Tapping Islamic bonds’ infinite potential

Despite representing a microscopic portion of the global conventional bond market, Islamic bonds or sukuk have managed to gain a steady ground and post significant gains even during the recent tough economic conditions, financial analysts say.

In its Global Sukuk report published last month, credit ratings agency Moody’s mentioned that the worldwide issuances of Islamic bonds in 2009 jumped by a massive 50 per cent compared to the 2008 records. This growth had been primarily attributed to a growth in the number of issuances initiated by sovereigns and government-related issuers (GRI) for mega energy and infrastructure projects in the GCC region.

With its current value at around $54 billion (Dh198bn), Islamic bonds represent a measly 5 per cent of the entire Islamic finance market, which is worth over $1 trillion, says Dubai International Financial Centre (DIFC) chief economist Dr Nasser Saidi.

This figure, moreover, is a far cry from the global conventional bond market size of $83trn, as estimated in 2009 by the Swiss-based Bank for International Settlements.

However, the emerging popularity of Islamic finance – which HSBC data revealed had recorded an annual average growth rate of 28 per cent between 2006 and 2009 – coupled with the growing number of high-net-worth individuals seeking shariah-compliant investment products, has put sukuk in the global financial map.

Saidi says that while sukuk holds huge potential, there is obviously still a lot to be done to “standardise” it and make it available in as a mainstream financial instrument.

“Sukuks should be introduced as part of public finance for better debt management. [They should be used] to finance treasury bills and public works. Moreover, central banks and governments have to take initiatives to bring it in the spotlight,” he said.

The DIFC chief economist noted that the Gulf region requires some $2.8trn to finance infrastructure projects in the next 15 years. He said in order to finance these projects governments should look beyond oil and gas revenues, and instead focus on growing the regional sukuk market.

Another factor in ensuring a successful sukuk market, Saidi explained, is the development of an Islamic securities market, which should also encourage the participation of foreign investors.

“The Islamic securities market needs to be multi-currency, multi-country and multi-issuer,” says Saidi.

Standardisation key to sukuk growth

Unlike its conventional counterpart, Islamic bonds have diverse structures under four common categories, namely: debt-based sukuk, asset-based sukuk, project-based sukuk and asset-backed sukuk. While this characteristic may offer diversity and varied options for investors, it also stifle growth within the Islamic bond sector.

“The setting-up and transaction costs of each sukuk are high and when sukuks don’t interact among themselves, the market becomes less efficient,” says Dr Saidi.

The thin volume of trading that sukuks generally attract also results to a less efficient pricing scheme. This eventually leads to insufficient liquidity for the market.

Potential default is also a challenge that the sector has to address. “How do you deal with insolvency? The debt bond market has been here for 180 years and has been tested, but the system to deal with sukuk default has not yet been developed,” Saidi commented.

Aside from the availability of multiple structures, Islamic bonds suffer from the lack of regulatory convergence from an industrial standpoint, which, if implemented, could help resolve conflicting views about their use and purpose.

Dr Munawar iqbal, former chief of research at the Islamic Banking and Finance-Islamic Development Bank Group, says sukuk will remain “under cloud for some time and there’s a big challenge for financial engineers to come up with new sukuk structures that can reassure investors about their shariah-compliance.”

New regulations to boost market

Moody’s, however, is optimistic about their outlook for the global sukuk market for 2010 as they expect new regulations and legislation to be introduced in new jurisdictions. The move to facilitate the issuance of Islamic finance securities has already been initiated in Luxembourg, the United Kingdom and Indonesia.

“France and Australia could become one of the new jurisdictions to implement similar actions. The UK looks set to be the first European jurisdiction to introduce a sovereign sukuk issuance given the advanced legislations that are soon to be approved by the UK Parliament. Nevertheless, the passing of the legislation into law could make it more likely for corporates to issue sukuk rather than a sovereign issuer, given several corporates’ pressing funding needs,” the agency noted in its report.

The credit ratings firm added that similar legislative actions by governments of more mature sukuk markets in the GCC and the Asia-Pacific regions have “created an environment of confidence, especially amongst international issuers.”