UBS’s Islamic finance team talk to Edward Russell-Walling about the new products they have been working on, including the world’s first sharia-compliant exchangeable sukuk for Khazanah Nasional and sharia-compliant and commodity-linked certificates.

News that the UK Treasury will introduce specific regulation for issuance of Islamic bonds (sukuk) is an indicator of the growing reach and allure of Islamic finance in general. UBS has responded to the growing demand by creating a new Global Islamic Finance Group (GIFG), which has already notched up a number of firsts.

UBS reckons that Islamic (sharia-compliant) assets total between $300bn and $500bn globally and are growing at 10% to 15% a year. In the Gulf states, they represent only about 15% of total Gulf assets, and the bank believes there is a “tremendous” opportunity for this sum to grow.

As the world’s leading private bank, UBS is no stranger to the Middle East; it has been active there for 40 years. From 2002, it had its own Islamic bank, based in Bahrain. The bank, called Noriba (riba is Arabic for interest, which is impermissible under sharia law, so there is a touch of Swiss humour there), no longer exists, however. Its Islamic operations have recently been folded into the GIFG, which sits inside UBS Investment Bank.

“The group is a centre of excellence covering all sharia-compliant product structures,” says Catharine Furrer-Lech, who chairs the group. “It also covers wealth management and asset management.”

Sharia expertise

Established in September, the group has a panel of three sharia scholars, who advise on and approve compliant structures and documentation. A Syrian, a Bahraini and a Saudi, all three sit on the board that advises Dow Jones on its Islamic Market indices. Unlike some other banks, UBS has an in-house compliant structuring capacity.

It showed off that capacity to good effect in September with the world’s first sharia-compliant exchangeable sukuk for Khazanah Nasional, Malaysia’s state investment arm. The five-year $750m sukuk pays an annual coupon of 1.25%, yielding 5.07% if held to maturity. It can be exchanged into shares of Telekom Malaysia.

The deal was Malaysia’s largest ever equity-linked transaction. UBS was global co-ordinator, responsible for structuring the issue, and joint bookrunner with Malaysia’s CIMB and HSBC. Traditional bond structures are not allowed under sharia law because they create a direct debt obligation and pay interest.

“To be sharia-compliant, the structure must create beneficial ownership for investors and generate an income stream – lease income, for example,” explains Idayu Zainuddin, the GIFG’s head of structuring and product development. “In this case, the income stream is the dividend from the equity. The dividend flow is parked in a sinking fund to give comfort to investors that there is certainty of coupon payment.”

Sharia law insists on a beneficial interest in an asset that is both tangible (not money, for example) and acceptable (not arms or pork). “And the coupon should not be confused with interest,” Ms Zainuddin points out. “So the transaction must be structured and documented accordingly.”

Islamic investors were a target market but not the only one. “We see this as an investment product that happens to be sharia-compliant but also offers attractive and comparable returns to all investors,” says Ismail Dadabhoy, the GIFG’s head of global distribution.

Considerable effort went into familiarising exchangeable investors with the intricacies of sukuk. Islamic investors needed to feel comfortable with the nature and appropriate treatment of exchangeables. As it turned out, 28% of the deal went to the Middle East, where investors clearly liked the risk and the returns. But so did investors elsewhere. Orders worth $3.2bn came pouring in, prompting an increase from the original size of $500m. The deal was priced in the middle of its marketing range.

Islamic market growth

In the meantime, UBS has been rolling out other Islamic products, using commodities as tangible and acceptable assets. Peter Ghavami, the bank’s global head of commodities and sponsor of the GIFG’s creation, reiterates why UBS wants to be a major player in this market. “Growth is being driven by two factors,” he says. “One is the growing Islamicisation of the investing public. The other is the tremendous wealth creation in the Middle East and south-east Asia.”

Islamic financial institutions continue to multiply, too. “In 1975, there was one,” Mr Ghavami notes. “Today there are over 300.”

There remain, however, distinct gaps in the product range available to Islamic investors and this is where UBS is concentrating much of its effort. In September, it launched two tailor-made, short-term investment products: a commodity murabaha, and a sharia-compliant FX BLOC. The first mimics a traditional deposit account, using the murabaha principle of cost-plus sale. Essentially, the investor buys base metals and sells them to UBS for a profit that, together with the principal, is paid back on a deferred basis. Certain precious metals, such as gold, would not be permissible because they are regarded as money.

The FX BLOC is a dual currency murabaha offering a slightly higher return in exchange for assumption of currency risk. “The client invests in one currency on a murabaha basis and may get his return in another currency, depending on the FX rate on the maturity date,” says Sabri Ulus, the GIFG member responsible for structuring Islamic FX products.

The commodity murabaha and FX BLOC tenors generally range from one week to one year. “There has been a gap in one-to-five-year maturities offered in the market, however, and we have done a lot of work to provide a full array of choice for Islamic investors,” Ms Furrer-Lech says.

Commodities product

One notable result of UBS’s labours is a new range of sharia-compliant, tailor-made, commodity-linked certificates. These marry two of the investment world’s strongest current themes: the growth of Islamic finance and the role of commodities as an emerging asset class.

“Some research now suggests that 5% to 10% of a portfolio should be in commodities, because of their non-correlation with bonds and shares,” observes David Kemp, a member of the GIFG team.

What sets the UBS certificates apart, the bank says, is that they are the first of their kind to be tradeable. “Historically, commodity-linked certificates have not been tradeable under sharia law,” says David Kemp, a member of the GIFG team. “You couldn’t buy and sell them; you had to buy and hold. But what if you wanted to monetise a product where you had enjoyed gains?”

UBS is coy about the mechanics that allow its certificates to be traded, although it obviously believes it is on to something valuable. “The certificate is similar to a note, but it does not pay interest and the underlying assets are acceptable,” Mr Kemp says. “We have combined traditional financing techniques with sharia-compliant principles. The way in which we have done it is to innovative to the extent that we have applied for a US patent.”

The certificates are highly flexible. Investors can choose from numerous underlying commodities, including oil, copper, aluminium and lead, with whatever weightings may suit them. Tenors available range from one to 10 years, and the client can opt for a coupon paying or a zero coupon structure.

“We are putting the investor at the centre,” Mr Ghavami claims. “We’re saying: tell us what you want and we will provide it.”

Extending the range

This platform can reach beyond commodities into other asset types, and UBS plans to do exactly that. “We are working on extending the range of certificates across other asset classes,” Mr Kemp says. “We have a programme of rolling out certificate after certificate, giving Islamic investors the ability to on-trade if they change their view or wish to monetise their investment.”

UBS also hopes that the tradeability solution will address another problem faced by Islamic investors: a tendency to hold on to a compliant asset because, even if they wanted to sell, there is a shortage of suitable alternative investments.

“We hope that this will lead to the development of a more liquid secondary market,” Mr Kemp says.

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