Sukuk bonds from the Middle East have not escaped the sharp spread widening in the global debt markets over the past four months. And while issuance has not dried up, the investor base has become more local.
Nevertheless, optimism is high that Islamic-based project finance and the broader world of Sharia-compliant derivatives and structured instruments are set to take off next year. Philip Moore reports.
Be careful what you wish for. Put back the clock nine months or so and investment bankers guiding issuers of sukuk (Islamic bonds) to the market were expressing delight at the rapid internationalisation of the market, and at the levels of demand from conventional investors.
In the immediate aftermath of the US subprime mortgage meltdown, that internationalisation was quickly transformed from an asset to a liability, much to the justifiable puzzle of dedicated Islamic institutions and investors. After all, given Islams proscription of riba (interest), few financing techniques would be more unacceptable to Sharia scholars than high cost mortgages advanced to borrowers with questionable ability to repay.
"When the subprime fall out started Islamic institutions were initially sheltered from what was happening," says Danie Marx, head of capital markets at the European Islamic Investment Bank (EIIB) in London. "But increasingly there are two distinct types of investor in the sukuk market, and I believe the spread widening originated not from the dedicated Islamic investors but from conventional accounts reducing their positions. The root cause of this was not necessarily risk-aversion but liquidity constraints in the global markets, and a switch to more attractively priced conventional bonds in the region."
This repositioning had an exaggeratedly marked effect on spreads in the Islamic market. At Unicorn Investment Bank in Bahrain, head of capital markets Jaafer Badwan points to the secondary market performance of a sukuk such as the $1bn five year ijara transaction led by Unicorn and six others in June for the Saudi Arabian real estate developer, Dar Al-Arkan.
The issue, which generated almost $1.5bn of demand, was a follow-on to the companys inaugural sukuk in March. "The Dar transaction was priced at 225bp over three month Libor, and at the height of the subprime crisis had widened out to Libor plus 256bp," says Badwan. "Spreads widened less than they did in Western markets because of the relative illiquidity of sukuk. But a widening of 30bp was completely unjustified in the case of Dar Al-Arkan, which is the largest real estate developer in Saudi Arabia with almost $3.5bn of capital, a low leverage ratio and excellent profitability."
Marx contrasts these events with the more domestically orientated Malaysian sukuk market. "We were in Malaysia in September and prices of sukukwere actually contracting," he says. "In part, this reflects the influence of the exchange control practices which served as a shelter for the Malaysian market against adverse global capital flows."
A more insular market
While sukuk issuance in the GCC did not dry up after the summer, the market became somewhat more insular.
At the start of August, for example, National Industries Group of Kuwait issued a $375m five year floating rate sukukvia BNP Paribas, Citigroup, NBK Capital, Standard Chartered and WestLB, in line with pricing guidance of 105bp over Libor.
Oversubscription was modest in comparison with the trend before the subprime crisis, with Middle Eastern investors buying nearly 60% of the notes.
More recently, the decision by Jebel Ali Free Zone to denominate its benchmark Dh7.5bn ($2bn) sukuk in dirhams rather than dollars was seen as another indication of borrowers shift in focus away from international and towards more regionally-targeted issuance.
Bankers say that although there is no fundamental justification for any link between the sukukmarket and the more general weakness in the global bond market, there may be a silver lining associated with the slowdown in issuance.
"Before the summer, increased international demand for sukukhad the effect of narrowing the yield differential between issues at either end of the risk spectrum," says Idayu Zainuddin, head of Islamic structuring and product development at UBS. "One welcome result of the credit crunch for investors will be more realistic pricing of deals in the higher risk category of the market."
And it is not only international investors that are re-examining the nuts and bolts of sukuk. Islamic scholars themselves have recently expressed concerns about the acceptability of mudaraba structures involving purchase undertakings, which has put a handful of planned transactions on hold, according to Deutsche Banks head of Islamic structuring, Geert Bossuyt.
Meanwhile, bankers warn that it is important not to assume conventional and sukukbonds are to all intents and purposes interchangeable. That would be a dangerous assumption, for a number of reasons.
First, the products have very different secondary market profiles.
A paper published by the IMF in October looked at whether the secondary market behaviour of conventional Eurobonds and sukukwas "significantly different", allowing for investors to make "gains from diversification". It concluded that "the analysis employing the delta-normal as well as Monte Carlo simulation methods implies such [diversification] gains are present and in some cases very significant."
Not ABS by another name
A second and perhaps more serious way investors may underestimate the difference between conventional and sukukinstruments is in the fundamental structure of Sharia-compliant debt instruments, which are still erroneously viewed by some conventional investors as asset backed securities by another name.
"There is a misconception that in the event of default, investors have a claim on the underlying sukukassets, meaning that these instruments are effectively secured debt," says HSBCs regional head of debt capital markets, Declan Hegarty. "But as the rating agencies have made very clear, they are not. Sukukare unsecured instruments and their ratings are based on the credit profile of the issuer, rather than the underlying assets."
Such misperceptions are an inevitable by-product of the relative immaturity of a market that has only existed in its present form for a few years, and is constantly evolving.
"Although these products are based on principles that date back hundreds of years, those principles are continually being updated by scholars in line with the Islamic concept of Ijtihad, which is the process of reinterpreting Islamic principles to reflect modern society," says Amjad Hussein, head of the Islamic finance group at UK law firm Eversheds in Doha. "The result is that the instruments being developed today are first generation products, and the sukukof tomorrow will be very different.
That immaturity, twinned with the strength of the GCC economies, has meant that, to date, the legal robustness of the sukukmarket has yet to undergo the stress-test that would arise from a default.
While analysts accept that there is inevitably a degree of uncertainty arising from the lack of precedent, they argue that there is no reason to believe Islamic and conventional bonds should be affected differently by a default.
"People tend to assume that sukukare drawn up under Sharia law," says Philipp Lotter, senior credit officer at Moodys in Dubai. "Theyre not. They are Sharia-compliant but the transactions weve rated are governed by English law or DIFC law, which is very close to English law. So unless a local court were to overrule the law under which a transaction was originally set up, I dont see any additional risk arising from an instrument structured to be Sharia-compliant."
Sharia-compliant project finance
Two specialist areas exciting bankers are Islamic-based project finance and the broader world of Sharia-compliant derivatives and structured instruments.
Given the colossal infrastructure investment the region plans, the potential for Islamic project finance is obvious enough in theory, especially as Sharia-compliant funding structures are generally asset-based.
"One of the positive aspects of the sukukstructure is that it has an underlying asset backing it, which helps build investor confidence when there is legal recourse to the asset," says John Weguelin, EIIBs managing director. "The challenge is to broaden the asset base supporting the sukukmarket, which would make the infrastructure projects planned in countries like Qatar, Saudi Arabia and the UAE ideal candidates for Islamic financing."
That process has already begun. At Standard & Poors, credit analyst Karim Nassif points out that the sukukissued by borrowers such as DP World and Tabreed have both generated funding for infrastructure-related investment, although there are important differences between these deals and Western-style project financings.
"In both instances the companies were raising money to finance infrastructure business port terminals in the case of DP World and district cooling plants in the case of Tabreed," he says. "But with the project sukuks we have rated so far,the specific asset being financed is not always secured in the same way as it would be in a conventional project financing.
"This meant more weight was placed in the ratings on enhancements provided by the structure rather than the cashflow generated by specific assets. So as an investor you are relying much more on the ability of the parent to generate sufficient cashflow from its general business to meet its obligations, rather than on the credit quality of a specific asset or project."
Islamic derivatives catch on
Islamic derivatives are a controversial subject because of the Qurans proscription of gharrar loosely defined as uncertainty or speculation.
Among Islamic financial scholars, however, concerns about gharrar are starting to recede with the acceptance that in many instances derivatives can eliminate uncertainty much more effectively than plain vanilla instruments.
"From our discussions with scholars there is a growing recognition that when derivatives are designed to mitigate or to re-align risks by mutual consent they have the potential to be developed across the Islamic world," says Zainuddin at UBS. "The caveat is that they will continue to be prohibited if they are merely instruments for speculation."
At Deutsche Bank, Bossuyt agrees. Deutsche closed an innovative $615m Islamic Profit Rate collar structure for Dubai Islamic Bank in October, and Bossuyt says the conceptual development of similar structures should be quite uncomplicated. "From a period of denial two or three years ago, there is now a recognition among Islamic scholars that it is impossible to run a bank or company efficiently without tools to manage risk," he says. "They are also recognising that in spite of the prohibition of riba, because Islamic banks benchmark themselves against Libor they are exposed to interest rate risk."
That recognition has allowed banks like Deutsche to work on a range of Sharia-compliant off-balance sheet swaps. "That is a challenge because we are talking about a market that does not yet accept ISDA guidelines, which means the local enforceability and netting of the two legs for the swap is an issue that we have needed to work on," says Bossuyt.
"One of the other problems in developing these products has been available credit lines, because most Islamic banks are still small relative to their conventional counterparts. So while the conceptual framework for Islamic derivatives was established a couple of years ago, we are now dealing with some of the practical problems in implementing them."