rank Lead Manager Amount $m No of issues Share %
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1 Citi 857.45 5 12.87%
2 MUFG 848.66 4 12.74%
3 Industrial & Commercial Bank of China - ICBC 742.79 3 11.15%
4 JPMorgan 369.88 4 5.55%
5 SG Corporate & Investment Banking 293.72 4 4.41%

Bookrunners of India DCM

Rank Lead Manager Amount $m No of issues Share %
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1 Standard Chartered Bank 1,783.30 14 17.16%
2 HSBC 1,191.32 13 11.46%
3 JPMorgan 1,015.66 11 9.77%
4 Citi 941.15 11 9.06%
5 Barclays 802.96 10 7.73%