Author: Eric Uhlfelder

16 April 2007, FTFM

Soaring issuance of Shariah-compliant obligations is grabbing western investors attention, but there is uncertainty about whether projected returns adequately compensate investors in this nascent debt market.

Before 9/11, in the year 2000, sukuks were about as obscure as a borrowing instrument could be. Complying with the tenets of Shariah law, only three issues came to market, raising just $340 million. Last year, a variety of banks—including ABN Amro, Barclays, Société Génèrale, Deutsche Bank and UBS–underwrote nearly 190 issues, raising more than $27 billion. And Arul Kandasamy, head of Islamic Finance at Barclays Capital, projects the Gulf region will need a $1 trillion in additional financing over the next decade, with a significant portion of capital demands projected to be met through sukuks.

Sukuks differ from traditional debt because they technically do not pay interest—something that’s prohibited in Islam. Instead, investors are compensated through a cash stream that’s typically generated from assets placed in special purpose vehicles.

New found demand for Shariah-compliant products is especially evident in Saudi Arabia, where “the vast majority of retail investors in Saudi Arabia have a clear preference for Shariah-compliant assets,” says Ruggiero Lomonaco, head of Islamic Investment products at ABN Amro in London. “Currently, over half of all Saudi deposits are Shariah-compliant, up from zero a decade ago.”

In June of last year, even the US saw the issuance of its first sukuk in all places Texas by Houston-based oil and gas concern East Cameron Partners, which raised $166 million.

This segues the discussion into one of the more surprising aspects of soaring sukuk offerings: that the vast majority of investors buying sukuks—liberally estimated at around 80 percent by John Wegulin, managing director of the London-based European Islamic Investment Bank–are not Islamic.

Increasingly sophisticated structure of sukuks is reinforcing the notion, posited by the Japan Bank for International Cooperation, that “the rise of Islamic finance is one of the key financial developments of the 21st Century.” But at the same time, the bank is observing that “the speed of expansion in Islamic finance is matched by the lack of market understanding on the part of western observers.” And on the surface, the reasons for such demand are not ostensibly clear.

On average, projected annualized yields are by no means extraordinary, ranging typically between 50 and 150 basis points above US 6-month LIBOR. Issues are normally just several hundred million dollars, offering little secondary market liquidity. The majority of sukuks are issued in US dollars, which means currency risk for all non-dollar investors. Hedging will cut into returns.

Most bonds are not rated by a major credit agency. In some instances, that’s because many issuing companies are relatively new with limited financial records and years away from turning a profit. This leaves due diligence squarely up to investors. And when sukuks are rated, the depth of analysis is often handicapped by a lack of transparency, the cause of which is unclear—limited access to underlying financials or the lack of trained analysts on the ground.

However, examining several specific offerings begins to explain their underlying appeal to western investors seeking initial exposure to some of the fastest growing corners of the Middle East.

Last December, Nakheel Group, a subsidiary of the major property developer Dubai World, issued a record $3.52 billion sukuk, which dwarfed the average previous offerings by as much as ten times.

Despite being supported by record levels of petrodollars flowing into coffers of oil-producing states and guaranteed by Dubai World [which itself is wholly owned by the Dubai government], the three-year bond was priced at 120 basis points over US LIBOR, producing a yield of 6.35 percent. This was nearly 100 basis points higher than the 5-year yield of the Dow Jones Citigroup Sukuk Index and a 5-year “A” rated US corporate bond.

The premium was in large part due to Nakheel being only several years old, still years away from profitability, and this unrated issue was the company’s first foray into capital markets.

But it was the sukuk’s unique structure with IPO rights that captured the capital market’s attention, including that of Yan Swiderski, partner of the London based hedge fund group Finisterre Capital LLP, which runs two leveraged long-short funds with over $300 million under management. The sukuk will give investors hard-to-get access to shares at a five percent discount to the IPO price if the company goes public before the bond matures in December 2009. If Nakheel does not go public by this time, it will pay investors an additional six percent upon maturity. This would boost annualized returns to 8.35 percent. Swiderski sees a likely win either way. He was joined in this assessment by many European and Asian investors who gobbled up 40 percent of the initial offering and who have pushed down the spread to 90 basis points after just one month of trading on the secondary market.

But how safe is the security itself?

“We are experienced in examining less transparent emerging market securities,” explains Swiderski. “We seek diversity to reduce the overall risk of our portfolios, and here we see an issuer whose home country’s GDP has been growing by more than 12 percent a year. The company is part of a sector that plays an integral roll in the country’s development strategy. And the bond is guaranteed by a government-owned corporation that has more than $30 billion in assets, which is three times greater than its liabilities.”

Some investors are attracted by the terms associated with Shariah compliance, though they suggest more a bent towards caution rather than superior capital management. Hossam Rageh is Head Representative of the Cairo-based Commercial International Bank in Dubai, which has $50 million invested in sukuks. He explains that Shariah compliance requires a company to limit debt to no more than 35 percent of total assets, restricting leverage. Interest income is capped at 10 percent, which means that assets need to be actively invested in the company’s operations.

Making up for the lack of credit coverage, Rageh says the issuance process generates research by underwriters, the documentation bank [which holds the asset or special purpose vehicle], and governments who frequently own the issuers. Rageh supplements this baseline review with his own industry, technical, and financial analysis. And he often buys bonds directly through a bank syndication as a means to further reduce risk.

Rageh likes sukuks’ short maturities, typically 3-5 years, because they match the bank’s liquidity and risk management needs. Last year, for instance, he purchased a Turkish sukuk issued by Boyner Holding—the country’s largest retailer. The three-year dollar denominated bond was yielding 300 basis points over US LIBOR. But what helped mitigate both the company’s credit and currency risks was that the sukuk was backed by a revenue stream generated from Boyner’s export business to countries that operate in US dollars.

He also bought a sukuk issued by a Gulf-based government-owned airline that was struggling through a turnaround. The reason why the three-year $100 million offering came to market at just 150 bps above LIBOR, Rageh explains, is “the sukuk has a first lien on one of the airline’s most profitable routes to the US.” As a result, he saw value in the price, not only in its yield but also in the potential for capital gain.

With western fund managers having no shortage of familiar and more transparent investment choices with even Shariah-compliant investors seeing greater opportunities, sukuk issuers are spicing up their offerings to compete for capital. For investors willing to do the extra research essential before dipping into this evolving and challenging market, the question remains: is the extra effort worth it?

Number of Issues Total Capital Raised $ B
2000 3 $0.34
2001 4 $0.78
2002 8 $0.98
2003 36 $5.7
2004 67 $7.2
2005 90 $12.1
2006 188 $27.4

Source: Islamic Finance Information Services


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