Sukuk market share to grow following 2016

Sukuk issuance in core markets rose by 26% in 2016 and broadly maintained its share of capital markets funding despite large conventional bond issues by Saudi Arabia, Abu Dhabi and Qatar, Fitch Ratings says. We expect sukuk issuance to grow at a similar rate in 2017 and believe market share will rise as more sovereigns issue sukuk alongside conventional bonds.

New sukuk issuance with a maturity over 18 months from the core markets of the Gulf Cooperation Council (GCC) region, Malaysia, Indonesia, Turkey and Pakistan rose to USD40bn in 2016 from about USD32bn a year earlier. This represented 28.5% of total bond and sukuk issuance in these markets in 2016, down marginally from 29% in 2015. We focus on longer-term issuances because frequently rolled-over short-term debt can distort underlying trends.

The proportion would have been higher, but for the return of Saudi Arabia, Abu Dhabi and Qatar to the sovereign bond market with combined issuance of USD31.5bn. They probably opted for bond financing to attract international investors. However, seven of 10 key markets did issue sovereign sukuk in 2016 and other sovereigns in the GCC region have indicated they could issue sukuk, or a mix, in the future, reinforcing our view that the market share of sukuk will gradually rise. Oil exporters in the Middle East are also becoming an important source of the flow of international bond and sukuk issuances, and that trend should continue.

The decision on whether sovereigns issue bonds or sukuk is driven by three main factors: the target investor and funding base, whether there is an existing sukuk structure and Islamic finance strategy, and the needs and size of the Islamic finance industry, because Islamic banks cannot invest in traditional bonds. Outside core markets, issuance prospects are limited due to a lack of standardization, which makes structuring sukuk a more complex and time-consuming process than a traditional bond.

Dominant issuers

Sovereigns are likely to remain the dominant issuers, but bank issuance may also rise in some markets, driven by issuance to meet regulatory capital requirements. Basel III implications for liquidity are fairly significant in GCC countries as banks have a substantial contractual maturity mismatch between medium-term lending and very short-term customer deposits.

Malaysian companies continue to be the most active corporate issuers. Several other key markets have introduced or updated sukuk laws in the past few years, including Saudi Arabia, Oman and Kuwait, which should gradually boost issuance by creating a standardized structure and improving transparency.

The recent sovereign bond issues from the GCC region should also help create a capital market pricing benchmark and lower bank liquidity could reduce the pricing gap between capital market funding and the bank loans on which GCC corporates have traditionally relied. The biggest remaining roadblocks to corporate issuance are the development of debt-management expertise and a change in the corporate culture to increase financial and management transparency.

GCC corporates that tap capital markets are more likely to issue sukuk or a mixture of both, rather than only bonds to attract a wider local and regional investor base. In addition, some corporates are limited to only sharia-compliant borrowing by their own rules or by their desire to be included in Islamic investment funds and indexes. As a result, corporate capital markets activity is essential for sukuk to grow significantly in terms of proportion of total issuance. The main risks to our forecast of continued issuance growth are from economic or political upheaval that significantly reduced investor demand, a much faster than expected rise in US interest rates or a rapid recovery in oil prices that reduced the funding needs of key sovereigns.