Opinion / 1 October 2014, 08:00am / Mohieddine Kronfol
ISLAMIC finance, particularly fixed-income instruments known as sukuk, has come of age and is now an integral component of the mainstream global financial system.
A decade ago, the sukuk market was valued at $9.6 billion and issues were generally small; the market was concentrated among a handful of issuers. Last year the market topped $269.4bn (R3 trillion), with exponential growth in the number of large deals and increasing diversification of issuers.
The Islamic finance industry is expected to continue growing at nearly 20 percent a year, and the pool of investors interested in sharia-compliant securities is expected to rise with it. While Islamic investors are the natural buyers of sukuk, the appeal of the instruments now extends beyond the Islamic world. Some estimates suggest that conventional investors may account for as much as 40 percent to 60 percent of any individual sukuk offering.
In our view, sukuk may be attractive options for Islamic and non-Islamic investors seeking to diversify their investment portfolios. Not only are the returns attractive relative to traditional fixed-income assets, the volatility of sukuk has historically been more subdued – something that could prove important in a rising interest rate environment.
Moreover, sukuk provide exposure to some of the fast-growing and most financially sound economies in the Gulf Co-operation Council (GCC) and south-east Asia, countries that are often under-represented in many traditional bond indices and funds. Due to their unique structure and market dynamics, sukuk returns tend to be less correlated with other parts of the global fixed-income market.
What are sukuk?
Sukuk is the plural of the Arabic word sak, literally translated as title deed. They are financial certificates structured to comply with Islam’s prohibition on the charging or paying of interest that grant an undivided interest or share in an underlying asset along with the profits, cash flows and risk commensurate with such ownership. Sukuk are often referred to as the Islamic equivalent of bonds.
But sukuk represent ownership of real assets, whereas conventional bondholders own debt. The three most popular sukuk contracts by issuance volume are:
n Sukuk al ijara. These are sale and leaseback structures that use revenues from an underlying asset such as a building to pay investors.
n Sukuk al musharaka. All partners contribute capital and labour. Profit is shared among partners at an agreed-on ratio or on a declining basis. Losses are shared in proportion to the contributed capital.
n Sukuk al murabaha. This is a contractual agreement according to which a financier buys a good or an investment and then sells it to a customer with a mark-up on a deferred basis.
Sukuk can also constitute partial ownership in a project (sukuk al istisna) or an investment (sukuk al istithmar).
The bulk of sukuk issuance still comes from Malaysia and the oil-rich Persian Gulf states, but an increasingly wide array of countries and companies in other parts of Asia, Africa and Europe are taking advantage of vigorous demand.
In June, the UK became the first Western government to issue Islamic bonds. The yield offered was comparable to what the UK government pays on its conventional gilts, with investors receiving rental income based on three government-owned properties.
We expect this trend to continue. Tangible progress is being made across the globe to support Islamic finance and further sukuk issuance. Sixteen governments have issued sukuk since 2001, and more are likely to follow in the next few years. These deals, we believe, will further help to diversify primary market activity and improve secondary market liquidity.
There may be a number of clear benefits to owning sukuk, not only for sharia-compliant investors and financial institutions but also for sophisticated mainstream investors around the world. Growing diversification is a key advantage.
Sukuk offer investors who are not bound to be sharia compliant a chance to broaden existing core global fixed-income allocations. Because some of these fixed-income instruments are backed by a real asset and the payments are derived from profit sharing or rental income, they tend to be more insulated from market events and have lower correlations to other asset classes, including global bonds and global equity.
From a geographical perspective, sukuk offer exposure to areas of the market that may not be captured in more traditional fixed-income indices, such as the GCC and south-east Asia – two areas where credit ratings are relatively strong and economies have been expanding at a rapid clip.
In the GCC, for instance, issuers backing these bonds have tended to be of high credit quality with strong balance sheets. As a result, the credit risk profile has tended to be lower than high-yield debt, for example. As the market continues to grow and more companies and sovereigns begin to tap the Islamic finance markets, we anticipate these global and sector diversification benefits are likely to increase.
While we see interest in sukuk broadening globally, the fact remains that Islamic financial institutions and wealthy Muslims are still the biggest buyers of sukuk because they have few other alternatives. As such, they view sukuk as sound, long-term investments that, in many cases, they fully intend to hold to maturity.
Furthermore, the generally strong capital positions of Islamic financial institutions reduce any need to sell these instruments in times of market tumult. Western bond investors, in contrast, can hold a broad range of fixed-income securities and can shift out of asset classes as the perceived market environment changes.
With a large base of natural investors who have few investment alternatives and are unlikely to sell their holdings before maturity, sukuk offer conventional investors some downside protection in times of market volatility, in our view.
Sukuk may also gain traction in a rising interest rate environment. The US Federal Reserve and the Bank of England may be getting closer to actually raising rates. When interest rates rise, bond prices tend to fall. However, the impact depends on a bond’s duration, or its sensitivity to interest rate risk. The higher the duration, the more a change in interest rates will affect a bond’s price.
Sukuk offer a potential advantage. Typically, sukuk portfolios offer a lower duration (and thus less interest rate sensitivity) than major fixed-income indices. Indeed, when talk of an end to the Fed’s quantitative easing programme surfaced early last year, sukuk held up better than US treasuries and emerging market debt.
Liquidity is continually deepening. While the perception remains that the market is relatively illiquid, the demand has gained such momentum that secondary market liquidity has improved significantly and price discovery is becoming somewhat easier. Today, bid/offer spreads are comparable to those seen in the market for conventional fixed-income securities. Furthermore, as more companies and countries look to issue sukuk securities, deal sizes have been increasing.
Geopolitical tensions in the Middle East in recent years may raise concerns. Sukuk look to be relatively insulated from the regional turmoil. Given its relative stability, massive hydrocarbon reserves and accumulated current account and budget surpluses, the GCC has been considered a safe haven in the region. That said, of course, unforeseen events could have a short-term effect on GCC-related financial assets.
Mohieddine (Dino) Kronfol is the chief investment officer for global sukuk and Middle East and North Africa fixed-income strategies at Franklin Templeton.