In early September, the UAE emirate of Sharjah made its first foray into the sovereign sukuk market with a $750m issue. It was the latest in a series of debut Islamic debt security offerings in the Gulf, amid a frenzy of activity by sovereign and quasi-sovereign entities over recent months.

It reflects burgeoning interest in sharia-compliant instruments as a source of sovereign debt raising from some new and surprising players in the market.

The backdrop is one of healthy volumes for Islamically-structured bonds. Sukuk issuance in the GCC was up by almost 19 per cent in the year to early September, according to estimates by US ratings agency Standard & Poor’s (S&P), primarily driven by government and government-related entities hitting the market.

Sovereign growth

“The strongest growth is clearly in the sovereign space,” says Mohamed Damak, a director at S&P. “Government issuers in the Gulf have increased volumes by 111 per cent.”

Financial institutions are not far beyond, with a 94 per cent increase in issuance, according to Damak. This compensated for a 30 per cent drop in corporate issuance in the year to early September.

Gulf sovereigns are taking advantage of healthy economic fundamentals and robust appetite from investors for high-quality paper. Excess liquidity on the market, combined with increasingly attractive yields offered by sukuk, has made Islamic debt issuance a compelling proposition in 2014.

Urgent need

The underlying driver is the urgent need for new funding on the back of a substantial infrastructure and capital expenditure commitments in the region over the next 10 years. Dubai’s 2020 World Expo and Qatar’s 2022 Fifa World Cup are both likely to boost sukuk issuance.

The revived sentiment in the real estate sector is another factor in the UAE. Dubai developer Damac Properties’ $650m sukuk issued in April is a sign of heightened appetite for Islamic securities, and the company’s listing of the sukuk in Dublin suggests it is seeking a broader range of investors than those within the region.

The past three months have seen sovereign-focused transactions, which have opened up the sukuk product wider

Anzal Mohammed, Allen & Overy

The Gulf’s active sukuk programme in 2014 is part of a longer-term trend of growth in bond markets. The issuance of conventional bonds and sukuk in GCC countries has been on the rise for much of the past 10 years, climbing at rates of about 25 per cent a year to reach $42.8bn in 2012 - although there was a slight contraction in 2013 to $41.1bn. The slide last year reflected a global phenomenon, with the market expressing anxiety over US bond purchase tapering.

Global trend

This year has been a landmark year for sovereign sukuk worldwide, with debut offerings from the UK, Hong Kong and South Africa. The entry of new players such as Sharjah and major non-Islamic countries is expected to have a galvanising effect on the market. Oman, with as yet no history of sukuk issuance, is another regional government that has been mentioned as likely to launch an offering in order to fund infrastructure projects.

“The Sharjah transaction and others from new players such as South Africa and Senegal show the market is attracting significant interest from a variety of issuers now,” says Damak. “And one of the reasons why it attracts such a significant interest is the fact that issuing sukuk allows them to diversify their investor base, especially for entities that are domiciled outside of the core markets of the GCC and Malaysia.”

The Gulf is not yet a challenger to Malaysia as an issuance domicile, at least in volumes. The Asian giant continues to lead the way with more than 60 per cent of the share of new sukuk issuances worldwide.

In the first quarter of 2014, there was $160.6bn-worth of sukuk outstanding in Malaysia, while sukuk outstanding in the GCC totalled almost $85bn, according to figures from the Malaysia Islamic Financial Centre. S&P estimates year-to-date sukuk issuance at $17.9bn in the GCC by early September.

Other research backs up the trend. According to Kuwait Finance House estimates, a rebound in sukuk issuance has led the GCC primary market to account for 26.7 per cent of global market share of sukuk issuance in the first six months of 2014, up from 23 per cent in 2013. That carries on from the uptick seen in the fourth quarter of 2013, when Gulf entities sold $5.8bn of sukuk, the most ever in a final quarter, as issuers sought to lock in lower-cost funding ahead of the onset of the US Federal Reserve tapering programme.

Quality of issuance

Sukuk volumes of course are not the only metric to focus on. One reason for the generally upbeat mood among Islamic financiers in the Gulf is a distinct improvement in quality of issuance.

“Last year, volumes were lower than the preceding year, but the quality of issuance was very good. We had a lot of new issuers and some interesting new structures, with a notable increase in innovation,” says Mohieddine Kronfol, chief investment officer, global sukuk and Middle East and North Africa fixed income at the US’ Franklin Templeton Investments.

“This year, it is likely we are slightly behind on sukuk issuance relative to last year, but there is a noticeable ramping up of pace taking place now, so a large deviation from last year’s level appears unlikely.”

The increasingly accommodative climate for issuers to come to market - with low interest rates, tight spreads and robust economic activity - will lift issuance in the final few months of the year. There are potential problems ahead, however.

“GCC banks are more liquid at the moment than they have been in recent years, which represents an increased degree of competition for the bond markets,” says Kronfol. “Issuers have more choices for capital today.”

Big-name issuers of sukuk are waiting for their moment. Speculation suggests that high-quality Gulf corporates such as telecoms groups Zain and Etisalat are also preparing fresh sukuk programmes.

Regulatory push

One driver for financial institutions to launch sukuk is the regulatory push from central banks for lenders to meet Basel III minimum capital requirements.

In July, Abu Dhabi’s Al-Hilal Bank issued $500m of Tier 1 sukuk certificates, in a transaction that attracted demand worth nine times that amount. This followed the bank’s debut senior sukuk offering in October 2013, which had been structured to boost its chances of complying with Basel III capital adequacy requirements.

Gulf lenders started considering sukuk as a means of boosting capital back in 2012, when Abu Dhabi Islamic Bank issued $1bn of additional Tier 1 capital certificates, becoming the world’s first Basel III-compliant Tier 1 sukuk issuance.

The Sharjah sovereign sukuk stakes another claim for the UAE as one of the more active global issuing centres. The likes of Emirates NBD, issuing Tier 1, and new entrants such as Emaar Malls, which launched an inaugural sukuk in June, add heft to the country’s swelling reputation as a credible sukuk player. Yet, Saudi Arabia’s dominant position is unlikely to shift. The kingdom remains the most liquid and mature Islamic debt market in the region.

Saudi liquidity

What makes Saudi Arabia unique in the Gulf is its access to a liquid domestic market, while other GCC states are still broadly dependent on cross-border transactions.

“We continue to see a lot of activity in the domestic Saudi capital markets,” says Anzal Mohammed, a UAE-based partner at law firm Allen & Overy. “The kingdom is unique in the region in having a deep domestic capital market, and we are now seeing a lot of Saudi riyal-denominated issuance from the likes of Saudi Telecom, Fawaz Abdulaziz Alhokair, National Petrochemical Company and Banque Saudi Fransi.”

Banque Saudi Fransi launched a SR2bn ($533m) Tier 2 sukuk issuance through a private placement. Saudi retailer Fawaz Abdulaziz Alhokair completed a SR500m five-year sukuk offering in June, its first issue of an Islamic debt security. The Saudi market is getting deeper, with a wider group of participants, say experts.

“The market is becoming more diverse, with issuers from new sectors, as Alhokair demonstrates,” says Mohammed. “The product has become increasingly popular in Saudi Arabia over the past nine months or so.”

Sukuk still has some ground to make up on conventional bonds, however. In terms of absolute volumes, conventional bond issuance is still the dominant instrument for fund-raising in the Gulf. Year-to-date conventional bond issuance stands at $21.4bn in the GCC, according to S&P, while Franklin Templeton’s Kronfol estimates it higher still, at $28.5bn.

Wider acceptance

Even so, there is clearly a much wider acceptance of sukuk as a viable investment instrument. Issuers are drawn to sukuk because it enables them to tap a much wider audience.

Conventional bonds only access one part of the market. Sukuk on the other hand can bring in Islamic and conventional investors equally. “From an issuer’s perspective, it widens by a significant margin both the amount of money you can raise and investors you can access,” says Kronfol. “This is in addition to, generally speaking, better pricing.”

The character of the sukuk market is also evolving. Three years ago, Gulf issuers were launching Islamic bonds in an environment where liquidity was less abundant, economic confidence was lower and the main driver of issuance was to strengthen balance sheets. Today, the issuance is geared more to expansion and growth, or in some cases, leveraging balance sheets and facilitating the handing back of cash to shareholders.

Rising volumes

The recent dominance of sovereign and government-related issuers in the Gulf sukuk market may now give way to rising volumes of corporate issuance, say experts.

“The past three months have seen sovereign-focused transactions, which have opened up the sukuk product wider than the Middle East and Southeast Asia,” says Mohammed. “Having said that, we’re also seeing some blue-chip names coming to market - Saudi Telecom and Emaar Malls, for example.”

Policymakers in the Gulf too will give a steer to keep the sukuk market growing. A shared sense of purpose in seeing the development of Islamic finance is one key driver. Another is the steady increase in standardisation and acceptance for the asset class.

“It’s easy to issue sukuk and it doesn’t cost much more relative to conventional paper, so it does not represent an additional burden any longer,” says Kronfol. “Put all these factors together and you have a strong case for making sukuk the rational choice.”