Monday, January 24, 2011

Can Western corporates take advantage of sukuk?

The news that the UK government will not issue sukuk because they don't offer "value for money" is not surprising. A similar conclusion was reached earlier and it has been nearly four years since the government issued its report on the possibility of issuing sukuk. However, I agree with John Sandwick, who is quoted by Bloomberg: "This will discourage other governments from selling sukuk[...]If the U.K. says that sukuk aren’t value for money, it’s likely other governments may reassess their positions, and the number of sovereign issuers new to Islamic finance may drop."

It is a continuation of slower growth back in the sukuk market outside of Asia, where much of the recent issuance has come from. The idea of taking advantage of the latest hot trend in finance (which Islamic finance was in 2006 and 2007 and even into the first half of 2008) is no longer the biggest appeal post-recession where finance is more difficult to come by for all issuers, including some sovereigns. This focus on value for money is not necessarily a negative for Islamic finance because it should force the industry to develop more standardization in the lower-cost 'basics' like ijara.

The movement towards more simplified sukuk will put the focus on attracting new, quality issuers and will make it appear less imposing to issue sukuk compared with conventional bonds. With continuing liquidity flowing into the GCC, this will generate some additional demand for sukuk, so long as investors do not become wary of the sukuk structures used. This further supports the move towards less complex sukuk. The opportunity may not be missed as well as the International Islamic Financial Market is reportedly working on a standardized asset-backed sukuk master agreement to simplify issuance (and reduce costs for issuers).

This is a very positive development for Islamic finance. Before the crisis, the focus was on creating the next new sukuk structure; pre-IPO, convertible, etc. These were great in terms of generating publicity for the structuring firms and the issuer (as well as significant fees), but it did not facilitate easy understanding of how Islamic finance worked among new issuers. They could be assured that innovation was continuing, but not that this innovation was creating value for them if they chose to issue a sukuk.

The ultimate issue for Islamic finance investors is that there remains a stark lack of diversity among issuers in quality, geographical location and the term of the sukuk (most are under 10 years with a majority maturing in 5 years). The investors are not given the opportunity to diversify their holdings, which makes the fixed income component of their portfolio hard to fill and may lead them to substitute this portion through conventional bonds, cash, short-term placements using wakala or murabaha, or real estate. They are looking for diversification and this requires more than just new issuers from the GCC and Malaysia.

This presents an opportunity for Western issuers with solid balance sheets to tap a new source of liquidity and diversify their funding sources. However, unless the structure used is simple, affordable and legally secure (for both investors and issuer), it will be difficult to convince them to tap a market that is unfamiliar when these companies can issue conventional debt locally at low spreads over Treasuries. It is not, however, an impossible task. Gatehouse Bank and Bank of London and the Middle East each say they will facilitate the issuance of GBP200 million for European issuers. GE Capital, which issued a sukuk in 2009, is planning another in 2011.

The GE Capital sukuk (for which I provided a brief summary) was notable in that it converted conventional airplane leases to be Shari'ah-compliant by stripping out non-conventional aspects (payments from which were donated to charity). These sukuk were eventually unsecured debt (asset-based), but a similar method could be used to broaden the assets which could be used for asset-backed sukuk.

There is much to be done to make sukuk less of a foreign concept and to reduce the costs to issues, but global (particularly Western) corporate issuers could provide a boost to sukuk issuance and also provide needed diversification for investors.

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