Making markets

24 October 2003
If investors were to adopt the jargon of the fashion world, the sukuk would be the new black. And there are no shortages of models queuing up on the catwalk. Bahrain is on the cusp of issuing a $250 million sukuk al-ijara issue that will bring its programme up towards the $1,000 million mark. Lebanon is close to staging a $200 million debut, and Turkey could issue before the end of the year. Recent shows have been staged by Qatar - which saw its first sukuk issue so heavily oversubscribed that it was upsized to $700 million - and there has been a $600 million sovereign debut from Malaysia and a $400 million issue from the Islamic Development Bank (IDB).

As with exotic fashion designs, global financial trend-setters are increasingly seeking out sukuks. But while in the ephemeral world of haute couture products fall victim to their own popularity, the less rare the sukuk becomes, the greater will be its appeal. And it is already eying a place in the regional finance high street.

The main reason is that sukuks offer a solution to one of the key problems that has plagued the development of Islamic finance, that of liquidity management. The prohibition on money earning a return on itself closes the usual avenues open to conventional financiers for the short-term placement of funds. The result is that most Islamic financial institutions have highly liquid balance sheets with fast-swelling liabilities but only limited opportunities on the asset side.

And sukuks have, over the last two years, been creating billions of dollars worth of new opportunities. A form of Islamic securitisation, the instrument is often referred to as an Islamic bond. The key difference from an Islamic perspective is that sukuks must be asset-backed. Earning a return on a debt-backed instrument is essentially accruing riba (interest) and as such is proscribed by Sharia. Typically sukuk issues are structured as bundles of ijara - or leasing - transactions. While this structural difference is critical to the Islamic investor, the asset behaves much like a conventional security. And this is an important factor behind the broad investor interest. If it walks and talks like a bond, it seems a safe bet to treat it as such.

Manama, the home of choice for the Islamic financial world, has pioneered the sukuk. The Bahrain Monetary Agency (BMA - central bank), which issues instruments on behalf of the government, issued the Gulf's first tradable sukuks in September 2001. Since then the pace of issuance has quickened and, more often than not, surging demand has seen deals increased in size (see table).

Common market

While the thinking behind the various sukuks varies, there are common themes. First, the issuers are looking to tap new, diversified funding sources - and, in most cases, they have found them at comparatively attractive rates. Second, they have been looking to set benchmarks for potential corporate issuers. And third, most of the issuers to date have been keen to develop Islamic capital markets. 'The bank doesn't require the funds,' says Dost Mohammed Qureshi, adviser to the IDB chairman. 'The idea is to create a triple A-rated benchmark which will demonstrate to the market that Islamically-structured instruments are no less attractive than the conventional paper of the world's most secure financial institutions. And we want investors who miss the bus chasing it next time it comes around.'

Qatar's recent foray into the market differed in that the funds were tied to a specific project - construction of the Hamad Medical City. However, Doha can scarcely plead poverty. 'The government is cash-rich,' says a senior executive at HSBC, one of the sukuk's lead arrangers. 'The aim is to create a benchmark instrument for Islamic investors, as well as to diversify the funding streams available to the government.' Just how long before the benchmark is used and the likes of Qatar Petroleum start issuing sukuks remains to be seen. But when they come, the chances are that there will be no shortage of takers.

For Manama, the goal of a well-developed Islamic capital market is even more fundamental to its support of sukuks. The government wants to reinforce the kingdom's role as a global Islamic finance hub. The ambition is not just supported by the BMA's own sukuks. Serious attempts are being made to establish the Bahrain Stock Exchange (BSE) as the core market for international sukuk trading.

'The IDB issue is due to be listed here - we are co-ordinating with them and it will be soon. Qatar has followed with an issue and we have tried to encourage them to list here as well,' said BMA deputy governor Khalid al-Bassam in a recent interview (MEED 17:10:03, page 6). 'We are seeing the development of the market. The Malaysian is already listed and all our issues are listed.' Beyond the IDB and the Qatari issue, the BSE is also likely to see the Lebanese sovereign sukuk quoted.

On the supply side, the fashion for sukuks among issuers is unsurprising, be it for funding diversification, benchmark setting or market development. Likewise, on the demand side, for Islamic investors seeking a Sharia-compliant means of managing excess liquidity the appeal begs little explanation. However, sukuks are increasingly moving onto the radar screen of the conventional world.

Global financial heavyweights are waking up to the potential of Islamic finance in general. The likes of HSBC, Citigroup, UBS and BNP Paribas offer an increasing range of Islamic products, manage Islamic equity funds and even have wholly-Islamic subsidiaries. They are also becoming involved in sukuks.

HSBC is at the forefront: the bank lead arranged the Malaysian and Qatari sovereign issues. 'These are highly attractive instruments for all investors,' says an HSBC official involved in the Doha issue. 'We see the market for sukuks as one with huge global potential, not a niche offering of interest solely to the Muslim investor, and as such we want to play a part in it.'

This optimism is borne out by the figures. The Qatari paper was taken up 72 per cent in the Middle East and 28 per cent outside the region. More tellingly, 48 per cent of subscription came from conventional investors, including 24 per cent from institutional investors, 11 per cent by fund managers and, significantly, 13 per cent by central banks and other government institutions. The BMA's decision to mandate lead arrangers rather than marketing its own issues is partly aimed at broadening the investor base.

As the market develops, so has the infrastructure. Despite - or perhaps because of - plans championed by IDB for the establishment of an Islamic credit rating agency, the international rating agencies have become involved. And they have eased the flow of sukuks onto conventional balance sheets. As IDB hoped, its July sukuk issue became the first AAA-rated instrument issued in the Middle East - Islamic or conventional. Standard & Poor's (S&P) has rated all three sovereign issues at the country ceilings of BBB+, A- and A+ for Malaysia, Bahrain and Qatar respectively. 'We look at the specifics of the transaction, the robustness of associated contracts and features indicating that the underlying borrower will treat the obligation as it would direct, unsecured commercial financial obligations,' says S&P's Kristel Richard. 'These three sovereign sukuks incorporated strong government commitments to meet their obligations.'

In spite of the overwhelmingly positive market attitude towards the sukuk, there is one sense in which the instrument has failed. The stated aim of most issuers has been to create a vibrant secondary market, yet a very small proportion of the instruments are traded, with investors taking a buy-and-hold approach.

'As long as there is significant surplus liquidity on balance sheets there will be a stronger argument for buying than selling them,' says an Islamic banker in Bahrain. 'And such an imbalance of supply and demand does not encourage secondary market activity. In addition, if those holding sukuks choose to sell, what are they going to buy instead?'

Just where the point of critical mass will be at which a secondary market crystallises is a point of considerable speculation.

Diverse instruments

'There is still tremendous surplus liquidity in the hands of Islamic financial institutions. We need to have diversity of instruments: we need diversity in the maturity of issues, three years, five, seven and 10 - we need to make room for investors to sell long and buy short paper,' says the BMA deputy governor. 'Then we will need different issuances in terms of credit ratings as this will allow for spreads to develop.'

With more than $2,500 million worth of sukuks either issued or listed in the Gulf the market is small but growing. 'The tipping point is probably somewhere in the region of $10,000 million,' said Ahmed Abbas, head of structured finance at the Bahrain-based Liquidity Management Centre, at the MEED Capital Markets Conference in Dubai on 1 October. 'Only then will we see significant trading volumes take off.'

While this point is still some way off, it might be reached with surprising rapidity. Bahrain remains committed to replacing a substantial portion of its short-term conventional debt with medium-term sukuks. Qatar's funding diversification aims imply future issues. And the list of potential new issuers stretches beyond the Paris II-related Lebanese issue and Turkey's imminent foray. Iran - following up quickly on last year's debut conventional bond issues - is understood to be examining the sukuk route.

But the real point at which the market will come of age will be when corporate issues are made with regularity. Such a time may not be far off. Bankers report that a number of deals are currently under consideration and it may not be long before non-recourse project sukuks are structured and floated, adding further diversification to the market.

Sukuks are undoubtedly in vogue. And the chances are that they will prove to be more than just a passing whim, as the supply and the demand sides both stand to gain. If the momentum is maintained, the longstanding goal of an Islamic secondary market should be realised, with huge benefits for the wider world of Islamic finance.

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