To say the least, 2020 will certainly go down in the history of mankind as one of the most tumultuous years affecting people from all walks of life with debt capital markets being no exception to it. The COVID-19 pandemic continues and will continue to dominate the financial markets in general as headwinds from the pandemic are not abating; many parts of the world are still grappling with the second wave of it and there is no clarity in terms of a vaccine.
Since the global financial crisis, most of the growth in global debt markets occurred in the emerging economies, while remaining stable in the developed ones. This was heavily encouraged through monetary means to improve the business climate in the emerging economies, but left companies relatively more exposed to changes in market conditions such as the pandemic. Therefore, it was expected that, having grown the most, certain emerging markets will also be hit the hardest when corporate solvency risks materialize in a downturn.
Review of 2020
Since COVID-19 is an exogenously induced crisis, the impact on Islamic banks is comparable to that on conventional banks given the sim¬ilarity of their business model. In response to the pandemic at the start of the year, the global shutdown of most significant economic segments led to an immediate surge in demand for debt, including the Islamic finance market and this is evident with the recent Dubai plan to issue benchmark bonds as part of a US$6 billion Sukuk issuance program and a US$5 billion bond issuance program. The challenges of liquidity, resilience and capital for the Islamic banking sector — the largest component of the Islamic financial industry — were the highlights of the debt markets and this resulted in a lowering of reserve requirements, a lowering of regulatory capital buffers and multiple issuances in both markets — conventional and Islamic.
As expected, overall global debt activity grew significantly in the first three quarters of 2020 — debt product issuance was up by 32% compared with the same period a year ago, marking the strongest levels on record. To illustrate just how immediate the shock was, global debt markets in the second quarter set an all-time high in terms of both growth and volume.
As one of the youngest asset classes, private debt has consistently grown since the global financial crisis to become the third-largest asset class in private capital, ahead of infrastructure and natural resources. Private debt has become very popular in Islamic markets too but there are no concrete data available. The global dry powder levels in private debt were sitting at all-time highs before the pandemic at almost US$300 billion — although the fundraising pace was slowing down due to competition for deals. The pandemic revoked the overwhelming interest in the asset class from fund managers as they finally received ample opportunities to deploy raised capital.
The volumes of Sukuk issuance in the full year of 2020 are expected to be similar to 2019 levels and the comparable spike will not be felt. Various Islamic instruments are helping key institutions to navigate the current situation. Social Sukuk are being used to reinforce the education and healthcare systems amid the challenges and support in attracting environmental, social and governance (ESG) investors, with a prime example being the recent issuance of the IsDB and the issuance to come from Malaysia.
Preview of 2021
With a resurgence of the pandemic, it seems that the pace of the global economic recovery in the near term will be weaker and it is expected that GDP in the euro area and the UK would be contracting in the fourth quarter. The US Fed’s shift to average inflation targeting implies that rates will stay lower for longer than in previous cycles. Other central banks will adopt a similar framework and try to overshoot their target. Most central banks will continue to expand their balance sheets and absorb most of the new debt issuances, keeping bond yields low. More broadly, the fiscal and monetary policy will remain very accommodative in 2021.
Outside of the pandemic-related disturbances, the increasing demand for sustainability and ESG-focused portfolios continues to climb consistently as per the trends of previous years. It is worth noting that the Islamic finance-based markets are also subject to this trend — green and sustainability Sukuk, while still in their infancy, are experiencing double-digit growth.
Though there would be multiple developments of specific interest to debt capital market participants in 2021, one of the important and major concerns is London Inter-bank Offered Rate (LIBOR) transition. The transition from LIBOR remains a matter of great uncertainty. The term structures of the new reference rates, or even if they will have term structures, remain unclear. So does the timing of the transition. Indeed, LIBOR could survive beyond 2021 and continue playing its role as the reference rate for many financial products and contracts. But counting on that outcome would be a major gamble, which financial firms should avoid by beginning preparations now.
Although investors remain cautious, the environment is still positive. The prospect of further fiscal policy measures and expansionary central banks are the decisive factors but over the next six to 12 months, the recovery in the global economy and the potential availability of a COVID-19 vaccine may provide more clarity on yields and inflation.