Sunday, March 04, 2012

How much more expensive are sukuk than conventional bonds?

The main article from this week's newsletter, which I am posting again as a PDF (though future issues will only appear on the website with a lag, so you should subscribe on the right hand of the blog) deals with the costs of sukuk.  There are also other short articles which I am not posting up on the blog. 
One of the running debates in the Islamic finance industry is the issue of cost of Shari’ah-compliant products versus conventional products.  Whether it is an Islamic mortgage, Islamic structured product or a sukuk, the conventional wisdom is that there is a premium associated with Islamic finance (which I discussed last December in a blog post). 

However, a story from Bloomberg, quoting the VP at SJS Markets Ltd., Samer Mardini, puts a figure on this premium: 120 basis points or 1.2%.  The estimate from Marini estimates the coupon required to sell 5-year sukuk at 5.5%, significantly higher than the yield on conventional bonds of the same maturity according to Bloomberg. 

Perhaps this also puts some context behind the UK Treasury’s decision to again decide sukuk don’t offer value for the cost.  In an era where debt levels are rising and there is heightened attention paid to the sustainability of debt, few Western sovereign issuers are going to opt for a more expensive option, especially if the spread over convention debt exceeds 100bps. 

The question then follows: where is the spread coming from and is there a way to reduce it?  The answer to the first question, is two-fold.  Many people would immediately point to the additional legal and financial structuring fees, and this is a contributing factor, but I think that investors demanding extra yield is probably a more significant factor. 

I place a lot of responsibility at the feet of the secondary markets and the lack of development of liquid markets for the additional cost.  This was attributed as the cause of several Indonesian sukuk auctions back in 2010, despite the rapid growth in the economy of Indonesia. Due to illiquidity in secondary markets, investors demanded a spread of 50bps over conventional bonds, which are more liquid.  The article linked above quotes a fixed income analyst at Mandiri Sekuritas: “The main problem in sukuk auctions is liquidity”. 

The liquidity issue is a difficult one to resolve, but changing conditions in sukuk primary markets (where sukuk issuance has surpassed pre-crisis levels) may indicate that at least one piece is fitting into the puzzle: supply.  If there is sufficient supply of new issues, then investors may be more willing to part with the sukuk in their portfolio because they know they can replace it with a different sukuk, deepening liquidity in secondary markets. 

While this does provide some hope, there are still other obstacles blocking the path to a narrower spread between conventional bonds and sukuk.  Even if one excludes the legal costs for structuring a sukuk, it will still be more costly for investors because each sukuk is different and the prospective purchasers will have to spend more time reviewing the structure, rather than focusing on whether the issuer is risky or not.  

There are likely to be cases where a custom sukuk is the only way to go, but there will be many more instances where it will just add cost and complexity to the issuer and to the purchaser.  I like the idea that was proposed for IIFM and Hawkamah of creating a template for an ijara sukuk.  IIFM has experience in the past creating standardized contracts (some of which have been more successful than others), and ijara sukuk are probably the most common structure for issuers. 

There is no guarantee that either a template for an ijara sukuk, nor a more liquid secondary market would lower spreads to zero, but better to tread down these paths and see if it makes an impact than to keep marching forward down the current path. 

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