Since the start of the year, a strong pipeline of corporate issuance of Islamic debt securities (sukuk) has transformed Saudi Arabia into the region’s largest issuer, displacing the UAE from the top spot.

The kingdom accounted for 15 per cent of global sukuk issuance in the first quarter of 2012, placing it second only to Malaysia. So far this year, $6.55bn of Islamic bonds have been issued in Saudi Arabia, about 77 per cent of the Gulf’s total issuance, according to Bloomberg.

In a bold statement of intent, the year began with the largest ever single-tranche sukuk, a SR15bn ($4bn) 10-year issue by the General Authority of Civil Aviation (Gaca) in January, to fund the new King Abdul-Aziz International airport at Jeddah.

Sukuk flurry in Saudi Arabia

That landmark issue has been followed by a flow of major Islamic bonds from an array of high-profile Saudi companies and banks. In March, Saudi Electricity Company (SEC) drew orders in excess of $17.5bn for a dollar-denominated sukuk issue worth $1.75bn. Also in March, Saudi dairy company Almarai sold a SR1bn seven-year sukuk, while SABB issued its first domestic sukuk with a SR1.5bn issue through a private placement.

Other recent issuers of Islamic securities include petrochemicals company Sipchem, with a SR1.8bn debut sukuk.

Saudi appetite for sharia-compliant bonds shows no sign of abating. In mid-April, Banque Saudi Fransi announced a $2bn sukuk programme, and is likely to be joined by recurrent issuers, such as Saudi Basic Industries Corporation (Sabic). Sabic is set to push through a substantial volume of Islamic debt onto the market, having gained Capital Market Authority approval in late 2011 for sukuk issuance of up to $5bn. 

The thing about sukuk is that you tend to attract both sets of investors, conventional and Islamic

Atif Hanif, Allen & Overy

Fresh from the SR3.75bn Satorp project sukuk last year, state energy company Saudi Aramco is seeking to raise further debt with another joint venture partner, Japan’s Sumimoto Chemical. The plan is to raise $6bn to boost the capacity of the Rabigh petrochemicals plant to 3.7 million tonnes a year.

Given the surfeit of Islamically structured debt capital market activity, prospective Saudi issuers are struggling to find available windows for launches. Many are likely to be delayed until late in the second and third quarters.

Although most Saudi issuers are quasi-sovereign, enjoying some form of state backing (in the case of Gaca, it uniquely received a guarantee from the Finance Ministry) the state itself is not driving the sukuk wave. Instead, the appetite reflects a corporate need to diversify sources of funding though a trusted method, which also plays to shareholder agendas to use sharia-compliant financial structures where possible.

For many of the kingdom’s publicly listed firms, investors are posing questions of management as to why they are not doing more sharia-compliant finance given that the sector is now of a much larger size than 10 years ago. 

“There is strong demand for any kind of paper associated with government as SEC and Gaca are,” says Paul Gamble, head of research at Saudi-based Jadwa Investment. “At the same time, local institutions are very liquid so it’s a good way to diversify your sources of funding.”

With the state showing no inclination to go for a sovereign issue anytime soon, Gaca’s may set a benchmark for riyal-denominated sukuk, enabling local financial institutions to invest their excess liquidity in a solid quasi-sovereign debt instrument.

Benchmark issue

The advantage of the Gaca sukuk – the largest sovereign-guaranteed issuance in any emerging market in the past 10 years – is that it has been explicitly structured as a project finance and investment opportunity. 

“The Gaca sukuk was attractive not just because of the guarantee, but because Sama [The Saudi Arabian Monetary Agency] approved it for repo arrangements with zero risk for capital adequacy calculations. So, it gives sharia-compliant players an instrument to manage their liquidity, “says Jarmo Kotilaine, chief economist at the local National Commercial Bank.

Investors can either hold the security as an investment or use it as a liquidity tool by using it to guarantee cash from the central bank.

There are indications that the Gaca model might be applied to further revenue-generating projects in the infrastructure area.

With the Gaca sukuk being the closest thing to a government bond, Saudi banks now have access to a much-needed benchmark to price long-tenor issuances in local currency, crucial in the absence of new debt issuance emanating from the sovereign. The provision of a local yield curve will make it easier for Saudi banks to address the asset/liability mismatches on their balance sheet with longer-term funding.

Issuers such as Gaca will also make it easier for Saudi corporates to tap into the sharia-compliant capital markets more frequently. Sukuk in general is growing in appeal as a fund raising tool, not least due to the more competitive pricing compared with conventional fixed-income securities. For example, the 2.5 per cent profit rate on the Gaca sukuk is less than half the rate some European states have been forced to pay for their funds.

Safe haven

“If you look at the secondary market data, the tables have been turned; sukuk is now more attractive in terms of pricing than conventional bonds,” says Kotilaine.

Islamic securities also offer Saudi investors a relative safe haven amid worries associated with the eurozone debt crisis. 

“The uncertainty surrounding the eurozone has also affected conventional bond markets for emerging market issuers,” says Jamie Durham, a partner at law firm Allen & Overy, which has advised on a series of Saudi sukuk, including for HSBC, Almarai and SEC. “But what we saw in the second half of last year was a significant increase in sukuk issuance, as the sukuk investor base seemed less affected by the eurozone issues than the conventional fixed-income market.”

That Gaca’s sukuk was more than three times oversubscribed indicates considerable demand for high-quality Islamic paper.

The issuer was not intending to target a new investor base with its sukuk. Most of the investors comprise the usual mix of local banks as well as pension funds, insurance companies and corporates.  

Generally, Saudi sukuk issues are primarily aimed at the local audience, where the asset class is benefiting from growing structural demand emerging from sharia-compliant financial institutions that are looking for longer term paper to match against their longer-term lending commitments. 

Another attraction from an investor’s point of view is that the issuers tend to be the leading names in the sector, such as Saudi Aramco, Sabic, SEC and Sabb.

“They have both the resources and need to issue on a scale that makes the economics of sukuk issuance make sense,” says Kotilaine. “This way, investors can gain exposure to the best and most reliably highly related companies in the region, offering relatively strong capital protection and predictable returns. Given what the region has gone through recently, that is an attractive proposition.”

The SEC sukuk is an altogether different proposition to the other recent issues for being dollar-denominated, and seeking explicitly to tap increasing global appetite for Saudi corporate debt. The $1.75bn dual-series sukuk issue – comprising a $500m five-year tranche and a $1.25bn 10-year tranche – represents SEC’s first international sukuk issuance and the largest international debt capital markets issuance ever to come out of Saudi Arabia. It is also the first dollar-denominated Saudi sukuk since Sabic’s $1bn issue in October 2010, and marketed to a mix of European, Middle Eastern, and Asian investors.

If the order book is anything to go by, sharia-compliant Saudi debt securities are highly prized by this audience. Subscriptions for the two series exceeded what was offered 10 times.

While SEC has never encountered difficulties raising funds on the domestic market, it was conscious its major investment scheme to upgrade and add to existing generation capacity and transmission networks was going to be prove highly capital intensive. Smaller sukuk issues would normally only target the domestic market, which is both deep and attractively priced, but SEC wanted to extend its exposure beyond the Gulf and set a precedent for future debt issuance outside the kingdom.

Growth area

SEC’s decision to launch a major dollar-denominated sukuk was not dictated by necessity, but choice, says Atif Hanif, a partner at Allen & Overy. “SEC has so far managed to raise sufficient funding from the domestic capital markets and while it looks like this will continue for some time, things may change in the future,” he says. “Through this, it can tap a different investor base and get in front of international investors.”

Such motivations should sustain the early 2012 pick-up in sukuk issuance, making the debt securities far more than the current flavour of the month. This year, Saudi Arabia has become the largest Middle Eastern sukuk issuer, its first quarter 2012 volumes of $6.4bn outpacing the UAE’s $1.9bn.

“For Saudi corporates, sukuk is a natural growth area given current levels of liquidity in the Saudi market. While they will continue to have bank funding, it makes sense to broaden the funding base,” says Hanif.

To Saudi corporate issuers, sukuk now makes as much sense as any alternative means of raising funds. “The thing about sukuk is that you tend to attract both sets of investors, conventional bond investors and Islamic,” says Hanif. “So a lot of issuers take the view that if you are going to hit the capital market, you may as well structure an instrument that allows for a larger catchment of investors.”