The Islamic finance industry is currently embroiled in one of the most testing periods in its short history, with major Gulf issuers of sukuk (Islamic bonds) either warning of a possible default or already missing payments.

In November, the Dubai government said it was asking creditors to accept a delay of at least six months on repaying the debts of the Dubai World holding company, including the $3.5bn sukuk held by its real estate subsidiary Nakheel. In the same month, Saudi conglomerate Saad Group missed a scheduled payment on a $650m sukuk and asked creditors to refrain from legal action.

While the problems at these groups have been prompted by the wider global economic downturn rather than by the Islamic finance structures themselves, it is the first time Gulf businesses have had to cope with defaults on major sukuk issues.

It also poses important questions for the region’s construction industry, which has started to raise significant amounts of money through sharia-compliant deals to fund new developments.

Structural doubts

Neale Downes, regional banking and finance partner in the Bahrain office of UK-based law firm Trowers & Hamlins, says the default by Saad has called into question the integrity of sukuk structures.

“When some originators have found themselves in financial trouble or, worse, have become insolvent, sukuk investors have found themselves unexpectedly competing with the general body of creditors, rather than simply enforcing against or taking possession of the assets supporting their sukuk,” he says.

Despite the difficulties at Nakheel and Saad, sukuk issues still appear to be popular with issuers and investors in other parts of the market. In November, the International Finance -Corporation listed a $100m sukuk on Nasdaq Dubai, the government of Dubai issued a $2bn sukuk, which set a new record as the largest ever sovereign sukuk, and GE Capital, the finance arm of General Electric, issued a $500m sukuk, making it the first US corporate issuer of an Islamic bond.

Whether the market now decides to focus on the positive or negative aspects of the Islamic finance market could determine how useful sukuk will be for the construction industry in the coming years.

Before the financial downturn, which hit the region late last year following the collapse of US investment bank Lehman Brothers in September 2008, Islamic bonds had been gaining in popularity as a way of funding infrastructure developments and other major construction projects.

But new sukuk issues pretty much ground to a halt in the Gulf in the fourth quarter of 2008. The total value of issues for the year showed a fall of 44 per cent from $26.6bn in 2007 to $14.9bn in 2008, of which project and infrastructure sukuk accounted for about $1.6bn, or just more than 10 per cent of the total.

“The collapse of Lehman Brothers was the trigger that stopped banks lending and people could not borrow at reasonable rates,” says -Khalid Howlader, senior credit officer for structured finance at credit ratings agency Moody’s Investors Service.

As the turmoil swept through the Gulf’s -capital markets, the yields on corporate sukuk rose far in excess of those for conventional bonds, making them more expensive for companies to issue. In the market’s darkest day, on 11 -February this year, the yields on sukuk peaked at 17.2 per cent, compared with 11 per cent for bonds.

With investors demanding such high yields on sukuk, it made sense for companies seeking to raise money to issue conventional bonds instead. Combined with the severe slowdown in the projects market across the Gulf, the issue of sukuk for construction projects has come to a virtual standstill this year.

Islamic bonds are undoubtedly the way many infrastructure projects are going to be financed”

Farmida Bi, partner, Norton Rose

Gulf corporates issued $12.8bn in conventional bonds over the 12 months to the end of June 2009, compared with just $4.3bn in sukuk. This equated to a jump of 15 per cent in the value of conventional corporate bonds issued, compared with the previous year, and a drop of 74 per cent in the value of sukuk.

It is a far cry from the optimism in the construction and Islamic finance markets before the global economic turmoil. “Before the credit crunch, sukuk were increasing in number and size and were being issued for all sorts of financing needs, including the construction of power and water plants in Saudi Arabia,” says Farmida Bi, a partner at UK law firm Norton Rose and an expert in Islamic finance. “The first two sukuk deals I worked on were some of the earliest in the market and both were construction-related.”

One of these deals was advising the Dubai Civil Aviation Authority on a $1bn sukuk in 2004 – the world’s largest single sukuk at the time. The proceeds were used to finance the building of a second terminal at Dubai International airport and expand its existing infrastructure. The other was the ‘gold sukuk’ issued in 2005 by the Dubai Metals & Commodities Centre for building two office blocks.

Pioneering deals

Since those early deals, sukuk have proved adaptable and have been used in increasingly complex infrastructure financings, including those arranged in early 2008 by two UAE companies, the National Central Cooling Company (Tabreed) and Sorouh Real Estate.

Tabreed is using the money raised through its sukuk, known as Tabreed 08, to fund the construction of district cooling plants. For the first time in a sukuk transaction, the deal was structured to include both ijara (sale and leaseback) and istisna (construction and delivery) elements.

The Sorouh Real Estate sukuk, which was arranged through the Sun Finance special purpose vehicle, was raised to fund the building of utilities infrastructure at Shams Abu Dhabi, a 1.7-square-kilometre development on Reem Island, and the Saraya development in Abu Dhabi’s central business district. The sukuk was securitised against future revenues from the sale of real estate plots to property developers.

If the overall market for sukuk does revive, the structure of both the Tabreed and Sun Finance deals could provide a template for future construction-based sukuk, and encourage more innovation in the future.

Bi says an important step in the evolution of sukuk for the projects market will be in tying their payment terms more closely to the lifespan of a project – at the moment sukuk tend to be structured to be repaid with a few years, even if the project they are helping to fund could have a lifetime of several decades.

“I can understand why the Tabreed 08 and Sun Finance deals are described as project financing, but they are not the equivalent of a traditional project bond,” she says. “They have the maturity profile of conventional bonds, although the proceeds of issue will be used to finance the construction.”

One issue hindering the development of longer-term project sukuk has been the nature of the Islamic finance houses that buy them. Most sharia-compliant banks have only been set up in the past decade and are relatively small, so find it difficult to support large, long‑term financing deals. However, that is changing now that they are becoming more established.

“I am beginning to see progress, but I think it will be some time before such sukuk [with longer tenors] come to the market,” says Bi.

There are a number of other long-standing impediments that need to be removed for sukuk to become a more mainstream form of financing in the construction sector. First, the cost of issuing and structuring sukuk remains high, relative to conventional bank loans and bonds. This in turn is largely because the lack of standardised structures within the sharia-compliant market results in higher legal and accounting fees.

Consequently, industry insiders are calling for greater clarity in transaction structures and increased standardisation through greater consensus among Islamic scholars.

Yet, despite the difficulties, supporters cite compelling reasons for believing the market will recover, particularly for the construction industry. “Sukuk have attributes, such as their requirement for a tangible underlying asset, that make them more naturally suited for project finance,” says Howlader.

The trend towards private sector financing of construction projects in the Gulf economies could also provide a boost for the sector, particularly given the scale of spending planned. According to MEED Projects, which tracks project activity across the Middle East and North Africa, about $2 trillion-worth of projects are planned in the region by 2020.

“There is still a need for a lot of infra-structure construction across the region, -especially in Saudi Arabia, where we believe there is going to be significant work in the future,” says Bi.

“Islamic bonds are undoubtedly the way many of those projects are going to be financed. Sukuk are being used on construction deals that are expected to close shortly and our -clients are also asking us to look at doing -issuances for future infrastructure transactions.”

Finance industry analysts believe the GCC will be the focus of most sukuk activity in the infrastructure and project finance sectors in the short to medium term.

However, the matter of potential defaults first needs to be resolved to satisfy the concerns of potential investors. Many conventional bonds have suffered from defaults in the past without this denting the overall market appetite, as investors have confidence in what happens when things go wrong.

On that basis, the current difficulties in Islamic finance are an inevitable and important part of that market maturing.

The next major hurdle to be overcome will be on 14 December, when the Nakheel sukuk is due to be repaid.

If the bond can be restructured and legal action by creditors can be avoided, at least some of the concerns over using sukuk to fund projects will be allayed and this should pave the way for more construction industry sukuk to be issued in the future.