As we pass the midpoint of the year we seem stuck in the doldrums, with Sukuk issuance slowing right down amid a tense market girding itself up to face the impact of a withdrawal of US quantitative easing measures and a plethora of economic challenges. As the market drags itself through the lazy last days of the summer slowdown and Ramadan draws to a close, we talk to market leaders around the world to find out their opinions on the story so far, and what we can expect from the Sukuk sector in the second half of the year.
Market slowdown
Neil Miller, the global head of Islamic finance for Linklaters, confirms that: “The issuance market has become much quieter over the last few weeks.” The reasons for this might be obvious – including the combined effect of recent turmoil in global bond markets after the US federal reserve’s announcement that quantitative easing would be tapered down, in addition to the standard seasonal impact of summer, exaggerated by the effect of Ramadan – but they have no less impact for that. As of last week the market has gone seven consecutive weeks without an international issuance, with the last US dollar issuance placed by the Islamic Development Bank (IDB) in May, and governments and state entities appear to have all but withdrawn from the market. Total issuances the week of the 23rd July were US$1.7 billion according to KFH Research – well below the year’s weekly average of US$2.2 billion, and bringing total issuance for 2013 to US$66 billion. In June the market slumped still further, recording the lowest monthly Sukuk issuance in 18 months.
Anzal Mohammed, a partner at Allen & Overy, warns that we can’t expect much better for at least another few months. “Like the conventional bond markets, the Sukuk market has been affected by the volatility in the global capital markets since June and, with Ramadan and the summer, which is traditionally a quieter period for new issuance, we are unlikely to see new issuance until early September at the earliest assuming market conditions are conducive.”
Market volatility
While the current period of Ramadan has seen no deals being brought to market, Paul Bateman, the assistant director of Islamic capital markets at Bank of London and The Middle East (BLME), points out this is not unusual or unexpected, based upon previous market behavior.
However, the run-up to this year’s Ramadan was differentiated by a period of market volatility, principally driven by differing views on the expected pace of change in monetary policy in the US. “In addition to the effect this had on the interest rate swap market, there was a re-pricing of credit risk which had previously appeared to exhibit credit spreads which had become too tight,” explains Bateman. “When volatility levels subside, debt issuers will have greater confidence to meet with investors with new transaction proposals which are deemed to be priced fairly, and issuance volume should rise.”
US tapering
However for now, a number of factors continue to inhibit the market, the most significant of which is of course the US withdrawal of quantitative easing, which has contributed to the tumbling yields which have spooked investors and sparked a Sukuk sell-off, resulting in heightened risk aversion and a nervous market. Speaking to Islamic Finance news, Malaysian Rating Corporation (MARC) notes that in its view the slowdown is primarily a result of the rising cost of funds, driven by the US scaling back bond purchases in view of the improved macroeconomic outlook.
A source based in the Gulf suggests that the market may have overreacted to this, and we might be able to expect strong issuance once the market comes back in September after the summer holiday slowdown and the end of Ramadan. Mohieddine Kronfol, the chief investment officer of Franklin Templeton Investments, confirms that: “We expect by the time liquidity comes back, the market should have a more rational outlook for US federal reserve monetary policy and emerging markets economic growth.”
However Malek Khodr Temsah, the vice-president of treasury and investments at Al Baraka Banking Group in Bahrain, warns that investors are not only concerned by the impact of US tapering, but are equally worried by the implications of these actions on emerging markets, which have been the primary beneficiaries of capital outflows. “The recent acute sell-off in emerging market dollar debt in the second quarter of 2013 sheds light on these pent-up jitters, which are weighing down on market sentiment and which in turn is keeping Sukuk issuers at bay,” he explains.
Price premium
Another reason for the general slowdown, suggests a source, is that there has actually been little need for issuers to tap the market. “With the premium between Sukuk and conventional eliminated, there is less incentive for non-Islamic issuers to tap the Islamic investors from a price perspective, and up until May, there has been no need to tap the Islamic investors either from a liquidity perspective, as you could raise as much as you wanted from the convention investors.”
Basel III
Jeroen Thijs, the chief risk officer at Bank Islam Malaysia, also points out that the Basel III requirements have had a significant impact. “At least in Malaysia, the enforcement of Basel III requirements, especially the mandatory write-off or conversion requirement, is holding the market back. Central banks are unwilling to specify the trigger levels at what point a Sukuk needs to be written down or converted into equity.”
Another issue is that the exercise price of equity conversion cannot be set at the outset. This becomes even a bigger issue for banks that are not listed, as there is no trading benchmark for their equity. “All this will make issuance of Sukuk a lot more expensive given these added uncertainties,” predicts Thijs, warning that: “Also at the moment there are not enough Basel III compliant issues in the market that provide an adequate price benchmark.”
However, given that banks will have to issue sooner or later, there is still the likelihood that market activity will pick up towards the end of the year.
Malaysia moving ahead
MARC notes that Malaysia’s Sukuk market has been somewhat affected with uncertainties surrounding the 13th general elections, and suggests that: “Slower growth in private investment in 2013 will also be another factor for the slowdown in bond issuance in Malaysia this year.”
However, it must be noted that Malaysia’s Sukuk market has seen little slowdown compared with the rest of the world. According to Meor Amri bin Meor Ayob of the Bond Pricing Agency Malaysia, the market is “moving along nicely” with total Sukuk outstanding for the first half of 2013 (as at the 28th July) at RM492.6 billion (US$152.5 billion) – up from RM478.1 billion (US$148.2 billion) at the end of 2012 and an increase of 40% from 2011.
Malek of Al Baraka also points out that: “Moreover, as industry-wide bodies between both regions gradually converge from a regulatory and Shariah point of view in light of increased coordination and cooperation, we do expect additional cross-border Sukuk sales such as GCC issuers looking to tap the depth and breadth of liquidity in the Malaysian ringgit Sukuk market.”
Bouncing back
Most players still expect that the market will recover after Ramadan. Miller predicts that: “We anticipate a pick up from September onwards,” while Ng Kit Ho, the head of debt capital markets in Malaysia for RBS, points out that the market as a whole has been slow, not just the Sukuk market. “We expect the market to rebound in line with the rest of global liquidity,” he notes.
In fact Bateman believes that it is happening already. “Arguably, the US dollar Sukuk market has already rebounded strongly,” he suggests. Having peaked in May 2013 at a level of 148.822, the HSBC/NASDAQ Dubai US Dollar Sukuk Index fell to a 10-month low of 142.144 in June 2013, before rebounding to a recent level of 146.212, suggesting that the market is already on its way back up.
Malek is equally positive. “Sukuk issuance volumes will really start to pick up steam again in the first quarter of 2014. With US$35 billion in GCC bonds and Sukuk maturing in 2014, the refinancing needs of regional borrowers will ensure that the supply-side dynamics remain supportive of issuance.” Moreover, entering into 2014, the Sukuk market remains buoyed by sound fundamentals such as expansionary fiscal policies by GCC governments and massive infrastructure spending which will provide an impetus for state-linked borrowers to tap the Sukuk market and mobilize the significant liquidity parked on the balance sheets of Islamic financial institutions.
However, Abradat Kamalpour, a partner at Ashurst in London, is less optimistic: “I think the market is at least a good six to 12 months away from starting to rebound… One issue is that a lot of the international banks (who take the lead on many deals) are restructuring themselves, and this inevitably leads to delays on transactions.”
A healthy pipeline
This might be true, but according to most market players the pipeline of deals coming to market is looking good, suggesting that all is not as black as it’s painted. Miller confirms a “reasonably healthy pipeline,” noting that: “We have more than half a dozen transactions at varying stages of progress. It is always difficult to predict the markets and unanticipated extraneous events are always a possibility; but that aside we think it ought to be quite easy for the taps to be turned on again once we get through summer and Ramadan.”
Anzal of Allen & Overy agrees: “We are advising on a number of transactions which are in the execution phase and we expect the last quarter of this year to be particularly busy.” Ben Moylan, a partner in the Qatar office of Eversheds, notes that for the Qatar market too: “There are deals in the pipeline, with issuers ranging from financial institutions to large corporates, and we expect many of these to come to market in the coming quarters.”
MARC is also optimistic on the future for the market, particularly in the Gulf region. “The long-term prospects of global Sukuk issuance remain promising as there is a significant amount of investment taking place in GCC countries over the next few years following government intentions to diversify their economies away from the oil and gas sector,” said a spokeperson to Islamic Finance news.
Overall economic growth looks resilient in the GCC area and there are reportedly projects worth more than US$900 billion at various stages of development throughout the region, including several mega infrastructure projects that are being planned or executed, particularly in the real estate segment. “We believe that the implementation of these mega projects would revitalize bond issuances from these countries,” MARC confirms.
Upcoming sectors
Sukuk activity is also likely to continue in the Islamic institutional sector and Miller predicts that it may include further Tier 1 and Tier 2 issues. “We also anticipate more regional sovereign and GRE issuances which have of course been the staple for several years. We may also see the start of an interesting niche with some corporate hybrid issuances in the offing,” he explains.
Ng of RBS identifies a number of other key areas to watch: “Some interesting deals in the pipeline include EXIM Malaysia, Genting Plantations, Turkish banks and corporates, Saudi Arabian banks and utility companies and Malaysian utility companies.”
New markets
Saudi Arabia is in fact causing considerable excitement in the market, as people believe that 2013-14 could be the year that its Sukuk sector really takes off. Adulkader Thomas, CEO of SHAPE Knowledge Services, highlights that: “Saudi Arabia is a key market to watch.” Malek agrees: “In light of the recent successful debut Sukuk by the Saudi Arabia dairy corporate, Almarai, we anticipate 2014 to be the year where Saudi corporates will increasingly emerge from the shadows and issue local-currency Sukuk.”
Qatar is another promising market with impressively strong domestic growth and expanding domestic credit, which grew by almost 25% between 2011-12 on the back of robust public sector lending. S&P expects credit growth in Qatar to stay above 20% in 2013, pushing up the demand for funding by Qatari banks and, consequently, the level of debt capital market issuances. Moylan comments that: “As far as I am concerned, there is no Sukuk specific slowdown here and the lack of Sukuk issuances is really part of a more general ‘wait and see’ attitude to both debt and equity capital markets issues over recent months.”
Qatar is embarking upon several major infrastructure projects over the coming years and it is accepted that banks in particular will need to undergo capital raising in one form or another in order to fund many of these projects, leading to an inevitable boost for the Sukuk market. Moylan however warns that: “As of now, not all of the contracts associated with the projects have not been awarded, and institutions seem to be awaiting the outcome of these awards and a consequent clarification of their likely funding needs, before entering in the markets, through Islamic instruments or otherwise.”
Sovereign push
But while these markets are making strides forward, other new entrants have a little more work to do. Ng points out that: “Some of the jurisdictions that have an interest in issuing Sukuk still have not or have only just harmonized their legal framework, e.g. Hong Kong. It will take time for a first mover to issue a benchmark and set up a curve. If these countries are interested and serious about issuing Sukuk, they will need to set a curve, which means that the sovereign or proxy to the sovereign needs to make the first issuance so that the rest can follow.”
The coming year is also expected to see a lot of new markets arriving to tap the Sukuk sector. Malek notes that: “We’ve seen a plethora of new sovereigns either jump on the bandwagon and amend tax laws and regulatory frameworks to facilitate the issuance of Sukuk or indicate a keenness to make their jurisdictions more Sukuk-friendly. Oman, Tunisia, Morocco, Kazakhstan, and Nigeria are amongst a pool of governments that are expected to explore Sukuk issuance.”
It is not just in new markets that sovereigns need to take a stand though. One other reason for the slowdown in Sukuk issuance has been the absence of governments and sovereigns from the market. Timucin Engen, an associate director of S&P in Dubai, notes that: “Looking at the breakdown of global issuance to date, there was a slowdown in the sovereign and quasi-sovereign issuance which drove the overall relatively lower issuance this year, whereas the corporate issuance (which also includes banks) was strong.”
A Dubai-based source agrees that: “We need to see much more push from government and government-related entities to issue Islamic paper. We see that from Dubai, and we see it in Saudi Arabia – although Saudi is still very domestic. I think we will see bonds moving back towards US dollars as well, with very little local currency issuance, and in Saudi, a declining proportion.”
However, the future looks positive and governments are hoped to move back into the market towards the end of the year. Kronfol confirms that: “We expect sovereigns, quasi-sovereigns and banks to tap the markets relatively soon.”
Banks drive forward
In fact financial institutions have been a driving force behind the Sukuk market this year. Specifically in terms of GCC deals (both conventional and Sukuk), issuance over the past 12 months has been very healthy as banks attempt to capitalize on the low interest rate environment. “One particularly interesting development in the same period was the emergence of first Tier I issuance structures in the GCC region by the banks,” notes Engen, “and these structures were in the form of Sukuk.” According to S&P, 45% of all GCC bank debt issued in 2012 was in the form of Sukuk, and last year GCC banks issued a total of US$6.7 billion in Sukuk – representing a year-on-year increase of 136%.
Although long-term interest rates recently went up which could increase the cost of funding, this is likely to have a limited impact on bank activity as investors continue to search for higher yields, allowing bond and Sukuk issuers to secure long-term funds at relatively low cost. Institutional interest combined with rapid growth in the GCC banking sector is expected to continue pushing this growth forward, and banks will remain key players in the Sukuk market in the coming months as they attempt to replace more expensive issuances with lower cost Sukuk sources, retiring high-cost notes.
For example, the National Bank of Abu Dhabi retired a certain portion of its Tier 2 notes in 2012, while in January this year the bank used its option to retire its AED2 billion subordinated convertible note first issued in February 2008. S&P confirms that: “Given the need to manage costs in an environment of limited revenue growth, UAE banks will likely maintain their focus on reducing funding costs. We believe this will keep fueling issuance in the Gulf.”
A positive end to the year
Despite all this positivity, until there is a clearer picture of where global economic growth is heading, investor appetite is likely to remain remain fragile. However, the supply-demand imbalance in the Sukuk market remains, and should provide something of a cushion from this global uncertainty and therefore will continue to underpin appetite from Sukuk investors.
And there is still hope that 2013 will finish on a strong note. Although the year-to-date issuance figures are relatively lower than last year, S&P still expects to see a healthy level of issuance for the remaining period of 2013. Engen notes that: “We still expect the total issuance to reach over the US$100 billion mark this year. We do not see any change in the positive long-term drivers for the Sukuk market.”