Sukuk: debt vs. equity, Islamic finance assets grew 2008 to 2009

Reuters has a good article on the debate around sukuk and whether they should be more akin to equity or debt. The article includes an update on the progress of the East Cameron bankruptcy. Sukuk holders may propose a reorganization that would give them an equity interest in the underlying company and their counsel expects that East Cameron will emerge from Chapter 11 bankruptcy early next year. The debate over sukuk is one that has been particularly in the forefront over the past two years following the AAOIFI ruling that prohibited mudaraba and musharaka sukuk from including repurchase agreements to redeem them, as well as by several high profile sukuk defaults.

The debate will continue, but the likely end result will probably be a compromise between the sukuk being debt or equity. They will likely continue to be arranged with fixed or variable payments based on an underlying interest rate, making them more like debt. However, they will also probably include more equity-like features that have been included in some recent sukuk. They will also probably move away from the asset-based structure that transform them into unsecured obligations of the issuer. This means that the asset used in the structuring is transferred to the SPV issuing sukuk with a purchase obligation clause at the maturity or in cases of default that gives investors no claim to the asset, only a claim on the issuer.

In contrast to asset-based sukuk, asset-backed sukuk effect a transfer of the asset to the SPV that gives the sukuk holders legal claim to the asset if there is a bankruptcy of the issuer or default on the sukuk. This was the structure of the East Cameron sukuk and one of the issues tackled by the bankruptcy court was whether the sale of the overriding royalty interest to the SPV was a 'true sale' or whether it was only done to create a financing transaction. The court documents suggest that it is the former, which if finalized would create a significant precedent for future sukuk issues in the U.S. A Reuters Q&A provides a similar overview of sukuk and the East Cameron sukuk in particular. A Factbox shows a few examples of asset-based and asset-backed sukuk. Reuters also provides a brief timeline of developments in the sukuk market.

Reuters also presents the views of two experts, an Islamic finance lawyer Megat Hizaini Hassan and the CEO of a Malaysian ratings firm.

A report by The Banker magazine finds that there are assets of $822 billion in Islamic banks and Islamic windows at conventional banks, up 28.6% from the $639 billion estimated as of 2008. The industry, however, continues to miss growth opportunities because Shari'ah-compliant products are more expensive. At a conference in France, the CEO of Renault Nissan Carlos Ghosn said that company would raise money from Islamic investments if it were more cost competitive.

Other News

• The IFC sukuk could prove to be a significant issue despite its small size because it was listed exclusively in the Gulf and the arranging syndicate included mostly Gulf-based firms.
  
• Thailand continues to consider a sovereign sukuk, although it remains at least two years out because of a lack of regulatory changes needed to facilitate the issue.
  
• The Wall Street Journal wrote an article about the need for more trained professionals in Islamic finance and the growth in the number of business schools which offer programs in Islamic finance.
  
• The Irish newspaper The Independent has two articles about Islamic finance including one about how Ireland is considering changes to laws to attract Islamic finance.
  

Regulation in Islamic finance, Questions remain about Dubai GREs

Malaysia's prime minister Najib Razak said that the Islamic financial industry needs strong regulation to ensure it avoids future crises. This has been an area where the industry has been slow to recognize its susceptibility to a similar financial crisis that occurred beginning in 2007 in the conventional financial industry. For too long, there were many articles talking about how the Islamic financial industry was 'immune' to crisis because of the way it operated. I have been pointing out that there are some aspects of the Islamic financial system (including lack of deposit insurance and a true 'lender of last resort') that could even make Islamic finance more vulnerable to a crisis if there was a serious loss of confidence in one or a few large Islamic banks. It is good to see that there is a greater recognition of the need for regulation to prevent either poor risk management or damaging innovation from creating a situation where there could be a crisis. Now, all that needs to happen is for these regulations to be adopted. That could take a while, although the Islamic FInancial Standards Board has begun discussing liquidity standards that would address one potential area of systemic risks in Islamic finance caused by the difficulties of Islamic banks in managing liquidity and asset and liability maturity mismatches.

Some of the proceeds from the recent Dubai sukuk, which raised $1.93 billion, will be used to pay the maturing $1 billion sukuk from the Dubai Civil Aviation Authority, which matured today. The UAE said that the timing of the issue of a $10 billion bond planned by Dubai that may be used to redeem the Nakheel sukuk maturing next month will "depend on the needs at the time" according to the Minister of Economy. In a contrary development, ratings agency Moody's Investor Service downgraded five government related entities (GREs) because the government after the Dubai finance department relinquished its obligations to cover the entities' debts. Although the GREs are not part of the government and do not have a government guarantee, they are closely tied to the government and any defaults would likely have repercussions on the Emirate's perceived creditworthiness.

Other News

• Amlak and Tamweel, the two large Dubai-based Islamic mortgage firms will be merged beginning in January with their investors owning one-third of the resulting bank.
  
• Gulf Finance House is planning on converting into a commercial bank from an investment bank and will issue $100 million in a convertible Islamic instrument. GFH issued Macquarie Bank with a $100 million convertible murabaha earlier this year.
  
• The ISDA-IIFM template for Shari'ah-compliant derivatives will be released either this year or early next year.
  
• The IFC listed its $100 million sukuk on the Bahrain Stock Exchange and NASDAQ Dubai.
  
• The U.S. is selling the building in which its embassy has resided in London to Qatari Diar, which recently began the process of issuing sukuk to fund its European acquisitions. Al Salam Europe, the European unit of the Bahraini firm is also planning on expanding its investments in Europe with real estate and private equity investments planned by January.
  
• Islamic finance could continue its rapid growth and see total assets of $4 trillion in 8-10 years according to the CEO of Doha Bank in a speech recently.
  

A scholar raises issues of copy-cat products, IFC sukuk, South Korea considers sovereign sukuk

Shari'ah scholar Dr. Hatem El-Karanshawy, a former director of the Central Bank of Egypt, cautions the Islamic finance industry on 'Islamizing' products that do not inherently fit with Islamic principles. He says that venture capital can fit in well with few modifications. The growth in Islamic finance has been accompanied by 'copy-cat' versions of conventional financial products using contracts that allow Shari'ah scholars to approve them. In many cases, these products do provide value, but as I mentioned in a blog post two months ago, there is a need to keep in mind whether new innovation is beneficial in Islamic finance just as in the conventional financial industry.

The International Finance Corporation's $100 million sukuk is receiving favorable coverage from Arab News, which points out that many Arab countries have not yet stepped into the Islamic capital markets to raise funds. In addition to the most recent sukuk (and a Ringgit-denominated one it issued in 2004), the IFC has been involved in several other Islamic finance transactions over the past few years.

South Korea appears to be the latest non-Muslim majority country to work to attract Gulf money by passing laws that put Islamic finance including sukuk on equal regulatory and tax footing to conventional bonds. The country recently announced a list of state-owned companies that the government is looking to privatize and which it seeks Gulf investment. In addition, the government is considering an $80 billion initiative for environmentally-sustainable areas of growth. The government is also on a roadshow to gauge interest in a $500 million - $1 billion sovereign sukuk.

Other News

• HSBC is considering subscribing to the second $10 billion tranche of bonds issued by Dubai. The first tranche was purchased by the UAE central bank.
  
• Islamic banks' assets grew by 66% between the end of 2007 and the end of 2008 according to the Union of Arab Banks.
  
• The NY Times published an article on the growth of Islamic finance in universities' curricula.
  
• According to Standard & Poor's, the performance of Shari'ah-compliant equities lagged in the third quarter, a period when a lot of the leading stocks were financials.
  
• Bahrain-based Al Baraka plans on spending $30-$50 million on a bank acquisition in Indonesia. The bank also says that the IPO of its Syrian unit is oversubscribed.
  

Why are sukuk in the GCC issued with short maturities?

Mubadala, the Abu Dhabi sovereign wealth fund says that there needs to be a better developed secondary bond market for longer-term bonds to come to market. It also pointed to the need for a 'strong local bid'. Given that the GCC is the source of a large share of the sukuk issuance, and most sukuk outside of Malaysia are of maturities of 5 years or less, this poses a question of whether the Islamic financial industry can step in to fill the gap.

The sukuk secondary markets are notoriously illiquid, although there has been an improvement in this area as the number of new issues has declined in the past year or two. With a shortage of new issues, there has been an uptick in the trading of outstanding sukuk in the secondary markets. There has also been the nascent steps towards provide more opportunities for secondary market trading with the launch of bond and sukuk trading on the Saudi exachange Tadawul. However, even with these steps, there are few listed sukuk, with most trading on either NASDAQ Dubai (formerly the Dubai International Financial Exchange) or the Bahrain Stock Exchange.

As I have described before, the secondary market for sukuk has been caught in a chicken-or-egg problem (which came first?). During the boom times, there were a number of new issues, most of which were heavily oversubscribed. A decent proportion of these sukuk were listed on secondary markets theoretically giving investors who were not able to subscribe in the offering the chance to pick them up in the secondary markets. However, there wasn't much activity in the secondary markets.

This can be ascribed to two things. First, the secondary markets weren't active because the secondary markets weren't active. Although a tautological argument, it was true. If you subscribe to a sukuk and receive an allocation, then sell it on the secondary market, you would generally hope to be able to take the proceeds and purchase a new sukuk to replace it. In an illiquid secondary market, for one you could probably not receive what you perceive to be the fair value, but also, you would likely have to overpay for a replacement. Without the benefit of a market maker in the sukuk, the gap between bids and offers in the market perpetuated the illiquidity.

Second, the continuing stream of new issues made it less beneficial to chase the offer in the secondary market if there was a chance of getting in on a newly issued sukuk. Why pay up if there is a chance that another similar sukuk might come along that you might be able to receive an allocation at par?

However, this equation changed after the financial crisis when credit was generally scarce and expensive and there were few companies willing to issue new sukuk. In addition, the outstanding issuers were affected by the growing economic crisis so that their ability to repay came into question (in some cases, they defaulted on their sukuk). The investors in these sukuk, either through concern over the sukuk or their own need for cash, became more willing to participate in the secondary markets.

This created some market turmoil, with many sukuk trading far below par and yielding higher than may have been justified by the fundamentals of the companies and sukuk. However, it also created an opportunity for a few sukuk funds which launched over the past year to step in on the buy side of the market and create additional liquidity by narrowing the spread between the bid and ask of listed sukuk.

No sukuk exemplifies this transformation perhaps more than the Nakheel sukuk which matures in December. In an illiquid market, with concerns about Nakheel's ability to repay, the bond traded down to nearly 60% of its par value even though the payment on maturity, if made, would be nearly 115% of par. Since reaching this point, the sukuk has become more actively traded and has rebounded in the trading price to greater than par. Some of this rebound was due to the fundamental ability of Nakheel to pay, albeit with support from the Dubai government, but some could be chalked up to the greater liquidity and the entrance of bidders for the sukuk.

To be clear, the sukuk market remains illiquid in many listed sukuk names, but there has been a greater level of activity in secondary markets as of late. Returning to the initial point of what is needed for longer-term maturities, it is generally the case (even in US Treasuries, some of the most liquid bonds in the world) that longer maturity products are less liquid and more volatile in price than shorter-dated bonds. Without a liquid secondary market for shorter maturity bonds and sukuk, it is unlikely that investors would purchase longer-dated sukuk.

Mubadala's point is well taken and the sukuk market, largely as a result of external events, has begun to liquify. This is a necessary, but probably not sufficient, precondition for the introduction of longer maturity sukuk. The resolution of sukuk through cases of default will also go a long way towards reassuring investors that they will not be trappen in a 10-year or longer sukuk regardless of what happens. To see a possible future, the experience of Malaysia is instructive. The Malaysian secondary markets are active and there have been numerous resolutions of sukuk defaults. Consequently, there have been several longer-dated sukuk--for example, the Cagamas residential mortgage-backed securities which have maturity dates of over 10-years, something that has not happened in the GCC...yet.

Other News

• The performance of the Dow Jones Islamic Market Indexes for October are now available.
  
• The IFC sukuk was priced at 25 basis points over mid-swaps, which is the tightest pricing yet for a sukuk, although the sukuk received a higher pricing (by 10 basis points) over what conventional debt issued by the IFC would be priced at.
  
• Germany's financial regulator jumps into the mix of European countries wanting to attract Islamic finance shortly after France passed laws defining the rules for Islamic financial products, but far behind the U.K., which has so far led the EU in its accommodation of Islamic finance.
  

Dubai issues $1.93 billion in sukuk

Dubai announced the results of its 5-year sukuk issuance today. There were two tranches, one for $1.25 million of USD-denominated sukuk and the other was $680 million in AED denominated sukuk. The sukuk were priced at 375 basis points over mid-swaps. Bloomberg reports that the USD sukuk were priced to yield 6.39%. The AED tranche are floating-rate notes based on a spread over EIBOR, priced to yield 5.65% according to the same Bloomberg article.

The nearly $2 billion issuance is the first issuance of bonds by Dubai since April 2008, before the real estate markets in Dubai began to tumble in the wake of the global credit crisis. There are a number of maturing debt issues--some $6.8 billion in the fourth quarter of 2009--none more crucial to Dubai's reputation than the $3.52 billion Nakheel sukuk. The Nakheel sukuk is not officially sovereign debt, but it is a government-related entity guaranteed by Dubai World, the government-linked holding company.

Nakheel, the developer of the palm-shaped islands off the coast of the Emirate, has run into severe difficulty following the property crash in Dubai, and has confirmed it has received money from Dubai's Financial Support Fund, although the amount has not been disclosed. Although the funds raised in this sukuk issuance will go to the government, in part to pay maturing sovereign sukuk, there will soon be another $10 billion bond issuance, a part of the $20 billion bond program that was started with a $10 billion bond issued to the UAE central bank.

Nakheel has been reported to be in restructuring talks over the $3.52 billion sukuk, which could include a tender offer involving equity. However, a number of investors have publicly criticized the possibility of recieving equity for their investment. Due to the deferred lease payments throughout the sukuk, the total amount payable on maturity is around $4 billion. Were the Nakheel sukuk to not be fully redeemed upon maturity, it would send a bad signal to the bond markets about the credit-worthiness of other highly-indebted government-related entities and could affect the Dubai government's ability to raise future debt.

However, the ability of Dubai to access the international capital markets, as well as the support from the UAE central bank through the earlier bond, sends a positive signal that Dubai will not allow Nakheel to default on its debt. The outcome is still uncertain, although the secondary market trading in Nakheel suggests that there will be a favorable outcome. The latest pricing is 107 - 108.5 as of October 28th. The final maturity value of the Nakheel sukuk is near 115.

Other News

• Indonesia plans its next sukuk in mid-November. The first two auctions have seen investors demanding higher yields. The first auction had all bids rejected and the second auction saw less than 5% of the total bids accepted.
  
• Jordan continues to consider issuing a sukuk, although the discussions are in an early stage.
  
• Next year may see $20 billion in sukuk issuance according to a poll. The issuance was $9.3 billion in the first seven months of 2009. The total sukuk issuance this year could be around $15-17 billion. However, with a pipeline estimated at $45 billion, this would be less than some expect.
  

Sukuk markets recovering, IFC sukuk listed in Dubai and London, Islamic asset management faces a 'chicken-or-egg' problem

The sukuk market is expected to recover following signs that Nakheel will avoid default and GE Capital Corporation, which has a joint venture with Abu Dhabi-based Mubadala, was reported to be considering issuing a sukuk. The recovery in Nakheel's sukuk have come following the $10 billion in bonds issued by Dubai and the prospect for the Emirate to issue $6.5 billion in bonds and sukuk. The sukuk-reported to be $2.5 billion of this amount-are reported to be priced near 6%. The funds from the bond and sukuk issuance are expected to be administered by the Dubai Financial Support fund, which has provided some assistance to Nakheel.

With the listing of the World Bank Group's IFC sukuk, NASDAQ Dubai expects the sukuk and bond markets to pick up before the IPO market. The sukuk will be listed on both NASDAQ Dubai and the London Stock Exchange and is rated Aaa by Moody's.

The Islamic asset management industry faces a 'chicken-or-egg' problem as the industry has a shortage of investments to choose from, particularly in the fixed income area, while there are few investments available because of questions about the strength of demand. The increasing involvement by governments is a double-edged sword, notes an article from Reuters. Governments can provide a source of issuers willing and able to issue sukuk, but could crowd out other issuers, particularly lower-rated issuers. So far this year, roughly 80% of sukuk have come from government issuers and many of the others were issued by high-grade corporate issuers.

Emirates Business 24/7 has an interesting article about the debate over standardization in Islamic finance. There are many views on how standardization should happen, whether it should be a goal at all and what aspects of the industry should be standardized.

Other News

• The International Swaps and Derivatives Association (ISDA) is expected to release guidelines on Islamic derivatives, and these could come by December. The standardized agreement, being jointly developed by the ISDA and the International Islamic Finance Market (IIFM), would provide a standardized contract for Shari'ah-compliant hedging products.
  
• The opening of the country's first Islamic bank led German paper Das Spiegel to write a good article that provides an overview of the industry's development.
  
• Tamweel, the troubled Dubai-based Islamic mortgage company, made a periodic payment on its sukuk due in 2013.
  
• The Irish Revenue Service has clarified its rules on the taxation of Islamic finance products and a summary is available from Arab News.
  
• The CIO of CIMB-Principal Islamic Asset Management Dr. Zeid Ayer believes that Brunei should open its sukuk up to international investors to broaden the base of investors. The sultanate issues sukuk despite large oil reserves and little need to raise financing as a way to promote the growth of its Islamic finance industry.
  
• The results of an Islamic Finance Perceptions survey are summarized in an article.
  
• As Malaysia issues RM3 billion ($888 million) in sukuk, it has also extended the tax exemption on Islamic financial products to 2015 that have helped the industry grow rapidly in the country.
  

Dubai wades back into international capital markets, sukuk coming back or are defaults too strong a headwind for the next year

Dubai Civil Aviation may issue sukuk and conventional bonds to refinance $1 billion in debt maturing in November, in signs that Dubai may be re-approaching the sukuk and bond markets despite uncertainty about the level of debt in government-related entities like Dubai World and Nakheel, which has a $3.52 billion sukuk maturing in December. The ability of Dubai to tap capital markets has been buoyed by the return of risk appetite among investors as well as the repayment a month early by Nakheel of over $1 billion in bank debt extended earlier this year. However, there is still skepticism about Dubai's ability to restructure its debt and government-related entities.

A senior executive at Nomura believes that there will be a further uptick in the issuance of new sukuk by corporate and sovereign issuers in the next 18 months. The issuance through the end of September was $13.5 billion, primarily out of Saudi Arabia, which accounted for 44% of issuance and included sukuk from Saudi Electric Company and the Islamic Development Bank. Other more recent data shows that $18 billion in sukuk have been issued so far this year.

The sukuk market remains in a state of flux because of the unresolved issues about asset-based and asset-backed sukuk, which is discussed in an article in the Financial Times. The important point brought up in the FT article is that not all sukuk transfer ownership of the underlying asset to the investors. In many cases of asset-based sukuk, the asset is transferred to the SPV that issued the sukuk but with a repurchase agreement that requires the issuer to repurchase the asset in the case of default. This means that the asset ownership transfers back to the company and the sukuk holders are given essentially an IOU that the company will redeem the principal of the sukuk in a default. This is different from an asset-backed sukuk where ownership is transferred to the sukuk holders, who then have legal right to the asset. This was the case in the East Cameron sukuk, which was based on an overriding royalty interest that entitles the sukuk holders to a share of production in the underlying lease. Other sukuk transfer ownership of a tangible asset (the ORRI is legally recognized as real property in Louisiana, but is not a transfer of the underlying properties being drilled, which are leased from the US government).

Other News

• The World Bank's IFC sukuk price guidance is 35-40 basis points over 5-year US Treasuries.
  
• Jordan is considering offering sukuk to cover its growing budget deficit.
  
• A columnist in the Guardian discusses the role of regulation and religion in finance.
  
• Emirates Development Bank, the government funded bank that is anticipated to take over Islamic mortgage lenders Amlak and Tamweel is one step closer to launch, although the fate of Amlak and Tamweel remains uncertain.
  
• Saudi Electric may tap sukuk markets again to finance a new contract the firm signed.
  
• There is a nice article is in a Minnesota paper about local organization African Development Center, which offers Shari'ah-compliant home and business financing.
  
• An English paper has a good article about the growth of Islamic finance.
  
• Korea needs incentives for investments in sukuk, according to the head of Doha Bank's representative office in the country.
  
• Islamic Finance Resources links to a recent paper on the history of Islamic finance in France, a relevant article given the recent French law about Islamic finance that was struck down by the constitutional court on procedural grounds.
  
• Ithmaar is offering a rights issue as well as a 5-year mandatory convertible sukuk.
  
• Gatehouse Bank, based in the UK, joined Paris Europlace, a Paris-based organization that promotes the French financial industry and established an Islamic Finance Commission in December 2007.