The sukuk (Islamic bond) is the most high-profile of the new wave of sharia-compliant financial products. It has captured the attention of Islamic institutions wanting to opt out of the traditional finance system, as well as conventional investors eager for exposure to corporates in the booming Gulf region.

However, the sukuk bubble has been deflating since the beginning of this year, thanks to the global credit crunch and a ruling from the Accounting & Auditing Organisation for Islamic Finance Institutions (AAOIFI), which criticised the structure of some sukuk.

The chairman of AAOIFI, Sheikh Ibrahim bin Khalifa al-Khalifa, said one of the common forms of sukuk issuance, which guarantees the price at which an issuer will buy back an asset, contravenes the principle of risk and reward sharing, which is integral to Islamic finance. AAOIFI also said sukuk must represent true ownership of an asset for the sukuk holder.

Undermining appeal

Since the beginning of the year, issuance in the sukuk market has fallen by 50 per cent, although there is some disagreement among industry observers over whether the slump is the result of concerns over compliance or the credit crunch.

Most bankers in the region insist that issuance of every type of asset class is down and that the impact on the nascent sukuk market appears more dramatic than it is.

Between January and August this year, $11bn worth of sukuk was issued in the Gulf region, compared with $21bn for the same period in 2007.

However, figures from UK-based law firm Trowers & Hamlin show that in the 12 months to June 2008, the volume of sukuk issued rose by 17 per cent compared with the previous 12 months, to $17bn.

The figures illustrate the slowdown in sukuk issuance activity in 2008, compared with the second half of 2007. Conventional bond issuance has been flat, at about $11bn.

Spreads on Islamic bonds have widened to 319 basis points above the London inter-bank offered rate (Libor), from 201 basis points at the end of January, following the criticism by Sheikh Ibrahim.

The graph of spreads (see page 54) for sukuk in the region shows the impact of Al-Khalifa’s comments. As investors became nervous about some sukuk instruments and decided to sell out of them, secondary spreads were hit.

A second drop in spreads occurred in April, mirroring falls in the conventional markets and indicating that the Islamic market’s fortunes are tied in with the global financial markets to some extent.

Gilles Franck, head of capital markets for the Middle East and North Africa at Standard Chartered Bank, says while some investors have become increasingly nervous about the industry, the Islamic sector is no more vulnerable than any other.
“Spread widening is a region-wide phenomenon with little that points to it affecting Islamic products more than conventional ones,” says Franck.

Others agree. “Issuance of every type of asset class is down at the moment because of the credit crunch, so it is impossible to separate the fall in the sukuk market from the wider economic environment,” says the head of trading at one international bank.
Several difficulties have arisen this year, which makes it too complicated to attribute the fall in sukuk issuance solely to the AAOIFI criticism.

In addition to the credit crunch, the region has suffered from a rapid withdrawal of the money that was pouring into the financial markets from speculators hoping to profit from the revaluation of Gulf currencies.

This influx of liquidity has driven down local currency lending rates to offer borrowers a cheaper alternative to dollar financing.
But as liquidity has dried up, sukuk is no longer such an attractive form of financing for many borrowers.

Saad ur-Rahman, head of investment banking at Banque Saudi Fransi, says the downturn in sukuk issuance is entirely market driven. “Nobody wants to come to the market at this stage, not with pricing where it is,” he says.

Next generation

However, there is some speculation that the controversy sparked by AAOIFI could significantly dent future appetite for sukuk. “The sukuk market has been dealt what could be a fatal blow,” says Darshan Bijur, director of corporate finance at consultant KPMG.

Bijur says the problems the AAOIFI has with sukuk structures relate to Islamic principles that stipulate investments are profit and loss sharing. Sukuk issues under their current structure mirror conventional bonds, which simply repay a principal plus interest.

If sukuk are restructured to give investors exposure to downside risk, it could impact on the appetite from Western investors who were sold sukuk on the understanding that it was essentially a bond-like, fixed-income instrument.

Franck disagrees. “At this stage, I do not see any need to move sukuk products to something completely different,” he says. “I think they will continue to be fixed-income products that appeal to fixed-income investors around the world.”

Rahman says the structure will alter, but the next round of sukuk issuance will define a model for the future. “People have already worked out what needs to be done to adapt the sukuk industry,” says Rahman.

“But no one is issuing any capital markets products at the moment. The next wave of sukuk issues will point the way forward for the industry.”

Amjad Hussain, Islamic finance partner at UK law firm Eversheds, also says sukuk is an evolving structure. “Although there is some overhyped speculation that this will be the death of the industry, it should instead be viewed as a positive part of the process of developing Islamic finance products,” he says.

“The motivation for a lot of the conventional banks that have been working as originators of sukuk is to get to a standardised product as quickly as possible so that they can start selling it as widely as possible. But Islamic finance is still an emerging industry and needs a lot more research and development.”

Also, given the contribution that the sukuk industry has made to the development of Islamic finance, it is unlikely that it will be allowed to wither.

“Sukuk has been a very good thing for Islamic finance and has attracted a lot of attention to the industry,” says Mohammed Hussein, co-chief executive officer (CEO) of Bahrian-based Ithmaar Bank. “There is still further development ahead.”

Regaining momentum

The fundamental principle behind sukuk is sound, says Paul Homsy, CEO of US-based Crescent Asset Management, who has worked in the Islamic finance industry in the Gulf since the 1980s.

“It is a beneficial ownership interest in an underlying asset, and it is hard for that to be attacked,” he explains. “It is when you are doing other, more complicated, structuring that difficulties arise.”

It should be remembered that other sukuk structures remain uncontroversial. The ijara sukuk, for example, which operates as lease finance throughout the term of the investment, and at maturity transfers ownership to the borrowers, has not been questioned.

The biggest difficulty now for the sukuk market will be regaining the momentum that was sapped by the credit crunch and AAOIFI’s statements. Even conventional investors will be nervous and ask more questions about Islamic structuring, having seen the impact that these issues can have on sukuk pricing.

“When new transactions start to occur, international investors will be asking more questions, rather than just accepting what they were told about the sharia compliance aspect as they did in the past,” says the Gulf-based head of capital markets at one investment bank.

Risk departments will also have a new calculation to factor in to their evaluation of sukuk, says Eversheds’ Hussain. They will have to take into account the changes of opinion on sharia compliance, and possibly reassess the risk profiles of Islamic investments.

Salah Jaidah, CEO of Qatar Islamic Bank, is confident the sukuk market will rebound from its slowdown. “The challenges to the sukuk market from a sharia perspective will not make or break it,” he says. “Other sukuk structures are still approved by the majority of scholars.”

Franck agrees. “There is little pressure from the scholars to move away from sukuk to something different,” he says.
The next step for the industry is expected to be more widespread acceptance and standardisation.

Homsy says it is becoming more important for sukuk to be rated by the three main international rating agencies, so that they can be traded on international exchanges and sold to Western pension funds, many of which can only invest in rated assets. This will drive a greater acceptability of the sukuk sector.

Ithmaar’s Hussein says he sees Islamic finance being increasingly used by conventional institutions looking to tap different liquidity sources during this difficult period for Western finance. “I would not be surprised if we see some of the big US and European banks use sukuk to raise more capital this year,” he says.

This also ties in with the ambitions of the main Islamic banks in the region, which are eager to sell sukuk more widely and finance ever-bigger deals.

Overcoming this setback to the industry could take more than finding clever new structures of sukuk to get around the issues raised by AAOIFI.

“For international investors, who are increasingly buying up to 70 per cent of sukuk sold, the credit crunch has sparked a flight to quality,” says Bijur. “These investors may no longer be available to Middle East issuers.

“Islamic banks are also finding that rather than put their deposits into a sukuk and earn a few per cent return, they can be lucratively put back into growing areas such as Islamic credit cards, retail loans or mortgages, where they earn much higher returns.”

This shifting dynamic will demonstrate how much of the growth in sukuk issuance was really driven by demand, and how much the perception of demand has driven issuance. The Islamic finance industry is still small globally, with total assets of about $700bn, about the same as the UK’s fifth-largest retail bank.

Key fact

$11bn

The value of sukuk issued in the Gulf in 2008