There has been a spike in the number of sukuk issued outside the Muslim world. But while demand is up, there remains a significant number of regulatory and operational obstacles in issuing these sharia-compliant bonds.

What do Goldman Sachs, Bank of Tokyo-Mitsubishi UFJ, HSBC, the governments of the UK, Luxembourg, Hong Kong, South Africa and Senegal, the World Bank’s International Finance Corporation and the International Finance Facility for Immunisation have in common? To those unversed in Islamic finance, the answer might not be screamingly obvious, but this eclectic band have all issued sukuk instruments in the past few years, evidence of a growing trend towards sharia-compliant finance from institutions outside the Muslim world.

Though this type of sukuk issuance has gathered pace in recent years, its roots can be traced back to the 2008 financial crisis. Faced with shaky credit markets, corporates, banks and sovereigns realised that they needed to diversify their funding sources. “There was a lot of interest in sukuk at the height of the financial crisis. People realised that normal bank lending or capital markets activity couldn’t always be relied on, so they started to look at less conventional financing paths,” says Mohammed Dawood, global head of sukuk financing at HSBC.

A more permanent trend?

Interest in sukuk has come and gone since then, according to Mr Dawood, but the question now is whether the recent surge in deals can be converted into a more entrenched pattern in capital markets. From a demand point of view, sukuk issuance makes a lot of sense. Muslim countries, in particular Malaysia and those in the Gulf states, are home to banks and institutional investors that have very deep pockets, but are constrained by sharia law as to where they can place their cash. According to Dealogic, notional sukuk issuance has totalled about $40bn so far this year, a strong performance by all accounts but not one that will meet the appetite for sharia-compliant instruments.

“Islamic and non-Islamic investors are extremely receptive to sukuk issuance,” says Claire Bright, head of treasury at London-based Al Rayan Bank. Sukuk instruments are generally structured around returns from an underlying asset, such as property, and effectively give the lender ownership of that asset, rather than debt. Returns are accrued through profits from the asset, rather than interest payments.

There was a lot of interest in sukuk at the height of the financial crisis. People realised that normal bank lending or capital markets activity couldn’t always be relied on – Mohammed Dawood

“Because of the strength given to the sukuk by the underlying assets, defaults in this market are very, very rare," adds Ms Bright. "The framework of a sukuk means that both parties have skin in the game, so to speak. The issuer and investor have a shared risk, so that promotes the construction of stable instruments that are better to invest in.”

Meeting demand

Sukuk issuance from institutions in Europe, the US and Asia also meets a demand from Islamic investors for higher quality assets. According to Alex Armstrong, managing director of financial institutions coverage and structured finance at QInvest in Qatar, the average sukuk from the Middle East or other Islamic markets has a fairly short tenor, only five years or so, and is rated at BB or BBB.

“After the introduction of capital regulations such as Basel III in this region, there has been a demand for sharia-compliant, higher rated paper from Europe or other developed markets so banks can build stronger balance sheets and have a more geographically and credit-diversified portfolio,” he says.

“They are also prepared to accept a lower return on those assets than they would for an equivalent credit in the Middle East, such is the appetite for them. As a result, sukuk pricing is now roughly flat with equivalent conventional credit, whereas a few years ago it would have been higher, more expensive than a conventional curve pricing.”

Evidence of this large demand can be seen in the recent sukuk issuances from the UK, Luxembourg and Hong Kong, which were exceptionally successful. The UK was the first non-Islamic sovereign to hit the sukuk market in June 2014 with a £200m ($309m) offering. Maturing in 2019 with a yield of 2.036%, it received £2.3bn-worth of orders, with investors from the Middle East, Asia and the UK represented in the final allocation. Luxembourg released a similar-sized deal into the market in October of that year, and Hong Kong has so far issued two $1bn sukuk, one in September 2014 and another in May this year.

Proceed obstacles

However, while these sovereigns have been joined on the non-Islamic sukuk issuer list by banks and supranational agencies, Mr Dawood from HSBC indicates that there are still some major obstacles to this kind of instrument becoming more prevalent in mainstream capital markets.

“The first challenge is use of proceeds. It’s not enough for an issuer to put some assets together and structure a sukuk around them. To be fully sharia compliant, the issuer must prove that funds provided by investors are not used in any activity that involves the receipt or payment of interest in any capacity,” he says. This is especially problematic for banks. “There is an inherent conflict in the notion that you can raise Islamic funding for an investment bank whose activities are almost all interest-based,” adds Mr Dawood.

Goldman Sachs, which issued a $500m sukuk in September 2014, dodged this problem by linking the instrument to commodity returns, and funnelling the proceeds into its own commodity trading business. Similarly, the HSBC sukuk was issued by the bank’s Middle East operation, based on returns from the region. These solutions work fine for one-off issuance, but they may not be easily replicable for other banks, or even Goldman and HSBC themselves, on a regular, consistent basis.

A regulatory fit

Another problem for banks is the regulatory treatment of sukuk in non-Islamic jurisdictions, which can be out of sync with sharia requirements. Issuing a sukuk involves creating a special purpose vehicle (SPV) to which the pool of underlying assets, whether tangible or intangible, can be transferred.

“The UK government has done some work in creating sharia-compliant structures that should help corporates transfer tangible assets to an SPV. However, this does not apply to intangible assets that would typically be used by a financial institution as the underlying instrument in a sukuk issuance. Hong Kong has introduced more comprehensive legislation, but many jurisdictions have yet to make any progress in this area at all, so the issuance of sukuk can be challenging for banks,” says Mr Dawood.  

There is also a taxation hurdle. Property is commonly used as an underlying asset in a sukuk, which essentially involves the sale and leaseback of property between issuer and investor. In many jurisdictions there is no legal precedent for recognising such deals as holistic transactions, meaning that property and rental taxes must be paid on each property involved in the sale, gumming up the process and imposing extra costs on participants.

Corporate reluctance

Though the legal and operational costs of issuing sukuk in non-Islamic markets have fallen, the relatively low take up by banks has not encouraged corporates to take the plunge, something that dismays Mr Armstrong at QInvest. “We pitch to European corporates quite a lot, but there hasn’t been as much initial demand as we would have hoped. That’s probably a function of the amount of time that advisors or bookrunners [spend] in the sukuk market. The natural client coverage universe of the main players in sukuk is not European corporates, so it depends on how much time someone can dedicate to educating a new European client base of the benefits [while continuing] to service their home markets,” he says.

In the end, expansion of the sukuk market is likely to come down to further issuance from sovereigns, and more work from governments to clear up the legal intricacies. Hong Kong has visited the market twice, but other non-Islamic sovereigns have yet to establish a fully fleshed presence in sukuk.

That is a particular problem for the many Islamic banks based in the UK. In order to fulfil the Basel III liquidity coverage ratio (LCR), they have to hold enough highly liquid assets to survive a 30-day period of market stress. The Basel Committee expects much of that buffer to consist of sovereigns bonds, but that a problem for firms such as Ms Bright’s Al Rayan Bank.

“We can’t take non-sharia compliant instruments onto our balance sheet, effectively ruling out conventional gilts or other bonds. There simply aren’t enough sterling-denominated, sharia-compliant assets out there for us to use to meet the LCR standards,” she says.

Consequently, the bank has to take on dollar-denominated Islamic assets to comply with the ratio, which is far from ideal. “Our balance sheet is heavily oriented toward dollars, so there isn’t a huge problem around currency mismatches, but a lot of that dollar activity is only there to facilitate our compliance with the LCR in the first place," says Ms Bright. "It would be much easier for us and other Islamic banks in the UK if the government were to issue more sukuk instruments to help create a sterling market for these assets, and create an Islamic finance funding window to bring more flexibility to the sector.”


All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker

For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Top 1000 2023

Request a demonstration to The Banker Database

Join our community

The Banker on Twitter