As of October 31, sukuk will be eligible for JP Morgan’s EMBI, GBI-EM, CEMI and JACI indices. Inclusion not only boosts the profile of the product, but also supports inflows from international institutional investors and passive tracking funds.
One London based EM fund manager said that eligibility would reduce the sukuk risk premium, which he estimated to be around 30bp over conventional bonds in Malaysia, to a negligible amount. With little to no pricing differential, this could encourage more borrowers to issue in sukuk format to take advantage of a new pool of Islamic mandates without the extra cost.
Malaysia is expected to be the biggest beneficiary. It is by far the principal issuer of sukuk and has printed some $13.8bn of Islamic bonds this year, well outstripping United Arab Emirates’ $4bn. But beyond Malaysia, the impact will be limited, partly because, but not limited to, the fact that so few bonds have been included.
JP Morgan has identified just four sovereign bonds, as well as two domestic issues from Malaysia and two dollar corporate bonds for inclusion. Indonesia’s 2024s, Malaysia’s 2026s and Turkey’s 2024s will be included in the EMBIG, and Pakistan’s 2019s will be in the JACI alongside Indonesia and Malaysia’s aforementioned bonds. DP World and Saudi Electricity will be included in the CEMBI.
With the exception of Oman, Middle Eastern countries are not included in sovereign indices. UAE, the principal issuer of international sukuk bonds this year, is not index eligible, nor is Saudi Arabia, which is expected to bring a sukuk issue as part of its anticipated $10bn capital markets issue, nor Kuwait.
In addition, sukuk is a more opaque structure involving a higher degree of credit work and analysis. When JP Morgan announced its move, one institutional asset manager said all his clients phoned asking him to describe exactly what sukuk was.
It is also commonly smaller in size and less liquid than conventional bonds. While the majority of borrowers continue to issue conventional bonds alongside Islamic notes, the former is likely to remain the most attractive to investors, particularly if the “sukuk premium” is substantially reduced.
But one of the largest barriers to wider adoption of Islamic bonds is the lack of standardisation across issues, and the lack of harmonisation across different jurisdictions. Sukuk can be issued in multiple formats, making like for like comparisons difficult and the costs associated with issuance expensive.
Shari’ah accreditation by an Islamic scholar can be difficult, and in many cases costly, to obtain. The UK, Hong Kong, Luxembourg and South Africa all issued in Islamic format in an attempt to develop that market regionally, but there has been no follow-on issuance. In addition, assets are required to link to the bonds, though the investors have no recourse to these assets.
However, Fitch points out that the move towards standardisation is occurring. Kuwait's Capital Markets Authority announced a broad sukuk framework in November 2015, and the central bank in the UAE has proposed creating a Higher Sharia Authority to provide unified supervision and guidelines on Islamic finance-related matters, it said in a note on August 23.
While the inclusion of sukuk will go some way to boosting the profile of the asset class and improving the liquidity of sovereign issues from Malaysia, Turkey and Indonesia, material improvements in the product are more likely to be made by the efforts towards standardisation, rather than index inclusion.