Once considered the Islamic finance industry’s rising star, demand for sukuk (Islamic bonds) has waned considerably since the onset of the global credit crisis in early 2008.

Total global sukuk issuance fell by 44 per cent to $14.9bn in 2008, compared with $26.6bn in 2007, and the market has continued to contract this year. Total sukuk issuance amounted to $9.3bn in the first seven months of 2009 compared with $11.1bn in the same period in 2008, a 20 per cent decline.

Since 2002, the GCC has been one of the main engines for the growth of the sukuk market, thanks to years of high oil prices that generated record economic growth and fuelled demand for investment products.

However, the drying up of liquidity due to the global credit crisis has resulted in shrinking demand for investment products in general, and the rapid decline in sukuk issuance.

“It has been a dry year for sukuk issuance for the most part,” says Farmida Bi, a partner at UK law firm Norton Rose. “The primary reason for the drastic reduction in total sukuk issuance is the disappearance of international investors from the market.”

Undermining confidence

The most dramatic change in the Gulf’s sukuk market since 2008 is the significant decline in issuance from the UAE, which accounted for 35.6 per cent of total global issuance last year, or $3.9bn. So far in 2009 it has accounted for just 4.3 per cent of global sukuk issuance, which comes entirely from the $400m Islamic bond issued by Ras al-Khaimah’s RAK Capital in July.

There are two factors behind the decline in UAE sukuk issuance: the correction in the Dubai real estate sector, and the less supportive macroeconomic environment. Ratings agency Standard & Poor’s expects UAE gross domestic product growth to be either flat or slightly negative in 2009, compared with growth of more than 7 per cent in 2008.

While the UAE’s share of total sukuk issuance has diminished this year, Saudi Arabia’s has doubled since 2008 from 11.2 per cent to 22 per cent, with $2.05bn worth of sukuk issued so far in 2009.

The continuing global slowdown means corporates have been reluctant to re-enter the market and activity has been dominated by government and government-related entities, which have accounted for nearly three-quarters of all sukuk issued. 

“A large portion of new issuances have come from the government,” says Mohamed Damak, an analyst at Standard & Poor’s. “Sovereign sukuk give investors more confidence than pure private-sector issuance because it means they can factor in support that could come from the government.”

Sovereign sukuk are expected to kick-start a recovery of sentiment among corporate investors. They have been credited with helping to create a yield curve that private sector issuers can use as a benchmark for pricing their debt.

According to the sukuk index produced by UK bank HSBC and Nasdaq Dubai, the average yield on corporate GCC sukuk currently stands at 7.6 per cent.

Industry insiders report a backlog of sukuk issuances that have been delayed as issuers wait for the market to pick up. Standard & Poor’s estimates the pipeline of sukuk waiting to be issued stands at $50bn.

“There are deals that were ready for issuance 12 months ago that are still waiting for the right window in the market,” says Bi. “There are a number of high-profile deals that will be coming to the market after the Eid holidays end, if the market conditions are deemed to be right.”

Analysts predict capital market activity will pick up signficantly now that Ramadan has ended. “Issuers could bring sukuk to market quite rapidly because a number of the deals are ready to go,” says Bi. “Particularly towards the end of last year, when the markets were very choppy, a number of issuers established Islamic medium-term note programmes [a note that usually matures in five to 10 years], and those issuers have the flexibility to issue under those programmes very quickly.”

In mid-September, Saudi Arabia’s Islamic Development Bank (IDB) launched an $850m fixed-rate sukuk under its $1.5bn medium-term note issuance programme, which was 2.4 times oversubscribed. IDB says the legal documentation and ratings for the sukuk had been in place since July, but it decided to delay the issuance because of the summer lull and the Ramadan slowdown.

Certainly, there are signs that there is pent-up demand for sukuk issuance. Middle East investors bought 30 per cent of the $650m sukuk the Indonesian government issued in April, which was seven times oversubscribed.

Meanwhile, the Central Bank of Bahrain issued a $500m sovereign sukuk in June, which was oversubscribed almost eight times. As a result, the value of the sukuk was raised to $750m.

Gradual recovery

There is now a consensus among analysts that the trough in sukuk issuance was hit on 11 February when the average yield on corporate GCC sukuk stood at 17.2 per cent, up from 6.5 per cent in August 2008, when the global financial crisis began to have an impact on the region. A bond’s yield is inversely related to its price – if the price falls, the yield rises.

Since then, the market has begun to stage a slow recovery. The GCC governments’ stimulus packages have contributed to the region’s economic recovery, most notably Dubai’s $10bn bailout from the Central Bank of the UAE in February. State-linked companies have benefited directly from the federal loan, which has enabled them to resume the payment of outstanding bills, and governments have helped companies refinance loans coming to maturity.

Consequently, the risk of defaults in the Gulf is perceived to have fallen, which in turn has helped push down yields. “I think the government’s stimulus packages are having a positive impact on the economy,” says Damak. “That should create additional financing needs, a portion of which will probably be financed through both sovereign and corporate sukuk.”

However, the sukuk market will continue to be dominated by government-related entities until at least the end of the year. Sukuk is increasingly being viewed as a viable financing alternative by governments seeking to fund big infrastructure projects, especially given the drying up of credit in the project finance market.

As the largest economy in the GCC, Saudi Arabia’s financing needs are perhaps the greatest, especially in light of the $60bn worth of new projects that were announced in the kingdom’s budget for 2009.

The creation in June of the Saudi sukuk and bond market by the Saudi stock exchange (Tadawul) has been welcomed as a positive development. Although activity has been slow to date, with just five sukuk listed by two companies – Saudi Basic Industries Corporation and Saudi Electricity Company – it is likely to provide a boost to the sukuk market in the long term.

In the short term, however, the global sukuk market’s low liquidity levels have caused problems by constraining investors trying to exit the market.

In June, the downturn led to the first sukuk defaults in the region by Kuwait’s Investment Dar Company and Saudi Arabia’s Saad Group.

“I think the financial community has learned some valuable lessons from these defaults,” says Bi. “They have learned how important disclosure is in terms of the under-lying assets. A lot of the investors in the sukuk that are in trouble are from the Middle East, and now that they are on the receiving end, they are starting to understand how important disclosure is.”

Investors remained concerned over the likelihood of UAE real estate developer Nakheel defaulting on its $3.5bn sukuk, which will mature in December 2009. The large size of the sukuk exacerbates the difficulty of refinancing.

In addition to the low liquidity, the lack of standardisation remains a hurdle to growth.

The emergence of an integrated sukuk market is being inhibited by the differing interpretations of what constitutes sharia compliance. For example, some sukuk issued in Malaysia are not considered sharia-compliant by GCC investors.

Some positive steps have been taken. Bahrain’s Accounting & Auditing Organisation for Islamic Financial Institutions has announced it will screen products and services for compliance, which will not only provide more uniformity but should also lend greater credibility to the instruments.

“Both non-Muslim countries, including Canada, France and the UK, and Muslim countries, such as Kazakhstan, the Philippines and Pakistan, have expressed interest in issuing sukuk at some time in the future,” says Damak. So we continue to see a lot of appetite for this instrument.”

It is clear that there is no shortage of supply or demand for sukuk, but what is lacking is investor confidence in corporate sukuk.

With market conditions slowly improving, issuers should return to the market in 2010. But it will be sovereign sukuk that continue to dominate and could therefore precipitate the recovery of the corporate sukuk market.