Sukuk hopes remain high
The sukuk market has been hit hard by the credit crisis but the longer-term picture is expected to remain positive. William Thornhill reports.
The credit crisis has badly affected the sukuk market and with assets expected to come under increasing stress, investor differentiation between the structural substance of deals will become ever more critical. However, given the Gulf region's large financing needs and the desire of many global lenders to tap its rich seam of demand, the longer-term picture is expected to remain positive.
Islamic finance should be able to withstand the current economic crisis and may well emerge stronger, with a return to the 30% to 35% annual growth rates in primary issuance that were seen in pre-crisis days, according to Moody's.
In a report published in February 2009 on Islamic finance, the rating agency said that the retail market, the Islamic mutual fund sector and asset management businesses in Islamic finance all have a strong future. Nonetheless, it is likely that progress will entail some conditions being met, such as improved transparency and risk management, a better understanding of the product, and continued structural innovation.
The sovereign market for sukuk issuance could well prove one of the first to make a comeback. Bahrain is planning to make a US$500m Sharia-compliant five-year sukuk issue, expected at the end of May, while Indonesia has stated an intention to issue its inaugural overseas sukuk of US$650m.
Indeed, the sukuk market in general is expected to power ahead this year. According to the chief economist of NCB Capital, Jarmo Kotilaine, the sukuk pipeline for this year is estimated at nearly US$40bn, with the Gulf region accounting for the lion's share.
In a report entitled GCC Debt Capital Markets, Kotilaine wrote that the sukuk market had the "potential to capitalise on the growing appeal of Sharia-compliant finance in today's significantly more risk-averse market environment". According to NCB, Islamic bond sales from the UAE are likely to account for the bulk of financing from the Gulf region, with an estimated US$12.6bn expected this year, including as much as US$2.5bn from the Abu Dhabi ruling family-owned First Gulf Bank PJSC.
But it is not just the region itself that is likely to provide the major issuers. Speaking at the Reuters Islamic Banking & Finance Summit, the chairman of the Islamic finance committee at Paris Europlace, Gilles Saint Marc, said that a French financial institution could issue €1bn of sukuk, possibly as early as this June.
At that time, Rami Falah, head of Islamic banking, Middle East, at BNP, said that sukuk issues were trading at a discount and felt that the structured murabaha market could have even greater potential.
After rising to a peak of around US$34bn in 2007, Sharia-compliant sukuk issuance tumbled to about half that level in 2008, according to S&P. According to Moody's, the sukuk market totalled US$47bn in 2007, taking the outstanding to almost US$100bn. Had it not been for the credit crisis, Moody's reckons that 2008 issuance would have been almost three times as much as the US$15bn that was actually seen.
The ijara sukuk was the preferred structure of 2008, after the mudaraba sukuk that was the most popular in 2007. The increased popularity of the ijara sukuk "reflects its simple structure and the abundance of tangible assets with which it can be structured", Moody's said.
Despite the sharp fall in issuance in 2008, it was not a year without highlights. Two very deserving transactions illustrate just how innovative the region is capable of becoming.
Citigroup priced the first true-sale Islamic securitisation backed by land instalment sale receivables. The deal, originated by Sorouh Real Estate PJSC, saw Sun Finance, a Jersey SPV, issue Dh4.016bn (US$1.09bn) of sukuk certificates using a Sharia-compliant structure.
The sukuk al-mudaraba al-muqayyada certificates were backed by scheduled instalment payments owed by sub-developers arising from the sale of plots of land on the Shams and Saraya developments that are taking place on a natural island off the coast of Abu Dhabi city.
The structure benefits from over-collateralisation, subordination, an enforcement reserve fund, a liquidity reserve fund and an infrastructure reserve fund. The transaction was notable for a number of reasons.
It was the first Islamic securitisation of land and associated rights to payment and It is backed by freehold title to the land, in the form of an instalment sale contract that is secured by land. Perhaps more importantly, it was the first full Sharia-compliant deal structured according to the latest guidelines.
In early 2008, the sukuk market suffered a setback when a senior Islamic finance scholar voiced concern over the Sharia legality of some specific forms of issuance.
In contrast to past full-recourse deals, Sun Finance adhered to the new standard by featuring partial recourse to the originator. It was also notable for being the first sukuk issue to deliver subordination, being structured into a Senior A class and two further subordinate B and C classes.
A few months before the Sun Finance transaction, Merrill Lynch arranged an issue for Villamar Sukuk. This deal was notable for being the first fully non-recourse asset-backed real estate issue for the Islamic market.
The transaction was structured on a musharaka basis, which is a form of profit-sharing involving a joint venture between partners. The SPV, Villamar Sukuk, is a Cayman Islands entity sponsored by Gulf Holding Company and provides funding for a mixed-use development in the Bahrain Financial Harbour.
Non-recourse means lenders can take the property pledged as collateral to satisfy a debt, but they have no recourse to other assets of the issuer or sponsor. Sales made with recourse allow the buyer to resell a portion of the assets back to the seller, and thus, from an accounting perspective, are treated as financing and not a true sale.
Substance over form
Yet, as upbeat as this all sounds, Moody's has made it very clear that the structuring ideal of Shariah-compliant sukuk issues still has room for improvement and it recently emphasised the need for investors and issuers to focus on substance over form.
"As sukuk issuers begin to face distress, it is important that investors focus on the substance and not the form of their risk, which is a concern in Islamic finance," said Khalid Howladar, senior credit officer for asset-backed and sukuk finance at Moody's.
He went on to point out that sukuk issues were supposed to grant investors a share of an asset or business venture, along with cashflows and commensurate risk of ownership, but warned that "most current sukuk structures are designed to replicate conventional fixed-income instruments".
The assets in the structure are commonly there for Sharia-compliance purposes only, and ultimately have no bearing on the risk or performance of the sukuk investments, particularly in a distress situation, he said.
The disparity between various sukuk transactions was also highlighted by the Accounting Auditing Organisation for Islamic Financial Institutions when, in February 2008, it published six recommendations. The AAOIFI recommended that issuers refrain from selling structures in which they were obliged to repurchase or guarantee the sukuk deal at a future date and at a specific price, as this would not be in accordance with the principle of Sharia, or in other words, profit and risk sharing.
Moody's advice and the AAOIFI recommendations come in response to the concerns expressed by the senior Islamic finance scholar over Sharia legality.
The AAOIFI recommendations are aimed at bringing the product closer to the tangible and risk-sharing principles that most bankers in the region broadly agree on. That being said, their implementation can often result in complexity.
Sukuk issues can encompass many sub-sector structures – such as mudaraba, musharaka and ijara – but even within these sub-divisions the actual legal structure and risk characteristics can vary significantly from deal to deal.
"Until there is some broad standardisation, investors will need to look at each structure individually to understand the risk/return profile irrespective of the type of sukuk structure used," said Howladar.
As a result of the lack of standardisation, the sukuk is not a liquid instrument. That lack of liquidity has been compounded by the crisis – as Islamic banks now find it increasingly difficult to find buyers of impaired sukuk deals at what they consider satisfactory prices.
The lack of liquidity has meant that the premium to other more liquid debt markets has grown, which could explain why the market has performed so poorly. The HSBC/DIFX Sukuk Index (SKBI)3 widened three-fold from August 2007 to reach 400bp prior to the collapse of Lehman Brothers, when it blew out to 900bp.
While the appetite to issue sukuk is still there, given the Gulf region's long-term financing needs, spread levels remain prohibitive, "making banks less inclined to fund long-term projects", Moody's said.
Thus, despite all the hopes for the sector, a resurgence of the corporate and real estate market still looks set to lag issuance in the supra-sovereign and agency sectors – at least until spreads start to normalise.
This lack of funding capacity could well prove to be a catalyst for consolidation of the fragmented Gulf region banking sector, which from a longer-term perspective is probably not a bad thing.
Sukuk pipeline (in a box)
Four factors were to blame for pushing the value of sukuk issuance in 2008 down by 56%: global market turmoil, drying up of liquidity, widening of credit spreads, and investors' wait-and-see attitude, according to a Standard & Poor's report in January, which claimed the market would remain dormant until at least H2 2009. A Fitch Ratings report predicted a similar timeframe of inactivity for GCC sukuk in the key construction and property sector. By Mark Kolmar.
Mohamed Idriss, managing director and head of global market sales for MENA at Nomura, suggests a glut of sukuk could hit the market when the time is right. "We would expect activity to pick up in late 2009, by which time there will be a backlog of issuances and activity levels could return very quickly," he says. "The sovereigns and quasi-sovereign entities will be first, followed by private sector corporates, some of which will be delayed by having to attain ratings first."
Aside from macroeconomic improvement, the sukuk sector is itself still developing and structural improvements will enable greater activity. Karim Nassif, Standard & Poor's credit analyst, prioritises standardisation as a means to boost sukuk issuance, saying: "Standardised loan documentation would reduce the time and costs of due diligence. The market would also benefit from a harmonisation of views amongst scholars." Dubai Financial Market is expected to announce a set of standards for sukuk issuance in the Emirate by the end of May. Below are the major deals in the pipeline.
Bahrain has mandated Calyon, Deutsche Bank and HSBC to lead its US$500m sukuk offering, planned for late May. The new offering will be the first issue under a US$800m programme to fund housing projects and plug the Kingdom’s budget deficit. The second stage will be a dinar-denominated three-year BD250m (US$663m) issue. The timeframe for the second issue, and whether it will be a conventional or Shariah-compliant offering, is as yet unknown, although a sukuk issue is likely given the potentially wider market at a time of low liquidity.
Bahrain last visited the bond market in March 2008 when it printed US$350m of Reg S five-year sukuk at 75bp over Libor, having attracted about US$800m in investor commitments.
Unicorn Investment Bank wants to issue US$425m of ijara-structured sukuk by the end of Q3, and has begun discussions with two regional banks about running the issue, which would be used to fund the bank's expansion. Unicorn is targeting a number of banking acquisitions in the next few months in the Gulf, Asia and Europe.
Islamic Development Bank (IsDB) has confirmed that the first US$500m sukuk under a US$5bn five-year programme will be launched by the end of June. The bank wants to raise US$1bn a year from the sukuk market to fund its projects in member countries. The programme will be US dollar/euro-denominated, with the first issue to be in US dollars.
IsDB has already printed one small sukuk issue this year as part of its Malaysian ringgit-denominated programme. It issued M$100m (US$27.2m) of AAA rated five-year sukuk through Standard Chartered with a coupon of 4.05% in late March.
Jabal Omar Development Company will ask shareholders to approve a sukuk issue at an EGM on June 10. In April, Jabal Omar admitted that it had been unable to secure SR12.4bn (US$3.3bn) of project financing to fund a real estate development in Makkah. The firm cancelled the mandate it had awarded to Jadwa Investment Company last July to raise the funding for a real estate development of 39 residential and hotel towers opposite the Grand Mosque in Makkah.
Emaar Properties has appointed HSBC and RBS as leads on a US$2bn sukuk programme, although no timeframe is known. Alongside the sukuk will be a US$2bn Euro medium-term note programme, on which HSBC has been appointed lead manager.