Sukuk: an international asset class

Author: | Published: 18 Mar 2015
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Sohail Jaffer of FWU Dubai Services describes the gathering momentum of sukuk at an international level and asks if it may stimulate investment into the Middle East

2014 has been a landmark year for the internationalisation of the market for sukuk, which are increasingly attractive to both issuers and institutional investors in Europe, Asia and the Mena (Middle East and North Africa) region. Although total issuance in the global sukuk primary market slowed in 2013, growth was restored in the first half of 2014, with 244 sukuk tranches raising $66.3 billion, up by 8.2% on the same period in 2013, according to data compiled by Kuwait Finance House.

According to the same data, while Malaysia continued to account for the lion's share of global primary issuance, contributing $41.7 billion or 63% of the total, issuers from 11 jurisdictions came to the market in the first six months of 2014. A process of internationalisation that had passed an important landmark in 2012, when Turkey issued its debut sukuk transaction, has gathered conspicuous momentum in 2014. In June the UK's Debt Management Office (DMO) issued its long-awaited inaugural sukuk, a £200 million ($313 million) five-year transaction, which was priced flat to gilts but generated total demand well in excess of £2 billion.

"The South African debut transaction is a reflection of the growing importance of Islamic finance in Africa"

The international diversification of the sukuk market took another significant step forward in September 2014, when a number of maiden sovereign issues were launched. Luxembourg completed its €200 million ($248 million) five-year transaction, which generated demand of more than €500 million, while Hong Kong and South Africa also launched highly successful debut sukuk issues. Hong Kong's $1 billion five-year ijarah sukuk attracted demand of $4.7 billion, and was priced at 23bp over US treasuries, which was the tightest pricing ever for a dollar benchmark from an Asian government (ex-Japan). Over 120 investors bought the Hong Kong issue, with 36% placed in the Middle East and 47% going to Asia. South Africa, meanwhile, generated demand of more than $2 billion for its $500 million five-year sukuk, almost 60% of which was placed with investors in the Middle East and North Africa.

The significance of these sovereign sukuk issues was not their fundraising element. The UK planned to sell £127 billion of gilts in 2014, so £200 million hardly scratches the surface of its total funding programme for the year. The UK, Hong Kong and Luxembourg transactions were important milestones in the evolution of the global Islamic capital market, however, because they reaffirmed the commitment of three of the world's premier financial centres to Shariah-compliant finance. These transactions, as well as the South African issue, also established benchmarks that can be used by a wide range of other borrowers to inject further diversity and liquidity into the sukuk market.

Luxembourg: building its sukuk credentials

AAA-rated Luxembourg presented a revised bill to its Council of State in June 2014, paving the way for the Duchy to launch its debut sukuk. The presentation of this bill was driven by the Council's request for a 'convincing explanation' as to why a sukuk would be a more appropriate form of financing than a conventional bond, given the additional costs of appointing a Shariah board to verify the transaction's adherence to Islamic law.

The passage of the bill, in July 2014, allowed Luxembourg to securitise three government properties to back a €200 million sukuk transaction, further enhancing the Duchy's role as a key centre for Islamic finance. By 2013, 16 sukuk with assets of some €5.5 billion were listed on the Luxembourg Stock Exchange.

The potential of Africa

In other regions, the South African debut transaction is also a reflection of the growing importance of Islamic finance in general and sukuk issuance in particular in Africa. The south-western state of Osun launched Nigeria's first sukuk issue in October 2013, and Senegal unveiled its inaugural sovereign sukuk in July, a CFEFr100 billion ($208 million) issue. The Nigerian and Kenyan governments are also said to have government sukuk in the pipeline.

In its extensive report on the outlook for the global market in 2014, Thomson Reuters Zawya identified the north African quartet of Tunisia, Libya, Morocco and Egypt as being among the most promising sources of new issuance. It is hoped that the passage of a new banking law in the summer of 2014, which for the first time contains articles relating directly to Islamic banks, will encourage the long-awaited emergence of a sukuk market in Morocco.

Tunisia, meanwhile, passed a law allowing the issuance of sukuk in July 2013. Mohamed Araar of the Central Bank of Tunisia observed that "sukuk has been identified as an important avenue to plug the Tunisian government's deficit and raise financing for the country's infrastructure and development needs".

Core sukuk markets

While an expanding list of countries will add to the international diversity of the sukuk market, Muslim-majority countries will continue to account for most of such activity, where the growth of Islamic banking has been identified as a priority at government level. One of these is Pakistan, where Shariah-compliant assets accounted for around 10% of the total in the banking system in December 2013. The stated objective of the State Bank of Pakistan's five-year strategic plan is to increase this total to 15% by 2018. In the global capital market, meanwhile, Pakistan is committed to building on the success of its $600 million debut sukuk issue in 2005.

Indonesia, which has issued regularly in the global sukuk market each year since 2010, has a similarly ambitious five-year plan to increase the penetration of Islamic finance in its domestic financial services industry. Although it is the world's most populous Muslim country, Shariah-compliant assets accounted for less than five percent of the Indonesian banking industry's total at the end of 2013.

It is Malaysia, however, that continues to lead the way in developing an Islamic capital market, the potential for which has not gone unnoticed among international issuers looking to diversify their global investor bases. In June 2014, for example, leading international banks such as Bank of Tokyo Mitsubishi and France's Société Générale cast an important vote of confidence in Kuala Lumpur's credentials as a hub for the Islamic capital market, by setting up multi-currency sukuk programmes in Malaysia.

In a report on the Malaysian banking sector published at the start of July 2014, Moody's commented that it expects Malaysia's strong growth trends to continue. This, says Moody's, will be driven by 'strong demand from the predominantly Muslim population coupled with the government's comprehensive and coherent strategy to increase the proportion of Islamic financing to 40% of total domestic financing by 2020 from 24% at the end of May 2014'.

A significant share of issuance from Malaysia will be driven by the banks' capital requirements, according to Moody's analysis. This looks at the Islamic banks' likely requirements if they maintain their 'current risk-adjusted profitability to support their internal capital growth of 8% per annum, and risk-weighted assets grow at 11% per annum'. In that scenario, Moody's estimates that the banks will need 'an additional MYR2.5 billion in new equity or capital-qualifying securities such as Basel-III compliant sukuk by 2016 to maintain capital ratios at current levels'. According to Moody's, this total is estimated to increase to M$8.7 billion ($2.5 billion) by 2020.

"Malaysia continues to lead the way in developing an Islamic capital market"

The market for Islamic bank capital has grown rapidly in the last 18 months. The first Basel III-compliant sukuk, for example, was issued in November 2012, a $1 billion transaction from Abu Dhabi Islamic Bank, which generated demand of over $15 billion. By May 2014 eight Basel III-compliant sukuks had raised almost $5 billion, with 48% of issuance accounted for by Saudi Arabian borrowers and 41% by banks from UAE.

Among other bank borrowers, meanwhile, a significant issue for the global Islamic capital market was the $500 million five-year sukuk al-wakala issued by Goldman Sachs in September 2014, which was the busiest month ever for new issuance of sukuk. The Goldman Sachs transaction, which was the first sukuk from a western financial institution, generated an order book of $1.5 billion, with 90% of the issue sold to investors in the Middle East.

Diversity of borrowers, maturities and structures

Depth of demand for sukuk in 2014 has also been reflected in the capacity of borrowers across the credit spectrum to access the market, with the emergence of double-B rated issuers such as Damac Real Estate, which issued a $650 million five-year transaction in April.

The growing depth and diversity of the sukuk market has also been reflected in the emergence of longer maturities in a sector that was once concentrated at the short to intermediate area of the yield curve. For example, when Saudi Electricity launched its $2.5 billion, two-tranche sukuk at the start of April 2014, it was the borrower's largest ever Shariah-compliant transaction, generating demand of $12.5 billion. This was divided into a $1.5 billion 10-year tranche and a $1 billion 30-year issue, which is an unusually long maturity for a corporate sukuk, and attests to the strength of demand from investors across the yield curve.

The process of lengthening maturities in the sukuk market took an important step forward in the same month when the Dubai Department of Finance issued a 15-year $750 million transaction that was more than three times oversubscribed. Aside from adding liquidity at the longer end of the market, the 15-year deal was regarded as providing a benchmark for other UAE borrowers, which will in turn support Dubai's goal of establishing itself as the focal point of the Islamic capital market in the GCC.

Sukuk wakalah – adding structural diversity

The global sukuk market is also diversifying structurally, with a number of innovations adding to the depth of the sector over the last 12 to 18 months. A notable example is the $100 million FWU Sukuk Wakalah programme, the first series of which was named as European deal of the year in 2014 by Islamic Finance News. Healthily oversubscribed when it was launched in October 2013, this Salam III issue broke new ground as the first securitisation of Shariah-compliant life insurance policies.

A more diversified range of sukuk issues – by geography, sector, credit rating and structure – twinned with a wider range of maturities, will clearly support the longer-term growth of the Islamic capital market. In February 2014, for example, it was notable that almost 20% of a debut $300 million sukuk from the Malaysian Export-Import Bank (Mexim) was placed with investors in the Middle East.

The role of sukuk in the infrastructure market


Sohail Jaffer
Deputy CEO

FWU Dubai Services GmbH
Al Fattan Currency House
DIFC PO Box 482026
T: +971 4175 500
F: +971 44175 555

Bankers are hopeful that the increasingly deep and liquid Islamic capital market will play an important role in helping to support much-needed investment in infrastructure throughout the Middle East and Africa. As the Malaysia International Islamic Financial Centre comments in a recent report that 'the immense infrastructure development plans globally present strong opportunities for sukuk to support and partly shoulder…global infrastructure financing needs'. Specifically, market estimates have suggested that in the GCC (Gulf Cooperation Council) countries alone, anything from $535 billion to $2 trillion will be required between 2010 and 2020 to overhaul existing facilities and develop new infrastructure. Africa, meanwhile, faces a jaw-dropping infrastructure gap of some $35 billion per year, according to the World Bank.

While much of this requirement will be met by support from official sources and conventional capital markets, the contribution of Shariah-compliant funding is likely to be significant.