As a result of the global financial crisis and ensuing recession in the US, and in keeping with its mandate to achieve maximum employment, the US Federal Reserve (Fed), responded by setting short-term interest rates to a near zero.
The Fed also began purchasing vast quantities of US Treasuries and mortgage-backed securities, a process referred to as quantitative easing (QE). These QE efforts, in combination with the anchoring of the short end rate, have kept the yield curve artificially low in an effort to revive the US economy.
In sustaining this low rate environment via securities purchases the Fed’s monetary policies have created massive liquidity in the capital markets. This influx of liquidity combined with low domestic interest rates provided both the means and the incentive for institutional investors to aggressively seek higher yield in alternative markets. Many investors have looked to fixed income securities such as high-yield bonds and emerging markets (EM) fixed income securities, including US dollar-denominated global Sukuk securities, for higher yields than were available from US Treasuries.
The idea that the Fed might begin the wind-down of the third round of its quantitative easing program (QE3) has been a dominant focus since May 2013, due to Fed chairman Ben Bernanke’s public comment that the Fed could begin to taper its QE3 purchases to later this year, if there were signs of a sustainable improvement in the US economy. Since that time, yields have been rising quickly, with the 10-year US Treasury going from a yield of 1.63% in early May to 3% as of early September. During that time, in response to the Fed’s direction, the market was very much trading on technical based on US economic data, seeing it as a guide to the timing of Fed’s action to reduce and eventually end QE3. Most recently, market participants seemed to reach a consensus, fuelled by further commentary by Fed officials and their read of the economic data, that the Fed would start to taper to some extent following the September 2013 Federal Open Market Committee (FOMC) meeting.
During this same period, given the implications of a consequential rising in rates environment, combined with receding excess in global liquidity, market participants reacted by selling off EM equities, and further selling off government, quasi-government and corporate fixed income EM assets. The result was a lack of market liquidity in those investment areas, as well as the significant spike in volatility witnessed over the past several months. The market’s reaction, or overreaction, caused a significant increase in yields and a commensurate fall in the prices of fixed income securities in most if not all global asset classes, leading to significant investment losses during the period following Bernanke’s comments.
Since the June FOMC meeting, the stream of US economic data has been, on the whole, more positive than negative, supporting expectations of sustained albeit modest economic growth. Bernanke provided some additional “clarity” in July, emphasising the staying power of the Fed’s accommodative policy in the near term should the economy not provide convincing and sustainable evidence of its strengthening. His remarks helped to calm global markets to a certain extent. However, uncertainty over the timing and pace of the reduction of purchases, as well as the unavoidable end of QE3, continues to weigh on market participants.
Sukuk is less impacted compared to conventional EM fixed income
The global market sentiment and volatility have caused dislocation in the mainstream fixed income markets and also affected the global Sukuk market. Nevertheless, Sukuk is better insulated and unlikely to underperform compared to its conventional benchmarks due to its defensive nature and buy-and-hold investor base (See to Table 1).
Table 1: Returns volatility of Dow Jones Sukuk Total Return Index (DJSUKTXR) and J.P. Morgan Emerging Market Bond Index (EMBI) Global Total Return Index over 2-year period | ||
Returns Volatility (%) | ||
Dow Jones Sukuk Total Return Index | 2.24 | |
J.P. Morgan Emerging Market Bond Index (EMBI) Global Total Return Index | 7.21 | |
Source: Bloomberg and CIMB-Principal Islamic Asset Management as at the 30th June 2013 | ||
Over the two-year period ending the 30th June 2013, the global Sukuk market (represented by the Dow Jones Sukuk Total Return Index) exhibited lower returns volatility compared to the EM bond universe (represented by J.P. Morgan Emerging Market Bond Index (EMBI) Global Total Return Index), supporting the view that, historically, global Sukuk as an asset class is relatively insulated compared to the conventional emerging bond market. |
Increasing demand and popularity for Shariah compliant products and structures post the global financial crisis have formed a strong demand base for Sukuk. Moreover, the global demand for Sukuk is forecasted to grow three-fold from US$300 billion to US$900 billion by 2017 according to Ernst & Young (EY). The exponential rise is primarily a result of double digit growth of the Islamic banking industry and the increasing appetite for credible, Shariah compliant, liquid securities.
In addition, two-year historical return performance for Sukuk is comparatively better than for conventional bonds because the investor base is less affected by unwinding of fixed income securities and EM asset positions. Much of this demand originates from Islamic financial institutions as well as fund managers and high net worth individuals. Hydrocarbon-based wealth and an economic resurgence in the MENA region are key factors positively shaping the investor base for global Sukuk investments. In addition to increasing the liquidity of the Sukuk market, investors can expect to see more stability in the global Sukuk market because a substantial proportion of the participants in this market have the intention of holding their Sukuk investments for the medium to long-term.
Sukuk is an ideal investment for investors looking for opportunities to position for economic recovery while maintaining exposure in Islamic fixed income markets. The financial sector is considered a proxy for the growth of an economy since banking entities typically flourish as a function of economic expansion. Given that Shariah compliant banks and other financials constitute the second-largest sector at around 28% of the Dow Jones Sukuk Total Return Index (DJSUKTXR), as shown in Table 2, a diversified global Sukuk portfolio can provide broad exposure to the financial sector including Islamic banks such as Qatar Islamic Bank (Qatar), First Gulf Bank (UAE) and Abu Dhabi Islamic Bank (UAE).
Table 2: World Broad Investment Grade (WorldBIG) Bond Index and Dow Jones Sukuk Total Return Index sector weightings | ||
Weightings (%) | ||
Sector | Dow Jones Sukuk Total Return Index | World Broad Investment Grade (WorldBIG) Bond Index |
Government and government sponsored | 44.42 | 68.22 |
Financials | 28.43 | 5.75 |
Energy & Utilities | 19.09 | 2.41 |
Industrial | 8.06 | 6.77 |
Collaterized (MBS and Covered Bonds) | – | 16.85 |
Source: Bloomberg and CIMB-Principal Islamic Asset Management as at the 3rd June 2013 | ||
Financials constitute the second largest sector at around 28% of the Dow Jones Sukuk Total Return Index. This offers an investment opportunity for conventional fixed income investors who want to diversify the quality of their overall portfolio’s exposure to the financial sector as they can gain exposure to Islamic banks such as Qatar Islamic Bank (Qatar), First Gulf Bank (UAE) and Abu Dhabi Islamic Bank (UAE). |
Managing global Sukuk portfolios in a rising rate environment
It is well known that interest rate volatility poses a real challenge to fixed income portfolio managers since rising rates can negatively impact the value of fixed income portfolios.
CIMB-Principal Islamic Asset Management (CIMB-Principal Islamic) significantly reduced interest rate risk across their managed global Sukuk portfolios by shortening duration earlier in 2013. The market expectation is that the Fed will start to taper purchases gradually, starting as early as this year and would then start increasing short end Fed Funds rates gradually with the first increase anticipated sometime in early 2015. A Sukuk portfolio that currently has a five-year average maturity would have only about three years to maturity by 2015, therefore escaping much of the duration-related volatility as rates rise. Over the course of this period, investors would be able to reinvest incoming proceeds in higher-yielding short and medium maturity securities.
Depending on investment parameters and risk tolerance, our portfolio managers will look to add existing and newly-issued higher yielding investment grade names to their portfolios. Some high yield credits are expected to outperform and provide annual returns of 6-7%. The expected returns on high-yield bonds are a function of two factors: (1) the magnitude of the recent sell-off which added significant yield for purchasers of the securities; and (2) higher profit rates for new issues and positive price performance in the primary market. As global economies recover, investors may tolerate more risk in their portfolios for added yield due to improving expectations on issuer performance and lower expectations for default. Recently, Moody’s Investors Service announced that the global default rate on global high-yield debt for the first quarter 2013 was 2.4%, near a record low.
In terms of asset allocation, CIMB-Principal Islamic continues to favor financials within the GCC region such as Saudi Arabia, Qatar, Abu Dhabi and Dubai. In addition to moving down the credit curve on senior unsecured securities in response to improving global economic growth data, our portfolio managers could allocate a certain proportion of their portfolios to subordinated Sukuk instruments of the strongest banks in the GCC.
Conclusion
The prospect of the Fed tapering the monetary stimulus programme sent shockwaves through the financial markets. Sukuk have not been spared by the impact of rising US yields. However, the global Sukuk market proved relatively more resilient in the face of this volatility. The resilience of the global Sukuk market has been largely a demand-driven phenomenon, propelled by investors for products that are more compliant with their religious faith. Sukuk are also emerging as a new asset class for conventional investors as the asset class has undoubtedly filled a gap in the global capital market. In addition the global Sukuk market is supported by cash-rich investors who tend to hold global Sukuk securities until maturity. Since the market is still very much focused on the possibility of the Fed reducing its bond purchases, one way to protect global Sukuk portfolios from the potential effects would be to employ proactive portfolio managers that are attuned to managing these risks.
Ramlie Kamsari (Chief Executive Officer and Executive Director)
CIMB-Principal Islamic Asset Management
Level 5 Menara Milenium 8 Jalan Damanlela
Bukit Damansara 50490 Kuala Lumpur Malaysia
Tel: (603) 2084 2000 Facsimile (603) 2084 2004
http://www.cimb-principalislamic.com