One of the areas that has been picking up in newsflow in Islamic finance is the launch of a number of sukuk funds that are, in part, motivated by distressed situations of several sukuk issuers in the past year. These funds, in part, are aiming on capitalizing on the availability of sukuk at possibly overly distressed prices. The financial crisis led to problems at institutions and companies which either held or issued sukuk and it appears that this has led to greater secondary market activity in sukuk.
However, the formation of sukuk funds should not look exclusively towards just the distressed assets, but can become an integral part of the Islamic finance marketplace by increasing secondary market activity in sukuk now and after the defaults have faded from th e headlines. They can provide a valuable part in the new issuance of sukuk and complement takaful providers and banks, which tend to hold sukuk on their books until maturity. Together, these two groups can be instrumental in restarting the market for new sukuk issuance as economic conditions improve.
The long-term holders (banks and takaful providers) and the shorter-term investors (sukuk funds) can provide a source of reliable demand for both primary and secondary sukuk transactions. At this point, however, the sukuk funds are in a rather nascent stage. If they grow to provide more demand for secondary market trading activity, they can have a significant impact on the primary market for new sukuk. By creating a more liquid secondary market for sukuk, the pricing of new sukuk may come down by reducing the premium demanded by investors for the illiquidity in the secondary markets now.
A reduction in illiqudiity premiums will make it (other things being equal), more likely that issuers consider sukuk instead of conventional bonds for those issuers that are ambivalent between the two forms of debt financing. These issuers, who may not be motivated towards sukuk issue strictly by their need for Shari'ah-compliiant financing. These issuers are likely to be more diverse than the current sukuk issuers, who are often banks and real estate companies, both in industries that have been hit the hardest by the recent credit crisis and economic downturn (and who are therefore least likely to have significant growth into the future).
The GE Capital sukuk was one example of where the diversity can come from. While GE Capital is a financial institution, it is attached to a large, global industrial firm, which may view the GE Capital sukuk as a test case of an alternative source of financing. Many other large, global companies may also look to the GE Capital sukuk as a test case for tapping a new source of capital to diversify their sources of funding. The credit crisis showed, among other things, that they can be hurt significantly if financial markets seize up based on financial conditions in one country.
One of the areas where this financial crunch was most acute was in the commercial paper markets where short maturities meant the debt had to be frequently rolled over and where the primary buyers of this debt were money market funds connected to the very financial institutions facing the most severe pressure. Thus, diversifying their funding sources away from the domestic commercial paper market should be a high priority.
If some of these issuers can be convinced that plain vanilla sukuk products represent a relatively stable source of funding, they may be willing to become regular issuers of sukuk alongside their conventional bond programs. This can bring in much greater volumes of new sukuk that will provide banks and takaful, as well as sukuk funds, with new sukuk in which they can invest.
A growth in new issuance from global companies also benefits the industry and the consumers who look to it for Shari'ah-compliant alternatives to conventional financial products. For example, although the two largest Islamic equity funds (the Amana Income and Growth funds) are based in the United States, there are no funds providing fixed income investment opportunities in the U.S., although a small mutual fund company, the Azzad Funds, has filed documents to start a fixed income Wise Capital Fund. The hold up for that fund, and others like it, is a shortage of investment opportunities. These funds don't necessarily need sukuk, they can invest in murabaha or ijara contracts that are held to maturity, but sukuk are preferable because of their ability to be liquidated if necessary.
The shortage of Islamic fixed income funds makes it extremely difficult for the average Muslim investor within the United States to construct a portfolio that meets their long-term needs. Few investors find portfolios composed entirely of equities to be suitable for their risk tolerance and investment goals. They need to balance the allocation within their portfolios between equities, fixed income and other asset classes and right now, they are unable to do so.
There are a number of areas where sukuk funds can be instrumental in expanding the sukuk market and also in providing for the needs of Muslim investors, whether high-net worth, institutional or the average Muslim retail investor. This should be an important area for the industry to focus on.