Saturday, May 30, 2009

S&P Islamic Finance Outlook (part 3)

The Standard & Poor's report (which I earlier discussed with a focus on Islamic banks and profit-sharing investment accounts) also goes into considerable depth on sukuk. I have organized this part of the summary into a few important categories: current state, near-term outlook, benefits from the sukuk structure, the use by Islamic banks, future developments, uncertainties and the secondary markets.

The Standard & Poor's report does a good job of describing the challenges that have led to a sharp drop in the number of new sukuk issuance and highlights some key uncertainties that both restrict issuance and raise the costs associated with issuance. The solutions, unfortunately, are quite difficult and are not likely to be realized quickly. However, the report is generally positive on the future of sukuk as a key part of the growth in the Islamic finance industry. Because S&P provided so much description and thoughts on many aspects of sukuk, I decided to structure it more like my summary of the State Street report, with many direct quotes from the report.

Current state

The S&P report describes how the sukuk market has mirrored the conventional bond market. In the secondary market, at least, the performance has been in the same direction (widening spreads), but the magnitude has been much greater. I have explored a few bond issues in particular (JAFZ and Nakheel) and while there are some factors that would be expected to raise yields, there are also some issues that are reflections of the illiquidity of the secondary markets for sukuk (discussed below). In terms of new issuance, the shift to smaller sukuk and towards local currency seems fairly natural given the lag between the economic conditions in the U.S. and other Western countries and those in the GCC. The market for risk dried up much earlier in the former than the latter and therefore there was less demand from investors looking for global currency sukuk. Sukuk issuers turned inward towards the (smaller) local currency markets.

"Credit spreads on sukuk have followed the same trend as for conventional bonds, with a sharp widening in the past 12 months. The average size of the sukuk issued last year declined significantly, partly due to the lower appetite of investors. At the same time, the U.S. dollar lost is place as the currency of choice for sukuk, with only about 10% of issues raised in this currency. Standard & Poor’s expects the sukuk market to continue being skewed toward issuances in local currencies, at least in the foreseeable future. Once global markets return to normal, dollar-denominated sukuk issuance will pick up again."

Near term outlook

"The market’s estimates of the current pipeline of potential sukuk issues are in excess of $45 billion. In our view, several factors support the sukuk market’s sustainable growth, including the increasing popularity of Sharia-compliant financial instruments, governments’ increasing openness to Islamic finance around the world, substantial investment and financing needs in the Gulf, and issuers’ desire to tap investors from the Middle East and Muslim Asia."

The healthy pipeline of sukuk indicates that when markets return to normal, there should be a pickup of new issuance hitting the market. However, since the GCC has lagged behind the rest of the world in entering the economic crisis, this recovery could be later than S&P expects (second half of 2009 and into 2010). However, because of the illiquidity in the secondary markets (mostly holders of sukuk being unwilling to sell), there is a bit of a chicken-or-egg problem. Holders of sukuk are unwilling to sell because they do not expect to be able to replace the sold sukuk with another sukuk. Newly issued sukuk are in short supply and secondary markets also suffer from a lack of supply. New issuance are scarce in part because global credit markets are stressed which has increased the cost of all debt and sukuk are by in large priced using conventional bond markets (LIBOR, for example). One factor which could 'unlock' new issuance is the recent rise in oil prices (WTI closed around $66 and Brent at about $65 on Friday). This means that additional liquidity has begun to flow again into the GCC and could lead to enough additional demand so that sukuk are priced with lower spreads over LIBOR/EIBOR than they have been when liquidity in the GCC was constrained by oil prices in the $30-40 range.

"In our experience, the costs of structuring and issuing sukuk remain high relative to conventional bank loans and bond issuance. Legal and accounting fees contribute to this higher cost structure, as does uncertainty regarding the perceived risk associated with these instruments. Moreover, the lack of standard structures, perceived differences in approach to sharia compliance, and a relatively illiquid secondary market may, in our view, discourage investor appetite for sukuk."

These risks (discussed in more detail below) are the growing pains for the industry. The are unlikely to abate quickly and are natural for something as new as sukuk which only became common within the last 5 or 6 years. Right now, sukuk largely mirror conventional bonds, but they do so in a way that is slightly different in terms of contractual form. This adds a risk that the differences will lead to different legal treatment. The Shari'ah-compliance issue poses a slightly different risk. If a sukuk were issued and then the structure were ruled to not be Shari'ah-compliant, it could significantly affect the price because much of the demand for sukuk comes from investors who would shun a financial product if its Shari'ah-compliance were in doubt. This is probably accentuated right now because the investors who saw sukuk as an alternative asset class and were not concerned about Shari'ah-compliance (or lack thereof) have taken a hit (think Western hedge funds for example). With fewer assets to invest and a pullback away from risk, the demand from this type of investors is well below where it was a year ago.

Benefits of the sukuk structure

”Furthermore, on a corporate basis it’s unlikely that there would be a significant difference in the risk component between a sukuk and secured corporate lending, assuming that the same underlying assets constitute security under the two different issues. It’s possible, however, that by having less off-balance sheet and derivative type counterparty risks, a sukuk transaction could be considered less exposed than a secured transaction with the same underlying assets.
"Ultimately, the flexibility of the sukuk instrument may hold key to it increasing its share in financial markets. Although most sukuk issues so far have been debt-like, their ability to be structured as an equity instrument through convertibility means they could access a much wider investor base than traditional loan financing.”

The difference between sukuk and conventional bonds are only beginning to take shape. Many of the sukuk in the market and many that will be issued over the next few years have bond-like structure for the simple reason that they are new and investors and issuers want to invest in familiar instruments. As investors and issuers become more comfortable with these sukuk, the industry will be able to take advantage of the flexibility of sukuk to take advantage of their quasi-equity qualities. Issuers will be able to receive financing at more attractive rates and investors will be able to invest in securities that, while resembling bonds, have the potential to offer greater returns without taking on equity-sized risks in many cases. Establishing liquid secondary markets will aid this development because it will not force investors to look at sukuk as hold-to-maturity investments and they will have more flexibility in changing market conditions.

Islamic banks' sukuk issuance

"Financial institutions are seeking to better balance their funding, especially in the Gulf where short-term funding sources typically dominate and maturities are increasing on the asset side.

The issuance of sukuk by Islamic banks is probably going to be one of the areas where supply is the most reliable in the future as Islamic banks move their liabilities towards longer-term sources. However, this supply is going to come gradually because one of the most common types of sukuk issued by Islamic banks were mudaraba and musharaka sukuk, which are still out of favor following the AAOIFI ruling which questioned their Shari'ah-compliance. Once an acceptable structure becomes more common for this type of sukuk, the supply should come as the Islamic banking industry grows.

Future developments

”In the longer term, we foresee increasing issuance of more complex sukuk with no credit enhancement mechanisms, which would fall into the second category. More generally, we expect securitization, particularly in the Middle East, to increase and to take the form of Sharia-compliant structured transactions, giving rise to asset-backed sukuk notes with limited or no guarantee from the asset originator. The tranching of liabilities, a conventional securitization tool, is still under discussion among Sharia scholars regarding compliance, although a few tranched mortgage-backed sukuk have already been issued in Malaysia and the Gulf region, as well as asset-based subordinated sukuk.”
"In our opinion, there are four important considerations that need to be addressed for sukuk financing to become a major component of project and infrastructure funding:
  • Greater clarity in transaction structures. Improved documentation, increased standardization, and lower overall complexity;
  • Consensus among Islamic scholars around the world, including better issuer and investor education about sukuk and sharia compliance generally;
  • A liquid secondary market; and
  • A more predictable legal framework. There is a lack of clarity of local law in a number of markets where sukuk issuance is prevalent. In particular, we consider that there are issues surrounding the enforceability of collateral."

The future development of the sukuk market will be a long-term process. As issuers and investors become more familiar with the types of sukuk, the prospects for investors in case of default and get a better idea of how sukuk perform in varied market conditions sukuk will become priced more competitively compared to conventional debt. Additionally, greater clarity about which sukuk are preferred by Shari'ah scholars will lead the industry towards certain structures and will encourage the greater use and (hopefully) greater standardization of these types of sukuk.


"In our view, the February 2008 announcement by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOFI), which addressed the issue of whether bonds structured with no transfer of collateral were sharia-compliant, contributed to market uncertainty. We understand anecdotally that the AAOFI's position may have prompted investors to seek a 'risk premium' for particular sukuk transactions and, consequently, to a lull in issuance. "
"Sometimes uncertainties pertaining to the legal environment surrounding sukuk issuances are simply due to the fact that the relevant legal framework has so far been untested, because the laws have been so new and defaults lacking."

All of these uncertainties will be cleared up over time, but it will take time. The AAOIFI ruling and the difficult economic conditions should force the industry to consider many different possibilities and defaults will increase the legal certainty about how investors can expect to be treated. However, until there is a longer history of sukuk with varied economic conditions, there will be a 'risk premium' associated with sukuk. The greater the degree to which industry addresses the shortage of Shari'ah scholars, either through training new scholars or reducing their workload by standardizing the 'plain vanilla' contracts, the quicker the risk premium will come down.

Secondary markets

”Standard & Poor’s Ratings Services estimates sukuk outstanding worldwide to be in excess of $76 billion at yearend 2008. Over two-thirds are unlisted, over-the- counter instruments, with the remainder listed. The number and size of listed sukuk are increasing fast, the largest being that issued by Dubai-based Nakheel Group in early 2007 for $3.52 billion, listed in London and Dubai.”
"The market for sukuk notes remains fairly illiquid because no developed secondary market exists. We understand that investments in sukuk are mainly classified as held to maturity."

As I mentioned above, the shortage of sukuk compared to the demand has caused much of the illiquidity in secondary markets. As the pipeline turns into new issues and economic and credit market conditions improve, this shortage will diminish. The standardization of contracts should also help encourage secondary markets because the pricing of different sukuk will become more meaningful in evaluating one sukuk compared with other sukuk of similar structure.

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