Islamic bonds become mainstream investments

Sukuk buffeted by global trends

DUBAI, Feb 27, (RTRS): In April last year, Dubai’s government issued an Islamic bond and sold nearly two-thirds to investors in the Middle East. When it issued another sukuk last month, just 50 percent went to buyers within the region.

The difference illustrated a historic shift in the market for Middle Eastern sukuk, which are structured to obey religious principles such as a ban on the payment of interest.

Until recently, sukuk were a niche market in the region, largely bought and held to maturity by Islamic institutions which were not only concerned with maximising their returns but also with following sharia guidelines.

Now sukuk are becoming mainstream investments, bought by a wide range of investors including some far from the region in Europe and the United States. These investors are primarily focused on boosting their returns, by trading sukuk actively in the secondary market if necessary.

The shift is in many ways positive for sukuk - it marks a coming of age for Islamic finance, which was born in its modern form only in the 1970s. The increased investor demand for sukuk means companies in the Middle East can fund their projects at cheaper rates.

But there are drawbacks. Because so many international investors are now involved, traded prices of sukuk have become volatile, reducing their effectiveness as a safe haven in financial markets.

And the active secondary market trading in sukuk sits oddly with the spirit of Islamic finance, which frowns on pure monetary speculation and says investment should focus on the real economy, not trading financial instruments.

“We are certainly beginning to see the product become more mainstream. Some of the growth in the market is organic, with new markets opening up, such as Oman, coupled with a lot more issuance,” said Mohammed Dawood, managing director for debt capital markets at HSBC in Dubai.

Investors

“So you will naturally see a lot more hot money come into the market as a result. For a lot of global investors, there is an understanding that should they need to sell out, there is a strong and broad regional bid available.”

New issues of sukuk, including issuance in local currencies, jumped to a record high of about $121 billion worldwide in 2012, according to Thomson Reuters data, from around $85 billion in 2011. Dawood predicted issuance would grow between 20 and 30 percent in 2013.

Most of last year’s issuance occurred in Malaysia but there was a big increase in Middle East, where sukuk deals accounted for about half of the region’s total debt issuance of about $40 billion.

One reason for the growth of sukuk was their relatively stable performance during the global credit crisis of the past few years. Prices of conventional bonds tumbled around the world as credit ratings were slashed and financially troubled Western investors sold to plug holes in their balance sheets.

There was little such selling of Middle Eastern sukuk, which were mostly issued by companies from the oil-rich Gulf and bought by cash-rich Islamic investment funds. The stability of sukuk prices gave them a reputation for safety.

That reputation helped the region’s sukuk market bloom last year. The government of Qatar conducted a $4 billion issue, the world’s largest-ever dollar-denominated sukuk deal, while Abu Dhabi Islamic Bank structured a groundbreaking $1 billion issue to boost its core capital.

Foreign money poured into such issues. Half of Qatar’s 10-year sukuk last year was placed outside the Middle East, along with just under 50 percent of its five-year tranche. ADIB attracted orders of $15 billion from global investors.

As a result, sukuk prices handily outperformed conventional bond prices in the Gulf; spreads on the HSBC Nasdaq Dubai GCC (Gulf Cooperation Council) sukuk index tightened over 130 basis points in past 12 months, while spreads on the comparable conventional index narrowed just 7 bps.

Risks

Now the sukuk market risks becoming a victim of its own success, however; because it contains so much foreign money, it is more vulnerable to trends in international markets.

This has become clear in the past few weeks as the world’s conventional bond markets have been battered by rising US Treasury yields and a shift of funds from bonds into equities.

Sukuk have not been spared; the price of the $750 million, 10year sukuk issued by Dubai last month has plunged by between 2 and 3 cents on the dollar, underperforming many conventional bonds.

“International investors are often more active and less ‘buy and hold’,” said Mark Watts, head of fixed income in the asset management group at National Bank of Abu Dhabi.

“The days when relatively unsophisticated players bought bonds and blindly held them are numbered. Naturally this will mean that when markets come under pressure, internationally-held bonds will be more volatile.”

Last year, many Gulf companies could issue sukuk more cheaply than they could sell conventional bonds, because investors believed sukuk were less liable to price drops in the secondary market. This belief may have been shattered in the past few weeks, meaning future sukuk issues will be priced very close to conventional debt.

Rizwan Kanji, debt capital markets partner at law firm King & Spalding in Dubai, said investors in the Gulf would have to get used to more volatile sukuk as the price of expanding the market in them.

If Islamic investors are concerned about the rise of speculative trading in sukuk, they should consult their own boards of sharia scholars who can rule on whether it is advisable to invest in specific financial instruments, he added.

For conventional investors now, sukuk are “just another debt security”, he said.