2009 - The year of ijara
Sukuk issuance in 2009 has been dominated by the ijara format. David French looks into why this is the case and whether this pattern will continue into 2010.
The reopening of the sukuk market in the past six months has been a major positive for all concerned. While sukuk issuance was at a premium for most of the opening months of 2008, the collapse into full financial crisis in the last quarter firmly bolted the door on any kind of fundraising – either conventional or Sharia-compliant. Therefore, with the bank market remaining impervious to all but the most determined borrower, the return of the bond market has meant that capital has still been available for a number of entities looking to continue with their development plans.
Much of the bond activity in the GCC in 2009 has been on the conventional side. The printing of US$3bn issues each by Abu Dhabi and Qatar at the beginning of April opened the way to a host of quasi-sovereigns to follow, such as Mubadala Development Company, Aldar Properties and Qatar Telecom. This conventional route has also been the prime avenue for issuers from South East Asia, the other traditional bedrock of Sharia-compliant financing.
However, within this dominance of conventional bonds, there have also been some memorable trades structured as Islamic products. Indonesia caused significant waves when it printed its debut US$650m sukuk issue in April, while Bahrain (US$750m), Ras al-Khaimah (US$400m) and Saudi Electricity Company (SR7bn, US$1.87bn) have all completed successful issues.
With bankers reporting a healthy sukuk pipeline for the rest of the year and into 2010, Abu Dhabi's Tourism Development and Investment Company due to complete its debut sukuk offering by the time this article is published, and Bahrain still scheduled to issue sukuk denominated in Bahraini dinar by the end of the year, the sukuk market is set to keep issuers, bankers and investors interested.
One question that can be asked, though, is in what form will these Sharia-compliant issues come. Since Indonesia reopened the international sukuk market, the majority of the larger offerings to come to market – with one or two notable exceptions – have been structured as ijara transactions. All three sovereigns to have issued sukuk this year, Indonesia, Bahrain and Ras al-Khaimah, have gone down the ijara route. And the second-largest sukuk issue this year, the US$1.5bn tranche of the US$4.5bn offering from Petronas, was also ijara-structured. Therefore, will this trend towards ijara continue or will other structures return to vogue?
To answer this, the question of why ijara has been so popular must first be tackled. For most people, including Chris Walsh, partner, capital markets, at Clifford Chance, there have been two main drivers.
"Ijara has no issues about whether it emanates from the Gulf or South East Asia, so it is globally accepted and gives you as wide an investor base as possible," he says. "It is simple and embraced by both investors and scholars. The Accounting and Auditing Organisation for Islamic Financial Institutions [AAOIFI] rulings in 2007 have also made other structures difficult. The number of musharaka transactions, for example, was building in 2007 but the market acceptance of this structure has since waned. They are still done but are in the minority."
Both factors have worked to turn the tide of issues towards the ijara format. The AAOIFI statement has required the market to pause for breath and re-evaluate many of the alternatives, like musharaka. Meanwhile, the plunge into recession has meant that everyone has adopted a back-to-basics approach where any activity is completed with the minimum amount of fuss.
This has had its benefits. With ijara being accepted by investors in both the GCC and South East Asia, investors from both areas have been allowed to expand their portfolios. For example, GCC investors had built up huge exposures to their own locale and desperately wanted some diversification. However, differences in interpretation of Sharia law meant that these Gulf-based players were reluctant to invest in products emanating from South East Asia. By adopting a cautious approach and employing an ijara structure, these issuers could appeal to Gulf investors and expand their investor base.
With the geographical interest in Islamic finance also continuing to grow, and with demand for Sharia-compliant paper increasing in Europe and elsewhere, it pays to keep the process simple. This helps to explain why all but one of the internationally marketed, dollar-denominated sukuk issues have been structured as ijara.
The issues that haven't been ijara have tended to be the ones launched in local currencies and aimed at a local populace. This was the case with the largest transaction of the year so far, the SR7bn Saudi Electricity Company sukuk al-Istithmar, which was only available to Saudi citizens. Other examples are the Islamic Development Bank's (IsDB's) S$200m (US$166m) private placement in September and CIMB Islamic Bank’s M$300m (US$86.6m) musharaka-structured sukuk issue in the same month.
As always though, there is an exception to the local/international split in sukuk structure: the IsDB's US$850m wakala-structured sukuk issued at the beginning of September. Under the wakala structure, a pool of assets is ringfenced and sold to an SPV. IsDB then retains the management of those assets, with their profit used to pay certificate holders.
The fact that IsDB could break away from the dominance of ijara was a product of choice and necessity. As Matthew Sapte, a partner at Denton Wilde Sapte, explains, the fact it is a bank meant certain ijara structures wouldn't be the best option for it.
"If you are a bank, what assets do you have to structure a sukuk with? The bank may own some property outright so it might be able to sell these assets into a sukuk structure, and then lease them back," he says. "Such an ijara based structure is possible, but it would be unusual for banks to be big property owners in their own name. Therefore, standalone ijara-based structures often won't work as the bank doesn't have enough unencumbered real estate assets. However, an Islamic financial institution would have a portfolio of Sharia-compliant assets – for example, Sharia-compliant home finance loans. It is these assets that could be sold into a sukuk structure."
Such a move away from ijara, when the market response to the likes of Indonesia, Bahrain and Ras al-Khaimah had been so positive, could have been a risky move. However, as Qudeer Latif, partner and head of Islamic finance at Clifford Chance, explains, Islamic investors are crying out for organisations like IsDB to issue Sharia-compliant paper.
"Fundamentally, there is a huge pool of investors looking for Islamic investments," he says. "In the early part of 2009, there was nothing there for them. Therefore, anything that is structured in an Islamic way is appealing as if they don't invest in these issues, then Islamic investors will be sitting on their money doing nothing. You just have to look at the Islamic Development Bank (IsDB) closing its sukuk during Ramadan. That kind of AAA rated agency is the kind of investment that Islamic investors are screaming for."
Therefore, IsDB had the star name that helped alleviate any concerns investors might have had in moving away from ijara. But what about other banks and corporates that don't have much real estate to use as collateral? As Sapte argues, although the AAOIFI statement restated its existing Sharia standards, it caused many people to re-examine how they were structuring transactions. Addressing the issues raised in a practical manner is key before equity-based structures such as musharaka and mudaraba can return.
"The rise of musharaka and mudaraba based structures was due, in part, to the balancing of competing demands – the availability of Sharia-compliant assets compared with the demands of an issuer to be as asset efficient as possible," says Sapte. "If you made widgets, how could you do a sukuk issue? You could use the factory itself for one ijara sukuk issue but then what? If the underlying business was a Sharia-compliant activity, what about creating some form of joint venture or co-ownership type structure that could be used as the basis of further sukuk issues? The challenge now is to meet the points raised by AAOIFI and to make sure products fit into the requirements of both investors and Sharia compliance."
What can be done, though, to help restore confidence in these other structures? Will it just require new guidance from scholars, in particular AAOIFI, on how to structure these products in a Sharia-compliant way?
Perversely, the economic conditions that the world has found itself working under could help with the process. The changing attitude towards risk in global banking has meant there has been renewed emphasis on the assets behind the transaction. Sharia-compliant products haven't escaped the pressures brought on by the global slowdown, with the drop in real estate values, for example, posing questions about sukuk backed by them.
Therefore, the ongoing analysis of how risk and reward plays out in financial products should be grasped as an opportunity to improve sukuk markets. One key question that needs to be answered before market players will be comfortable with structures such as musharaka and mudaraba is how the risk is managed.
According to Sapte: "Many international investors have treated the economic performance of sukuk in the same way as fixed income investments. In other words, they expected their money to be repaid. However, the argument is about risks and rewards. It would be easy, from a legal perspective, to change the exercise price under any purchase undertaking to be the 'market price' of the assets on the relevant exercise date. This would transfer all the risks and rewards of the underlying assets to the investor. However, then it becomes a question of whether investors will invest."
Therefore, for the short and medium term at least, it is likely that the market will remain where it is comfortable and stick with ijara as the dominant sukuk structure. It won't be until the market recovers its confidence in other sukuk products, and in the market in general, that we are likely to see the likes of musharaka and mudaraba return in any great numbers on the international scene.