Islamic bonds – a safe haven?; Sukuks represent a stake in a real asset or project, unlike conventional bonds that are pure debt

Islamic bonds – a safe haven?; Sukuks represent a stake in a real asset or project, unlike conventional bonds that are pure debt

(From The Business Times Singapore, provided by LexisNexis)
Publication: The Business Times Singapore

Said Abdullah

THE US sub-prime mortgage fiasco, which surfaced just about a year ago, has revealed $150US billion in losses at US securities firms and banks. The International Monetary Fund has warned that the world has not seen the end of the financial bloodbath. The feeling in the financial market is that in addition to Citigroup, UBS, Bear Stearns, Morgan Stanley, Barclays and Credit Suisse, there may be an unknown number of smaller institutions, mortgage lenders and hedge funds in the United States and Europe who may be caught up in this mortgage mess.

Standard & Poor’s estimates that the losses could exceed $265US billion. At the recent Group of Seven meeting in Tokyo, finance ministers of the G7 countries were convinced that losses could amount to $400US billion – with worries that the contagion is spreading to loans other than sub-prime mortgages, including credit card loans and car loans in the US.

So are there still safe havens for investors? Some would consider the opportunities in the fast-rising commodities, minerals, gold, platinum markets. Oil pipelines and refineries are also mentioned as potential safe sectors.

Islamic bonds or sukuk are also touted as products that are safe from this disaster. It is estimated that sukuk funds are currently worth more than $100US billion.

It is not a unanimous view. Some experts are convinced that this niche market is a safe haven, others believe that it is only a short-term sanctuary.

Sukuk (plural of sakk, or certificate in Arabic) securities represent the value of an asset. Like conventional bonds, sukuks are security instruments, assuring a predictable level of return on an investment. But unlike conventional bonds, which represent purely the debt of the issuer, sukuks represent, in addition to the credit risk of the issuer, an ownership stake in an existing asset or project.

Thus, while conventional bonds reflect a relationship between a lender and a borrower, sukuks reflect a lessee-lessor relationship. Since Syariah principles forbid the payment or receipt of interest, transactions must involve specific real assets such as property or commodities. Thus, sukuk must have intrinsic value and cannot be issued on debt receivables.

Salman Younis, who heads the Asian operations of Kuwait Finance House, is one of those who feel that the Islamic bond market is a safe haven. According to Reuters, when asked about the conspicuous calm in Islamic credit markets, he said: ‘We are investing in real assets, we are not investing in paper assets.’

‘When you securitise a trillion dollars worth of sub-prime mortgages, you don’t know which city, or which particular district, you are (invested) in. But here, you can touch and feel the asset.’

Still, others doubt that the sukuk market can stay out of the quagmire that the conventional credit market has sunk into. One senior Islamic banker even wonders if the exuberance surrounding Islamic finance is becoming irrational.

‘I think there’s a peculiar situation where there is too much liquidity in the market, arising from petro-dollars,’ said Badlisyah Abdul Ghani, head of Islamic banking for Malaysia’s CIMB bank, one of the biggest deal-makers in sukuk.

‘As far as the market is concerned, the impact of sub-prime is the same between Islamic and conventional. It’s just that the behaviour of market participants is somewhat irrational, given the fact there is this critical need to have Islamic assets.’

Mr Badlisyah is convinced that the storm in conventional markets will pass before it has time to shake the sukuk market, but he says that the sukuk market has too many ties to regular credit markets to ever insulate it from a sustained global credit squeeze.

The major investors in sukuk are also big buyers of conventional debt. In Malaysia, where there is more of a secondary market for Islamic paper, they include pension funds; in the Middle East, where secondary trading is scarce, the investors are banks.

Global banks such as Citigroup, HSBC, Barclays and Deutsche Bank are not only buying sukuk for institutional clients, they are also marketing sukuk issues. ‘Logically, there is a knock-on,’ Mr Badlisyah said. ‘At the end of the day, credit is credit.’

Some Islamic bankers point out that already, some sukuk issues have been delayed or are fetching softer prices, but Kuwait Finance House says that the credit squeeze is not entirely to blame. The tumbling US dollar is also giving issuers of sukuk pause for thought.

In the Gulf Arab states, companies issue sukuk in US dollars as a hedge against their piles of dollar-based assets, but investors now want local currencies instead, Mr Younis said. Nevertheless, analysts contend that sukuk has three overwhelming advantages over conventional paper: religious faith, a tidal wave of oil money, and a continuing shortage of high-quality sukuk.

There is an estimated $1US.3 trillion looking for high-quality Islamic assets, Kuwait Finance House says. But only $41US.9 billion in sukuk has been issued worldwide so far this year, according to the Islamic Finance Information Service.

Wishful thinking

Fitch Ratings, which assesses the risk of default for sukuk issues, believes that the sukuk market cannot insulate itself entirely, although it agrees that the dynamics of the Islamic paper market shield it somewhat from conventional markets. Nor does Fitch view sukuk as inherently safer than bonds.

‘It is a bit wishful to think that this is a safe haven of sorts and is totally insulated,’ said Ambreesh Srivastava, a Singapore-based senior director for Fitch.

But Abdul Kader Thomas, president and chief executive of US-based Shape Financial Corp and an expert in Islamic banking and finance, explained a diverging view via e-mail:

‘The issue here is that the Islamic market leans heavily on Western markets for both structuring and financing. So the credit crunch is affecting the Islamic markets, apart from Malaysia.’

Global banks are very much behind the design and restructuring of major deals involving petro-dollars. In contrast, the Malaysian sukuk market enlists the participation of foreign banks, but it does not rely on them to lead or fund deals, Mr Thomas said.

Indeed, none of the eight full-fledged Islamic banks in Malaysia have been hit by the writedowns from the US sub-prime crisis and the global credit crunch, according to Malaysia’s second finance minister, Nor Mohammed Yakcop. He pointed out that the way Islamic finance is structured, avoiding leverage and having the backing of real assets, has drawn interest from investors.

Holders of sukuks are paid returns obtained from underlying assets rather than interest. Thus, sukuks have been shielded from the worst effects of the sub-prime meltdown that has hit the conventional banking sector, the minister told a recent Reuters Islamic Finance Summit.

Mahmoud Amin El-Gamal, a professor of economics and statistics at Rice University in the US, points out in his latest book, Islamic Finance: Law, Economics and Practice, that sukuks serve at least two economic functions: ‘They can limit the issuer’s indebtedness to the value of its assets, minimising the probability of default or bankruptcy and they provide a second benchmark for the interest rate paid on the bonds, through market rents of similar properties, thus enabling the issue to borrow at lower rates.’

In the case of Malaysia’s first global sukuk issue of $600US million in 2002, structured and arranged by HSBC and issued in Labuan, the product was based on the sale and leaseback model, where the government sells a property – in this case, a hospital complex – to a special purpose vehicle (SPV) set up as the issuing party.

The SPV then leased the property to the government using an al-ijarah or leasing contract. The SPV collects the rental payments and distributes them to the investors. At the expiration of the lease term, the government will buy back the property and pay the SPV cash which is to be used to pay investors upon full redemption of the trust certificates on maturity.

As for the position taken by CIMB’s Mr Badlisyah, Mr Thomas said: ‘Badlisyah is right on the money. There is significant connectivity in the sukuk market and the mistakes of the sub-prime and other markets are infecting parts of the sukuk market.’

One recent instance is the Arab Banking Corp, a Bahrain-based commercial and Islamic bank, which has overseas units including in the US, UK and Singapore. It reported a 38 per cent drop in its full-year net profit to $125US million because of its holdings that were affected by the US sub-prime crisis.

Petro-dollars

On the question of Islamic credit markets being secure from the ill-wind that is now blowing through the conventional banking system, Mr Thomas said: ‘The overall Islamic market is not driven by the same factors as the Western markets. Although impacted by the West, the demand is domestic and the key providers are in major markets like Malaysia, Kuwait, Dubai, Qatar and Saudi Arabia.’ But ‘one has to take a careful macro view’, he cautioned.

The Securities Commission of Malaysia, in its latest quarterly report on the Islamic capital market on Feb 6, was bullish on the sector, pointing out that ‘demand for Islamic products will be turbo-charged by the windfall oil revenues for Muslim nations in East Asia and the Gulf’. It added: ‘Petro-dollars need to be recycled and will naturally look for Islamic assets.’

McKinsey, the consultancy firm, also points out in its latest report that with oil prices continuing to set new records, the influence of petro-dollar investors is likely to grow and shape trends in the financial markets.

The McKinsey Global Institute (MGI) estimates that at $50US per barrel of oil, the annual net capital outflows of the petrodollar would amount to $387US billion a year through 2012, representing an extraordinary infusion of more than $1US billion a day into the global financial markets. By 2012, MGI estimates, the total stock of petro-dollar foreign assets would grow to $6US.9 trillion. Even if oil prices declined to $30US a barrel, petro-dollar foreign assets would grow at a robust average rate of 6 per cent annually, to reach about $4US.8 trillion in 2012.

But Mr Thomas sees three serious challenges: the lack of sufficient qualified people; the ability of Islamic and regional banks to pick up the slack created by the retreating global banks; and whether the regulators implement the rules that allow businesses to compete on a level playing field.

With investors wary of volatile markets, it is more than likely that some will turn to Islamic products, particularly sukuk. At $100US billion, the current sukuk market may be just a small fraction of the more than $30US trillion global bond market, but it could grow in the coming years and lure more non-Islamic players.

SOURCE: http://jetfinvestments.blogspot.com/2008/02/islamic-bonds-safe-haven-sukuks.html