Sukuk sheds its niche status

In August 2014, the UK became the first non-Islamic country to issue sovereign sukuk. Hong Kong, Luxembourg and South Africa quickly followed, in what has turned out to be a landmark 12 months for the market. Building on these sovereign transactions, a number of high-profile, first-time corporate issuers have also emerged in 2014, including Goldman Sachs and the Bank of Tokyo-Mitsubishi UFJ Malaysia.

As such, total issuances in the first three quarters of the year were up 14.1% compared with the same period in 2013, according to Kuwait Finance House research. And, while the market’s growth story in terms of quantity is proving compelling, it is also being matched by an increase in the quality of its development.

The hard sell

All of these sovereigns, and a growing number of corporates, came to the market with international or so-called ‘hard currency’ issuances, which were denominated in UK sterling, euros, US dollars or yen. This trend is helping to address the dearth of such transactions in the Islamic finance industry, while opening up the prospects for more corporates and other first-time issuers to follow suit.

As the volume of these hard currency transactions continues to grow as a proportion of total sukuk issuances, a larger and more liquid global sukuk market is being established. In the first half of 2014, US dollar-denominated sukuk accounted for 18.9% of total issuances, up from 15.02% in 2013, according to data from Kuwait Finance House Research.

“I think 2014 has been a fantastic a year in terms of the quality of the sukuk market’s growth because we have continued to see a lot of new first-time issuers. These have come in the form of new sovereigns, as well as new corporates and new business sectors looking to tap the market. Moreover, we continue to have new types of innovative transactions,” says Mohieddine Kronfol, chief investment officer at US-based investment manager Franklin Templeton.

Japan jumps in

In September 2014, Bank of Tokyo-Mistubishi UFJ Malaysia became the first Japanese bank to issue a sukuk. Part of a multi-currency, US dollar-yen, dual-tranche transaction, the issuance was also the world’s first yen-denominated sukuk. As such, the implications of this transaction are considerable. Not only does it point to the growing viability of Islamic finance as a source of funding for major non-Islamic corporates, but it also opens up the market for further transactions to emerge from Japan and Japanese corporates.

“Our main objective for issuing in this multi-currency sukuk is to secure an alternative funding source for our operations in Malaysia, and to manage our liquidity position to match our increasing and growing exposure to the global Islamic banking business,” says Naoki Nishida, president and chief executive of Bank of Tokyo-Mitsubishi UFJ Malaysia. “Islamic finance is a little known concept in Japan. Hopefully, this issuance will familiarise potential investors and prospective issuers and catalyse the growth of a larger sharia-compliant marketplace in the country.”

The yen-denominated component of this transaction emerged, in part, through the joint efforts of the governments of Japan and Malaysia. Ongoing bilateral co-operation has seen both countries evaluate opportunities to advance the internationalisation of the Islamic finance market, an objective that marries well with the Japanese government’s own ambitions of promoting the yen in the global bond markets.

“As this is the first ever yen-denominated sukuk issuance, naturally it [should] be beneficial for the governments of both Japan and Malaysia,” says Mr Nishida.

Spreading the word

Crucially, this growing salvo of hard currency transactions, in conjunction with other market forces, has widened the potential investment universe for sukuk. With the growing interest of institutions such as pension funds and asset managers, there has been a shift towards greater transaction complexity and extended maturity dates. The Saudi Electricity Company’s groundbreaking 30-year sukuk tranches have met with significant global interest, not least from institutional investors in the US, Europe and Asia.

Moreover, every pioneering first-time issuance, such as the one issued by the Bank of Tokyo-Mitsubishi UFJ Malaysia, essentially acts as proof of concept for the market. Once potential issuers are aware that global or local demand exists for sharia-compliant debt, the investment case becomes much easier to make.

This is particularly important for sukuk transactions issued in non-Islamic jurisdictions, as the salient challenge remains one of awareness. With the level of knowledge regarding Islamic investment products among international investors still relatively low, each first-time transaction opens up a greater global investor base.

“Historically, most sukuk were being designed and structured for the demand that was coming from the Islamic banks. Whereas today you have demand coming from insurance companies, pensions funds, private banks and asset management companies. As such, these new non-bank investors will fuel the level of innovation in the market and the rise of new risk profiles will contribute to sukuk becoming a distinct asset class,” says Mr Kronfol.

Another way in

First-time corporate and sovereign issuers have been a notable source of growth for hard currency issuance this year. Yet, the primary driver of this trend over the medium term will be the dollar-pegged economies of the Gulf, according to Khalid Howladar, global head of Islamic finance at ratings agency Moody’s.

This dynamic will accelerate the already widening international investor base interested in gaining exposure to emerging economies, particularly in Gulf countries. The key impetus here is that foreign investors will not be faced with the kind of risk associated with buying into local currency transactions. In turn, this interest will augment levels of demand and liquidity in the sukuk market.

“Foreign investors don’t want to face the kind of currency risk associated with transactions denominated in Emirati dirhams or Saudi riyals. The fact that most Gulf states are natural dollar issuers, due to their currency pegs, also makes them an attractive emerging market dollar investment. This trend will drive hard currency issuance over the medium term,” says Mr Howladar.

Moreover, the sukuk market is arguably becoming the easiest way to gain exposure to the attractive markets of Malaysia and the Gulf. According to Mr Howladar, the scope of conventional investment options available in international markets had previously deterred investors from engaging with sharia-compliant instruments. Today, in light of the growing number of total issuances, the picture is different.

“It isn’t the appetite for Islamic or sharia-compliant investments that is driving a lot of these trends, it is the appetite for Gulf or Malaysian credit that comes first,” says Mr Howladar.

A growing investor pool

Over the medium term, the sukuk market is likely to receive a boost from the number of Islamic jurisdictions, particularly in the Gulf, that are embarking on ambitious infrastructure development plans. As such, the volume of sukuk being issued to support these objectives is increasing, making it difficult for global investors to ignore.

Yet, in the case of Malaysia, strong demand from the country’s domestic market has meant that international currency issuances remain a relatively small percentage of the total. Less than 10% of the $178bn in total outstanding Malaysian sukuk is US dollar-denominated, and this seems unlikely to change over the medium term, according to a research report from Moody’s.

However, as global demand increases for hard currency sukuk, there is scope for the country’s established corporates to tap the global market through such transactions, to a greater degree, over the longer term.  

Looking ahead, the increasingly global profile of the sukuk market and accompanying increase in hard currency transactions, will likely catalyse the formation of a much more diverse investor base.

“When you see the investor profile of the recent sovereign sukuk issuances from the non-Islamic countries, you would see a significant minority of non-Islamic investors subscribing to the sukuk. Over time, investors from the Gulf Co-operation Council and Malaysia will be competing with fund managers from Europe and North America. From an issuer’s perspective a bigger investor pool mitigate placing risk and could result in better pricing,” says Noel Lourdes, executive director of sharia advisory firm Amanie Advisors.