Fixed Income Sukuk: Prospects for Corporate Issuance
Islamic finance is one of the most exciting areas
of the capital markets at the beginning of the 21st century, and the Sukuk is
very much a product of the new millennium.The petrodollars boosting the Gulf
countries together with the vibrant economies of Southeast Asia have combined
to bring Islamic fi nance to the forefront of the international fi nancial
community. As a result, the Islamic capital markets are growing at an exponential
rate.
In both the leading Islamic centers of the Gulf
and Southeast Asia , issuers are seeking to tap
the capital markets in a Shariah compliant manner. The rest of the world is
catching on as well — from the UK to Japan and back across the Pacifi c Ocean
to the US, issuers are ooking to take advantage of investors’ increasing demand
for Shariah compliant investment products. Oft-quoted fi gures from the World
Bank cite some 300 Islamic fi nancial nstitutions and funds with more than
US$250 billion of assets, growing at approximately 10% to 15% per annum, with a
further US$200 billion of assets located in Islamic “windows” or divisions of
conventional banks.
Growth of Sukuk marketSukuk issues are a 21st
century product, although they draw on centuries of Islamic fi nancial
practice. While the 1990s saw a handful of structured-fi nance corporate deals
tailor-made for a carefully delineated audience, the fi rst sovereign issue
came in September 2001, with the US$100 million Sukuk issue by the Bahrain
Monetary Authority although this was essentially for liquidity management
purposes.
Other sovereigns soon followed suit, fi rst with
the US$600 million Malaysia Global Sukuk Ijarah in June 2002 — the fi rst truly
global offering — while Qatar
maintained the momentum in September 2003 with its debut US$700 million Sukuk
Ijarah issue.
The Sukuk market has continued to gain pace since
those early years and has, more importantly, widened its range of issuers.
In the GCC, 2005 saw 11 issues raising US$2.3
billion, while 2006 saw 17 issues raising almost fi ve times the previous
year’s volume, with just over US$11.5 billion being raised. Last year was
another record year, with global issuance to the end of September reaching
almost US$39 billion, from approximately 150 issues.
almost US$39 billion, from approximately 150 issues.
It is clear from these levels that the Islamic fi
nance market in general, and Sukuk issues in particular, are nevertheless still
a “niche within a niche” when compared with the international capital markets
as a whole. The industry is in the early stages of its life cycle and, as at
the beginning of 2007, new ground is being broken with every issue, whether in
terms of structure, volume or country of issuer.
In the Gulf Cooperation Council (or GCC,
comprising Bahrain , Kuwait , Oman ,
Qatar , Saudi Arabia and the United Arab Emirates ), the growth
of Islamic fi nance has several major drivers. First and foremost is retailOne
leading player in Islamic fi nance has described the business as “R2B” (retail
to bank), and there is little doubt that it is the retail customer (whether the
eponymous “Muslim in the street” or the increasing legions of “high net worth
individuals” and “ultra-high net worth individuals”) who is seeking to invest
and deposit money for utilization in accordance with Shariah.
As is well known, the amounts available from this
sector have grown steadily in this new century, with the repatriation of funds
to the Gulf region spurred on by events such as 9/11 and the fall of Saddam
Hussein, the continued high oil and gas prices and the continual development of
new Shariah compliant products.
The banking network in the whole of the GCC has
been impacted by this new liquidity and is reacting to it in a variety of ways.
Existing banks are establishing Islamic retail, commercial and investment banking
platforms. For example, in Qatar, Al Safa Islamic Bank has appeared via
Commercial Bank of Qatar
and QNB Al Islami via Qatar National Bank, while in the UAE MashreqBank has
started Shariah compliant operations via Al Badr Al Islami.
ther banks have gone a step further and
undertaken conversion to be fully Shariah-compliant, such as Kuwait Real Estate
Bank, Dubai Bank and Saudi Investment Bank.Completely new banks are also being
established at a heady pace. Notable recent examples have included Al Rayan Bank
in Qatar , Bank Al Bilad in Saudi Arabia , as well as Al Salam Bank and
United International Bank in Bahrain .
The latter captured the headlines in the fi
nancial pages in the GCC due to the initial authorized capital of US$3 billion,
as well as the public involvement of the family of Prince Al Waleed bin Talal
in the establishment of the bank.
Investors in the GCC are spreading their wings
outside the immediate region as well. Signifi cant investment is being made by
several leading players in Southeast Asia, with banks such as Kuwait Finance
House and Al Rajhi Bank establishing operations in Malaysia , including signifi cant
retail branch networks.
‘Double-dip’ opportunities
Activity has also been seen in Western Europe, in
particular in the UK where
fully Shariah compliant institutions such as the Islamic Bank of Britain and the
European Islamic investment Bank have been established, with further
institutions continuing to start up. Last year saw the authorization of the
Bank of London and the Middle East , with at
least two further institutions seeking the necessary authorizations from the
Financial Services Authority to start their Islamic banking businesses.
From an issuer’s perspective, Malaysian
corporations have for several years benefi ted from government-led initiatives
designed to stimulate Shariah compliant transactions. Companies in the GCC are
taking greater strides in the Sukuk market to broaden their appeal to fixed
income investors, while at the same time ensuring the issuer’s Shariah acceptability”
to its shareholders.
Sukuk issuance is also spreading beyond the GCC
and Southeast Asia and it is worth examining
why issuers outside these two main Islamic hubs should be interested in Shariah
compliant fi nancing. The growing numbers of potential issuers investigating
the advantages of Islamic issuance are primarily focusing on diversifying
sources of funding.
Potential issuers are in particular attracted by
the “double-dip” opportunities afforded by a fi nancing product capable of
appealing to “conventional” fi xed-income investors, as well as enticing the
participation of the vast wall of liquidity latent in the Islamic fi nancial
community.
The ball started to roll in August 2004, when the
German state of Saxony-Anhalt issued its €100 million (US$148.3 million) Sukuk
al-Ijarah. The US
broke its duck in 2006, when the US$165 million Sukuk al-Musharakah was closed
for East Cameron Partners, while the Sultanate of Brunei also saw its fi rst
issue with the US$150 million Sukuk al-Ijarah from the government (issued
concurrently with two local-currency issues).
As at the time of writing, debut Sukuk issues for
Japan and China had also
been announced (although not yet closed), namely a benchmark issue for JBIC and
a US$250 million power project respectively.
Perhaps most notably, the UK government
announced in April 2007 its intention to study the feasibility of a debut Sukuk
issue, with a further discussion paper to be issued by end-2007.
Development and innovation of structures A
notable feature of the Islamic Sukuk market to date has not only been the
degree of innovation and creativity involved, but also the pace at which those
skills have been, and are increasingly, deployed. Each new issue brings a new
structure or a signifi cant refi nement of a previously utilized mechanism.
This is, of course, to be expected given the
youth of the modern-day Islamic fi nance market, but there is also little doubt
that the overall trend is one of positive and constructive development, with
structures tending to be simplifi ed as the underlying Shariah principles
become better understood in the context of today’s fi nancial environment.
The simpler the structures, the more capable they
become of wider application and, therefore, of greater appeal to issuers across
the globe.
Perhaps one of the most noteworthy recent
developments in the GCC Sukuk market was the issue of convertible or
equity-linked Sukuk, fi rst by PCFC in January 2006 with its US$3.5 billion
Sukuk al-Musharakahissue due 2008, followed in December 2006 by the US$3.52
billion
ukuk al-Ijarah due 2009 by the Nakheel Group
(this latter issue is a novel pre-IPO Sukuk, as well as being the largest Sukuk
issue to Both issues combined structural innovation with a successful appeal to
investors for support, both within and outside the GCC, raising ignificant
volumes of fi nancing (even by international standards) and successfully
tapping into strong demand for equity-linked products.For the Nakheel issue,
for example, Sukuk holders were given the right to subscribe for any future
equity offered as part of an initial (or qualifying) public offering (QPO) by
any member of the Nakheel group, such rights subsisting during the lifetime of
the Sukuk issue. In addition, “look-back” rights were also given to Sukuk
holders, in this case subsisting for a period of 12 months after the maturity
date of the Sukuk issue.
In the event of there not being a QPO during the
relevant period, the return to Sukuk holders will be enhanced by an additional
2% per annum. Whilet the ground-breaking nature of both of these equitylinked
issues cannot be questioned, there is equally no doubt that
both transactions benefi ted by the issuers being seen as integral parts of “Dubai Inc”, namely corporate entities closely linked to the ruling parties in the Emirate of Dubai.
both transactions benefi ted by the issuers being seen as integral parts of “Dubai Inc”, namely corporate entities closely linked to the ruling parties in the Emirate of Dubai.
Another equity-linked product was the US$460
million issue by Aabar Petroleum, which was also notable for utilizing the Mudarabah
structure for the fi rst time in the international capital markets. In March
2007, another exchangeable Sukuk was announced, this time by Aldar Properties
in Abu Dhabi ,
for US$2.53 billion.
The US$225 million Sukuk issue by Sharjah Islamic
Bank in October 2006 is also worth mentioning. While being on an altogether
smaller scale than the “Dubai Inc” transactions described above, the issue was
a capital markets debut for another Islamic structure, the coownership of
assets based on the concept of Sharikat al-Melk.
Under this structure, certain rights and
interests in specifi ed assets on the balance sheet of Sharjah Islamic Bank
were sold to the special purpose vehicle (SPV) issuer of the Sukuk holders so
that such assets became effectively “co-owned”, with each of Sharjah Islamic
Bank and the SPV owning indivisible interests in the Sukuk assets.
The last 12 months have also seen issues
featuring put options, or including both put and call options. In Saudi Arabia,
Saudi Basic Industries Corporation or SABIC issued a 20-year Sukuk Istithmar
(”istithmar” meaning “investment”) encapsulating put options every five years.
The structure was geared to ensure that investors are almost certain to put the
issue back to SABIC after the fi rst fi ve years, as subsequent redemptions
will be at a discount to par.
The Investment Dar’s US$150 million Sukuk
Musharakah issue due in 2011 illustrated above included both a put and a call
option at the end of the third year. This allows Sukuk holders to focus on a
shorter maturity fi nancing for an issuer without an investment grade rating
from an internationally recognized rating agency, while affording The
Investment Dar the opportunity to retire the transaction after only three years
should such a rating materialize and allow it to refi nance at a lower cost.
Innovation continued to be seen in 2007, despite the moreApril saw the closing
of the US$650 million Sukuk al-Manfaa issue by the Sad Group in Saudi Arabia
via its Golden Belt vehicle (utilizing receivables under a master lease and
sublease structure), whilst National Industries Group in Kuwait has put in
place a ground-breaking US$1.5 billion Sukuk program based on a Mudarabah
structure. The first draw-down under the program closed in July 2007 in an
initial issue amount of US$475 million.
Looking ahead
Islamic fi nance and the Sukuk market in
particular are on the fast track. The geographical spread of the sector is
increasing in pace, while with each successive issue it seems that new
structures are being utilized and new investors being attracted to the sector.
There is also no doubt that the label of “Sukuk” in itself generates a higher
profi le for any transaction.
Two distinct, but related, trends in the
corporate arena will also maintain the momentum in the Sukuk market. First, the
turbulence experienced in almost every GCC stock index in 2006 has led many
corporations to consider the “Islamicization” of their debt to ensure their
equity is able to be treated as “Shariah-acceptable”, allowing Islamic equity
funds (and individual investors) to invest in their shares. For example, Saudi
Aramco and SABIC have each made a public announcement to this effect.
The second trend is the counterpart to this in
the private sector, where many companies are family-run and managed, with the
owners being Muslim. It is no surprise to understand that many such owners are
now considering Islamic fi nance — and the Sukuk market — to address their fi
nancing requirements. Both trends will be further reinforced by the steadily
increasing variety of Shariah compliant instruments.
For corporations outside the GCC, the main
attraction is the burgeoning universe of Islamic investors. The growth in the
number of Islamic banks, as well as Islamic “windows” of conventional banks,
has been described above and is leading to ever-greater interest by non-GCC
corporates looking to tap into this expanding and increasingly liquid investor
base.
At the same time, the universe of institutional
investors is also growing, with the proliferation of Islamic insurance — or
Takaful — companies and the increasing appetite and sophistication of GCC
pension funds.
Private banking clients are also showing an
increasing interest in Islamic fi xed-income products to bring a degree of
compliance to their investment portfolios.
There is no doubt, however, that Islamic funds
continue to be dominated by the real- estate and private equity sectors and
there is an increasing need for funds focusing on the Sukuk sector to be
established.
One sector where the market is still awaiting its
fi rst benchmark issue, however, is in the realm of securitization. Two small
transactions in Saudi Arabia
have led the way for others to follow, and the Saudi market is one of the focal
points for further securitization transactions during 2007, along with the UAE,
where Tamweel made its debut US$220 million 25-year securitization issue in
July 2007.
However, there are one or two myths and
misinterpretations prevalentin the current market that need to be dispelled in
order for a greater degree of clarity and understanding to prevail and to
assist market development.
As for all Islamic fi nance products, the
structure of a Sukuk issue must be asset-based. This has led to a certain
amount of confusion of terminology, as many commentators have leapt to the
assumption that every Sukuk issue is a form of asset securitization. This is a
long way from reality.
To date, only a very small handful of issues can
be seen as resembling the US
and European securitization model (which has, as its core features, the
concepts of true sale, bankruptcy remoteness, overcollateralization etc.).
Each and every other Sukuk issue has been
asset-based, but in fact very few have even been capable of being described as
asset-secured. The vast majority of issues revolve around an asset, or a pool
of assets, but are usually structured to ensure investors have recourse to the
full faith and credit of the issuer, rather than restricting their rights to
the asset or assets incorporated in the structure of the issue.
This is not to say that asset-backed issues or
true securitizations are not possible in a Sukuk format. Far from it — Islamic
fi nance is a prime candidate for such structures (and this is discussed in
greater detail below). However, in particular in the GCC, the market is still
some way from seeing such issues.
Development is in many cases hampered by the lack
of the necessary legislative framework in the relevant jurisdiction, although
it is widely expected that further mortgage-backed securitization deals will be
seen from the region in the near future.
One particularly interesting sector is the
housing market in Saudi
Arabia , where a long-term shortfall in the
housing supply is being addressed by an expansion in residential real estate
development and a corresponding need for an increase in residential mortgages.
The Saudi government has responded by announcing
amendments to domestic legislation to further the home loan sector and, in
parallel, to initiate the steps needed to develop securitization laws. It is
foreseeable that in the relatively short-term, fi nancial institutions in Saudi Arabia
will need to resort to the securitization market to meet local demands.
Elsewhere in the GCC, the massive expansion in
the real-estate sector in the UAE, and Dubai
in particular, has led to a different kind of pressure. Huge real-estate
requirements are regularly estimated to exceed US$500 billion and
credit-enhanced structures are required to ensure the requisite support from
the international fi nancial community, which to date has not fi nanced the UAE
real-estate sector in the volumes required for future projects.
Again, the securitization market is one possible
tool that could be used to enable the required developments. Islamic mortgage
providers are leading the market and it is in all likelihood the Islamic
securitization market which will provide the solution.
Issuers will, however, also have to be aware of
the challenges that are facing the Islamic sector. At the top of the list of
concerns is the fragmentation of Shariah interpretation across the GCC and
within each jurisdiction as well. At the heart of the matter is the fact that
each Islamic institution has its own Shariah supervisory board that is required
to review all activities of that institution, including investments.
However, there is more than one mitigating factor
at play. The lack of standardization is at the top of the agenda of almost
every multinational supervisory organization operating in the Islamic fi nance
sector, led by the Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI) and the Islamic Financial Services Board.
Harmonization is also one of the key
considerations for the leading indices and regulatory bodies in the region, in
particular the Central Bank of Bahrain .
An increasingly important factor is the fact that a very small number of
leading Islamic scholars are attached to an increasing number of Shariah
supervisory boards.
De facto, this is leading to a greater uniformity
of interpretation across the GCC (perhaps with the exception of Saudi Arabia ,
where it is generally acknowledged that a more conservative” school of Islamic
interpretation applies).
Another prime consideration is not to leave the
Islamic investors behind. The project fi nance sector has already seen the
phenomenon of carefully structured Islamic tranches that nevertheless fail to
attract any support from Islamic banks (e.g. the only Islamic players in the
Dolphin Energy tranche illustrated above were Islamic “windows” of conventional
banks).
In an era of double-digit returns for investors
in the private equity and real-estate sectors, it cannot be ignored that
investors in the GCC — whether Islamic or conventional — are able to pick and
choose their investments, with return at the top of their list of deciding
factors.
This ties in to one of the other main current
criticisms of the Islamic Sukuk market, namely that there is very limited
secondary market activity, which means it is diffi cult for issuers to get a
clear view on how its risk is seen — and priced — in the market. The Sukuk
investor base is characterized as a take and hold market and this is due mainly
to
the fact that the level of primary issuance has yet to achieve critical mass.
the fact that the level of primary issuance has yet to achieve critical mass.
Investors are reluctant to trade the assets they
have simply because there is no established pipeline of issuance. Equally,
however, there can be little doubt this will change in the future, given the
expected growth in issuance volumes in the short to medium term.
And last but far from least, a prospective issuer
must investigate the tax consequences likely to arise from a proposed issue.
This is essential, given the asset-based nature of Islamic fi nancing and the
changes of ownership entailed in the various modes of Shariah compliant
fundraisingfundraising.
The GCC is hardly known for its excessive
taxation (although zakat and withholding tax must always be taken into account)
and, in addition, the principles of Shariah are — to a greater or lesser extent
— recognized by or incorporated in the local jurisprudence.
In Southeast Asia, Malaysia has led the way in
introducing specific legislation designed to ensure that Shariah compliant
issues are treated on an equal footing from a taxation perspective with
conventional debt issues (indeed, the authorities have quite clearly enacted
legislation designed to stimulate the sector, with the result that more than
80% of Malaysian capital market issues are Shariah compliant).
Outside the GCC and Southeast
Asia , tax and regulatory hurdles will have to be jumped in each
jurisdiction in order to ensure issuers obtain the optimal tax treatment for a
particular issue. It is crucial for a transaction be treated as a debt-raising
and not a transfer of ownership in the relevant asset(s), which could otherwise
trigger capital gains (or losses) or other property-related taxes and duties.
In certain jurisdictions, such as the US , is possible
to seek relief from the relevant authorities on a case-by-case basis. In terms
of the most advanced legislative framework, it is the UK that has most explicitly
embraced Shariah compliant structures in order to facilitate fi nancial
services to be offered to the signifi cant Muslim community in that country.
The then Chancellor of the Exchequer went on
record in 2006 in announcing the Labour Government’s “long-term ambition to
make Britain
the gateway to Islamic fi nance and trade”. This ambition was stimulated by the
recognition that “Islam is Britain’s second-largest faith, and Muslims are
involved in every walk of British life”, evidenced by the healthy growth rate
in the Islamic mortgage market in the UK and the fl exible and supportive
approach adopted by the Financial Services Authority in its licensing of the
Islamic Bank of Britain and the European Islamic Investment Bank.
More recently, the UK government has enacted
legislation to facilitate not only Islamic retail products, but also commercial
and wholesale banking products with its development of the concept of
“alternative fi nancing arrangements”. For example, the Finance Act 2005
permitted Ijarah structures to be extended to commercial property, while the
Finance Act 2006 widened the ambit even further to Wakalah and “diminishing
Musharakah”.
Legislation has also been passed (in the Finance
Act 2007) allowing Sukuk issues to be treated for the tax purposes of both
issuers and investors in the same manner as conventional bond issues.
(By David Testa, Gatehouse Capital)
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