Fixed income is traditionally the asset class of choice during times of economic turmoil, seen as a relatively recession-proof investment strategy. For Middle Eastern sovereign and corporates seeking to raise funds amid frozen lending markets, the past two years has provided ample room to test out this theory.

Though sovereigns continued to tap the debt capital market with sharia-compliant bonds, or sukuk, in order to fund some large capital spending programmes, the sector has had a tough time.

The sukuk industry has struggled to reach the heights of 2007, when global issuance hit $34.4bn, according to figures from US financial services firm Standard & Poor’s (S&P). After a bad year in 2008, when issuers largely vacated the sukuk market, 2009 at least saw the beginnings of a revival. Global issuance reached $23.3bn, says S&P, with Malaysia leading the way.

Lost confidence

Global sukuk issuance declined by 8.7 per cent to $8.1bn in the fourth quarter of 2009. The largest sukuk was Dubai’s $1.3bn five-year offering, followed by Abu Dhabi’s Tourism Development & Investment Company (TDIC), which placed a $1bn sukuk in October. The share of the GCC region in global sukuk issuance declined marginally, from 41 per cent in the third quarter of 2009 to 39.6 per cent in
the fourth quarter, notes Saudi Arabia’s NCB Capital in its debt tracker, issued in January of this year.

Confidence in sharia-compliant debt issuance has been dented by defaults on two Gulf sukuk last year, issued by Kuwait’s Investment Dar and the kingdom’s Saad Group, and the near-default of a sukuk issued by Dubai late last year, which was averted at the last minute by a financial support package from Abu Dhabi.

These defaults highlighted abiding concerns over bondholder rights, in an asset class that has yet to reach full maturity. The sukuk industry’s bad press has also inflicted damage on Islamic finance’s unique selling point of being better insulated from the global financial crisis. Investors have taken fright from perceived untested forms of investments, such as sukuk, which are also regarded as more complex than conventional bonds. In contrast, the conventional bond market is seen as a more liquid alternative to the sharia-compliant fixed-income offering.

Waning appetite

There are other reasons why investor appetite for sukuk has waned. One is that the real estate and construction sectors – which have been most heavily impacted by the regional recession – were also the most active issuers of sukuk. According to figures from UK law firm Trowers & Hamlins, in 2007-2008, 38 per cent of sukuk issuance was by real estate companies, whereas only 5 per cent of conventional Gulf corporate bond issuance in the same period was from property firms. 

Trowers & Hamlins also notes that as investors were demanding such high yields on sukuk it made sense for Gulf corporates to switch to issuing conventional bonds. When the financial market problems hit the Gulf in 2008, the price of corporate sukuk fell much further than the region’s corporate bonds. At one point, the yield on corporate sukuk increased to 17 per cent, while the yield on the comparable index of Gulf corporate bonds at that point only increased to 11 per cent.

With investors spooked from the sukuk market, issuers have switched back to the conventional in increasing numbers. According to Trowers & Hamlins, GCC corporates issued $12.8bn in conventional bonds over the past 12 months to the end of June 2009, compared with just $4.3bn in sukuk. This represented a jump of 15 per cent in the value of conventional paper issuance in the Gulf from the previous year’s $11.2bn, while sukuk issuance slumped 74 per cent from the previous year’s $16.9bn.

For the first time since 2005-2006, corporate conventional paper issuance overtook sukuk.

In the months ahead, Gulf issuers of both sovereign and corporate bonds, are likely to take a broader approach to tapping the market. On 25 March, the government of Bahrain launched an oversubscribed $1.25bn 10-year bond at 200 basis points over mid-swaps. The fact that the Gulf’s first sovereign issue in 2010 was conventional, rather an sukuk, is highly symbolic: Bahrain’s three previous sovereign issues had all been sukuk.

Manama has set a course as a prime sukuk issuer to establish its credentials as the region’s main Islamic financial centre. The new bond is the sovereign’s first conventional issue for two years, and is issued under the US Securities Exchange’s Rule 144A, which expedites the sales of securities available for resale only to institutional buyers.

This will enable US investors to get involved, a sign of the need to diversify its investor base. “What’s interesting about Bahrain is it’s gone from being an issuer that has only done sukuk to the conventional in order to widen its audience,” says Nish Popat, head of fixed income-Middle East at ING Investment Management.

Issuers, who may previously have thought only in sukuk terms in order to tap a regional market where appetite for all things sharia-compliant seemed unlimited, are having to adapt to a new environment where the conventional fixed-income market plays a significant role.

Both corporates and sovereigns alike realise that the size of the conventional market remains considerably larger than the Islamic market. In order to expand their businesses and raise funds, they are prioritising the conventional side.

…Whether sukuk or conventional, the market is demanding high-quality issuers as of right now

Nish Popat, ING Investment Management

This does not mean that the sukuk market has had its day. Quality issuers of sukuk continue to attract investor demand, and there remains a healthy appetite in the market for high-quality sukuk, such as GE Capital’s $500m sukuk sold in November 2009.

ING’s Popat says once issuers complete a successful conventional bond, they will then more likely seek to tap the more selective sukuk market. Last year, Abu Dhabi’s TDIC came out with five-year and 10-year conventional issues, and then some three months later, in October 2009, launched its $1bn, five-year sukuk issue.

Recovering confidence

With the region’s debt capital market growing, there is clearly room for both conventional and sukuk issuance. The last quarter of 2009 saw a recovery of GCC debt markets, led by a slew of conventional issuance by UAE and Qatari sovereigns.

Gulf sukuk issuers are also starting to approach the market again. In February, Saudi real estate developer Dar al-Arkan raised $450m in the first international issue from the GCC region since the Dubai debt crisis. Although, in a sign of the lack of confidence afflicting the sector, this was below the reported $750m the issuer had sought to raise.

More sukuk are in the pipeline, with Dubai’s Emaar Properties, seeking to raise $2bn to fund the company’s expansion plans, and a $1bn issue for the Jubail Refining and Petrochemical Company in Saudi Arabia. Deutsche Bank has also hinted at a major sukuk in the works. Smaller offerings are expected on the corporate side, with Saudi Arabia’s Al-Aqeeq Real Estate Development Company gaining approval to raise $187m to fund proposed hotel and residential projects in the kingdom. 

S&P expects a global pipeline of sukuk issuance in excess of $20bn this year, dominated by sovereigns and government-related issuers, with the potential for another $10bn on top of that, should conditions permit. 

Sukuk remain a potent source of liquidity in an Islamic finance sector that urgently needs greater depth. With Gulf economies improving, leading to increased financing requirements in key sectors, the sukuk market still has a key role to play in meeting that demand.

Once the dust has settled on last year’s corporate defaults and investors are able to take a balanced perspective of sukuk’s true risk profile, a return to the robust growth seen in 2006-2007 could be on the cards. However, first the industry has much work to do to raise confidence levels and improve standardisation. 

As Popat says: “Whichever issuance that will come out, whether sukuk or conventional, the market is demanding high-quality issuers as of right now.”