Islamic finance supplement - Sukuk: caveat emptor

The global market for sukuk - Islamic Trust Certificates or bonds - was given a shot in the arm in April when representatives from the financial services sector and the UK's Muslim community gathered at the first Islamic Finance summit ever to have taken place at 11 Downing Street. That meeting was hosted by Ed Balls, Britain's City Minister, who announced soon afterwards that the UK saw "great potential advantages for the UK Government issuing Shariah-compliant debt".

As a result, Balls announced that he had asked the UK's Debt Management Office (DMO) and the Treasury to carry out a feasibility study into "opportunities for the Government issuing Islamic financial instruments in the wholesale sterling market".

With Standard & Poor's estimating that there is some $500 billion sloshing around the world in search of productive and dependable securities that don't technically earn interest (or riba, which is proscribed by the Koran), it is not difficult to see why the UK is considering issuing Shariah-compliant bonds.

Nor would the UK be the first borrower outside the world of majority-Islamic countries to issue sukuk - which are instruments that avoid the payment of interest, by entitling investors to a beneficial interest in the cash flows generated by underlying assets. The German state of Saxony-Anhalt, which raised EUR100m in a sukuk led by Citigroup, was the unlikely pioneer among European issuers in the Shariah-compliant market in August 2004.

Supply of sukuk by non-Muslim issuers, however, has paled into virtual insignificance relative to the demand for Shariah-compliant bonds among investors with no religious influence on their asset allocation. The explosive increase in global demand is a key trend in the market identified by Arul Kandasamy, Dubai-based head of Islamic finance at Barclays Capital and one of the experts who gathered in Downing Street in April.

Barclays Capital is among the international banks that has been at the forefront of the global promotion of the sukuk market; alongside Dubai Islamic Bank (DIB), it arranged the record-breaking $3.5bn pre-IPO transaction for Dubai Ports, Customs and Free Zone Corporation (PCFC) in January 2006. At the end of 2006, the Barclays Capital-DIB duo also led the three year $3.52bn convertible for Nakheel, the property arm of Dubai's DP World, which generated $6bn of orders.

That over-subscription level, however, was eclipsed by the $13bn of demand generated by February's sukuk for Aldaar Properties of Abu Dhabi. Barclays Capital, Credit Suisse and National Bank of Abu Dhabi were bookrunners on the Aldaar transaction, which was increased from an originally planned $1.3bn to $2.53bn in response to the weight of demand.

Outside the Gulf

Meanwhile, among borrowers from beyond the Gulf, Malaysia's Maybank also fuelled intense global demand for sukuk with its recent Shariah-compliant subordinated debt transaction. Led by UBS, HSBC and Aseambankers, this was a $300m 10-year non-call Islamic Lower Tier II transaction that was the world's first ever subordinated bank capital sukuk. This deal was seven times oversubscribed and distributed among more than 70 accounts, with only 13% sold to dedicated Islamic investors.

"Maybank has a substantial Islamic hire purchase asset portfolio and we see this sukuk as a comparable alternative method of raising funds from a diversified investor base. It was also anticipated to create some pricing tension which helped in making the issuance a success," says Idayu Zainuddin, head of Islamic structuring and product development at UBS in Dubai.

Another important recent transaction that further diversified the market was the $650m five year issue from the Saudi Arabian conglomerate, the SAAD Group, arranged by BNP Paribas. "The distribution of SAAD was very interesting, not just geographically, with more than half the bonds sold outside the Middle East, but also by investor type, with good demand from banks, insurance companies and pension funds," says Jacques Tripon, head of corporate and investment banking for GCC at BNP Paribas in Bahrain.

Kandasamy at Barclays Capital agrees it is not so much the absolute level of demand for these deals that has been significant. More important has been the development of the provenance of that demand. "At Barclays Capital, we have been focusing on the convergence between the worlds of conventional and Islamic finance which we have seen happening in a very big way," he says. "In the PCFC sukuk, 80% was placed with investors in the Middle East. That fell to 60% in the case of the Nakheel transaction and to just 20% in the Aldaar deal we led in February."

Kandasamy says that there are at least three decisive influences that are driving this rising demand. The first, he says, is diversification. "Countries like UAE and Qatar are Aa3 rated and have GDP growth rates that are among the highest in the world, so it is not surprising that investors should want exposure to the strong economic conditions in the Middle East," he says.

Second, Kandasamy says that the structural features of a number of recent sukuk transactions have appealed to international investors. "Typically, a European convertible will be launched off a term sheet, marketed and priced in a few days and sold with very few covenants or security," he says. "The convertible sukuk we've led have been accompanied by full-offering circulars and investors have enjoyed the protection of financial covenants."

Kandasamy states that a third factor underpinning increased international participation in sukuk is the growing liquidity in the market. "A long-standing complaint is that there has been such limited secondary market trading," says Kandasamy. "Recently there has been a huge uptick in liquidity. At Barclays Capital we trade an average of $20m a day in the sukuk market." That liquidity, Kandasamy adds, can only grow as an increasingly active CDS market in Shariah-compliant bonds gathers momentum.

So much for the good news. The less encouraging news is that there is a question mark over the degree to which non-Muslim investors have been prepared to make a full assessment of the risks embedded in the market. In their pursuit of diversification and yield, too many investors appear to have brushed aside or ignored the potential complications associated with the sukuk market.

Risk assessment

Those risks seem to fall into two distinct categories. The first is probably the more manageable and quantifiable of the two, because it is more familiar. "The wider investor community may not have thought long enough and deep enough about the nature of the risks involved in the sukuk market," says Neil Miller, global head of Islamic finance at Norton Rose in London.

He adds: "Sukuk structures are developing rapidly and this inevitably involves risk, although I think the main risk arises from the fact that these bonds are often issued in jurisdictions that don't have fully developed legal systems able to deal with the creation, recognition and establishment of title rights and security over property. Nor do these jurisdictions always have fully developed registries to record title interests, or well-established bankruptcy and insolvency regimes. But that is no different to the legal risk you would encounter investing in any emerging market."

By contrast, Miller says that the second category of risk - arising from Shariah law - is less of an issue in, for example, the participation of hedge funds in sukuk convertibles. "There is no reason why a hedge fund should not buy sukuk. The difficulties stem from the way hedge funds operate as Shariah law prohibits short selling," says Miller. "But compliant trading structures are being developed to help solve that problem."

Ifs and buts

Those that are relaxed about the risks arising from Shariah law ought to take a look at a report published by Fitch in March. Nothing in this report sounds an explicit warning to investors about those risks, but few assessments published by rating agencies are so heavily loaded with ifs, buts and unanswered questions.

The unspoken theme that repeats itself throughout the Fitch report is one of caveat emptor, in part because as there has yet to be a default in the sukuk market there is very little to go on by way of historical precedent. True, sukuk are generally issued under English law. But as Fitch cautions, "any judgement would probably be reviewed by the courts where the originator is domiciled - and may not be enforced".

Additionally, says the agency, "while these courts would ordinarily act in accordance with local commercial law, they may be influenced by Shariah law, which adds further uncertainty to any judgement". That uncertainty is exacerbated by the fact that the interpretation of Shariah law differs not only from country to country, but also from one board of scholars to the next. As a result, Fitch warns that "ratings assigned to sukuk do not imply any confirmation that the sukuk are Shariah compliant".

At S&P in Paris, credit analyst Anouar Hassoune confirms that, from the perspective of a rating agency, assessing the risks in the sukuk market can be hazardous. As an example, he points to uncertainties still hanging over the Maybank transaction, given the doubts that some Middle Eastern Shariah scholars have expressed over the basic principle of subordinated transactions that rank investors according to the seniority of their claims.

Similar uncertainties, he says, are likely to prevail over any market that may emerge involving the securitisation of Islamic mortgages. In theory, everybody agrees that Islamic finance is well-suited to securitisation, given its emphasis on the cashflow generating capacity of the underlying asset. But he adds that in practice, for a bank to foreclose on a mortgage loan and evict a family falling behind on its payments would be "unimaginable" in most Muslim societies.

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