CAIRO — Indonesia is passing a legislation that will allow the issuance of sukuk, Islamic bonds, for the first time in the world's most populous country to ease economic woes, diversify debt instruments and lure Islamic investments.
"We'll consider both the domestic and international environments when deciding whether the sukuk will be institutional and mainly international, or domestic retail," Finance Minister Mulyani Indrawati told the Financial Times on Wednesday, April 9.
The parliament is set to pass on Thursday, April 10, a legislation, which the government has been working on for two years, allowing it to sell Islamic bonds at home and abroad.
Mulyani said the government intends to issue up to $1.6bn in sukuk in the second half of this year, once the law is put into force.
Officials hope the sukuk will open up a new funding source for both the government and companies by luring Middle Eastern investors, many of whom only use Islamic products.
They believe that the Islamic bonds will also help to cover a ballooning state budget deficit.
Indonesia's need for the funding alternative has increased recently, with the government set to run a wider-than-expected 27 percent budget deficit this year.
Like other forms of Islamic financing tools, sukuk do not receive or pay interest.
It typically operates through actual transactions such as profit-sharing or leasing.
Companies that have issued Islamic bonds make payments to investors using profits from the underlying business, instead of paying interest.
Promising
The government hopes that by allowing sukuk, the country will tap into a booming global market.
"I'm optimistic that Indonesia will be able to compete," said Minister Mulyani.
Bankers are also optimistic that sukuk would bring good news for Indonesia amid the budget deficit and the soaring inflation.
Rakesh Bhatia, the head of HSBC in Indonesia, sees the sukuk legislation as "extremely positive".
"The law will give the government and the country access to additional capital," he told the FT.
"We're already in advanced talks with companies that are just waiting for the government to take the lead."
Abiprayadi Riyanto, head of Mandiri Investasi, a subsidiary firm of Indonesia's largest lender PT Bank Mandiri, doubts the country could compete with Asia's Islamic finance hub Malaysia "in the near future".
"The Malaysian government's commitment to develop sukuk is so high, while in Indonesia there are so many bureaucratic hurdles."
Southeast Asian giant Malaysia has the world's largest Islamic bond market.
It issued about 47 billion dollars or two-thirds of the total Islamic bonds outstanding worldwide last year.
Sukuk are increasingly popular and saw a growing market around the world in recent years.
They are already available in the US, Britain and Japan through corporate issuers, but never by a Western state.
Some countries, like Thailand, are contemplating the issuance of Islamic bonds of their own.
The British government has launched a comprehensive study to analyze the feasibility for the government to issue Islamic bonds to enhance London's standing as an Islamic finance hub.
Tuesday, October 21, 2008
Sukuk: Emergence as a Multi-Purpose Shariah Compliant Financing Product
With the Islamic banking and finance market estimated to be worth $500 billion, and having a growth rate of 15-20 per cent annually, affluent Muslim investors are looking for some serious investment options that comply with Islamic Shariah.
Standard and Poor’s estimates that 20 per cent of those investors, with billions to invest, would now spontaneously choose an Islamic financial product over a conventional one with a similar risk-return profile.
That has led to the increased use of the Sukuk, especially in the Gulf countries and Malaysia. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), defines Sukuks as “certificates of equal value representing after closing subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity.”
Introduced in varied structures and sizes, Sukuks worth $20 billion hit the market in 2006 and are expected to surpass $50 billion in 2007 as the companies seek to diversify their sources of financing. Although companies in Kuwait, Bahrain, Saudi Arabia and Qatar have all been actively using Sukuk financings over the years, Malaysia led the Sukuk issue market in 2006 with a share of about 60 per cent. That year also witnessed the first Sukuk that originated in the United States. The trends in 2007 clearly suggest that the United Arab Emirates, especially Dubai, have most likely taken over the lead.
Sukuk structures are being used for a variety of purposes and have evolved rapidly in response to the demands of issuers and investors. Sukuk issues have ranged from the simple sale and leaseback (Ijara) structures, such as the $1 billion Dubai Department of Civil Aviation Sukuk issued in November 2004, to the $2.53 billion trust finance Sukuk structure issued by Aldar Properties in March 2007, demonstrating the flexibility of Islamic finance principles.
Below are examples of some recent Sukuk issues that show and emphasise that Sukuk has matured into a diversified, internationally-acceptable instrument to raise corporate finance for acquisitions or working capital purposes, or to re-finance existing debt, or use in the transportation sector (especially in the shipping and aircraft sectors), real estate, construction and petrochemical projects in several countries.
German Sukuk (Saxony-Anhalt Sukuk)
In 2004, a €100 million Sukuk, structured as a Sukuk Al Ijara, was issued in the federal state of Saxony-Anhalt in Germany. The Federal Republic of Germany guarantees the debts of Saxony-Anhalt. The underlying transactions are a certain number of specified buildings owned by the Ministry of Finance. The master lease was sold for 100 years to a special purpose vehicle, incorporated in the Netherlands for tax reasons, which in turn rented it back for five years to the Ministry of Finance. The certificate holders receive a variable rent benchmarked to the EURIBOR over the rented period. The Sukuk is listed on the Luxembourg Stock Exchange. Incidentally, as of July 2007, the Saxony-Anhalt Sukuk remains the only sovereign Sukuk from a non-Islamic country to have tapped the market.
Sukuks by the Governments of Bahrain, Qatar and Malaysia
The Central Bank of Bahrain, on behalf of the Government of Bahrain, regularly issues Sukuk-Al-Ijara and Sukuk Al-Salam to finance various infrastructure projects in Bahrain. Malaysia’s Global Sukuk, launched in June 2002, was similarly backed by an Ijara lease on a single piece of government property. The money raised by the Government of Qatar through the $700 million Qatar Global Sukuk is being used partly to finance the construction of the Hamad Medical City.
First Airlines Sukuk - Emirates Airlines Sukuk
The first Sukuk issued by Dubai’s national airlines, Emirates, closed in July 2005. At $550 million, this was the single largest corporate Sukuk issuance at that time. The Sukuk has a seven-year tenor and is structured as a Musharaka. The proceeds of the issue, which is listed on the Luxembourg Stock Exchange, will be used to finance the new Emirates Engineering Centre and their headquarters building in Dubai.
First Ship Finance Sukuk – MT Venus Glory Sukuk/Al Safeena Sukuk
In 2005, ABC International Bank jointly with Abu Dhabi Commercial Bank arranged, structured and jointly underwrote a pioneering Islamic ship finance transaction through the issuance of a $26 million Al-Safeena Ijara Sukuk. At that time, Al-Safeena Sukuk was the first issue that combined Islamic equity with conventional debt for the same asset, which in this case was VLCC (called “Venus Glory”), owned by Pacific Star (Pac Star) International Holding Corporation, which in turn is owned by Saudi Aramco, the world’s largest oil exporting company.
Dubai Civil Aviation Authority Sukuk
The Dubai Civil Aviation Authority, a quasi-sovereign entity, broke the mould in 2004 by going down the Sukuk route instead of plain vanilla finance, by issuing a $1 billion Sukuk, the world’s largest single Sukuk issuance in terms of size at that time by any issuer. The proceeds were used to finance the building of a new international terminal and for the expansion of existing engineering and other infrastructure. The Musharaka was set up to develop a new engineering centre and a new headquarters building on land situated near Dubai’s airport that will ultimately be leased to Emirates. Profit, in the form of lease returns, generated from the Musharaka will be used to pay the periodic distribution on the trust certificates.
Bahrain Financial Harbour - Al Marfa'a Al Mali Sukuk
The Istisna'a-Ijara Sukuk, known as the Al Marfa'a Al Mali Sukuk, has been structured by the Liquidity Management Centre in accordance and in compliance with the principles of Islamic Shari'a. The Sukuk has a five-year term maturing in 2010 offering a quarterly profit distribution with the proceeds used to finance the development and construction of the Financial Centre which represents the first phase of the Bahrain Financial Harbour project comprising the Dual Towers, the Financial Mall and the Harbour House.
Dubai World Sukuk
In 2006, Dubai property developer Nakheel Group, developer of three palm-frond shaped islands off Dubai's coast, sold the world's largest Islamic bond after increasing its size by more than 40 per cent to $3.52 billion to meet demand. Nakheel will use cash from its Sukuk to fund projects in Dubai, which is leading a surge in Gulf Arab investment in construction and real-estate developments. The Sukuk has been listed on the Dubai International Financial Exchange.
DP World Sukuk
In 2007, global marine terminal operator DP World priced a $1.75 billion conventional bond and a $1.5 billion Sukuk. It is the first issuer to list both conventional and Islamic debt securities on the Dubai International Financial Exchange.
The $1.5 billion, 10-year Sukuk attracted demand globally, including from the United States. This was the first time U.S. investors had the opportunity to subscribe to a UAE corporate rated Sukuk. DP World's Sukuk is ground breaking and innovative because it is partly convertible to shares in the event the ports group lists through an initial public offering, thus becoming the first convertible instrument in the Islamic finance market. The issue is part of a large financing package being arranged for general corporate activities, ongoing business development needs, and expansion plans, including the financing of the purchase of the British rival P&O.
East Cameron Gas Sukuk
The first and only Sukuk to have originated from the United States tapped the market in 2006. The unique feature of the East Cameron Gas Sukuk was that it was the first ever Shariah compliant gas backed securitisation and was the first-ever Islamic securitisation rated by Standard and Poor’s. The $165.7 million Sukuk originated from Houston based East Cameron Partners, whose reserves are located in the shallow waters off the shores of the State of Louisana. The Sukuk was structured as a Musharaka structure in terms of the management of the assets and then a funding agreement between the issuer and the purchaser.
The initiatives taken by the governments of the UAE, Bahrain, Malaysia and the United Kingdom, to name a few, have acted as a catalyst for the evolution and growth of the Sukuk market and the development of Islamic Finance as a whole. The regulatory bodies within such countries have been actively introducing rules and regulations pertaining to the issuing and offering of Sukuks, which we hope in time will help provide standardisation, resulting in the maturation of the field.
From the financing structures focused mainly on plain vanilla type commodity-trading murabaha transactions to the complex structures involved in the Sukuks, Islamic finance has come a long way and Sukuks have emerged as high profile financial instruments. With top international banks, financial institutions, law firms and other financial services providers scampering for a piece of the cake in the Middle East, Islamic banking and finance has grown into a full-fledged practice area of its own. With a catalogue of successful issues worth billions of dollars reflecting the huge appetite for Sukuks, there are all signs pointing towards the long term success and growth of Sukuks.
For more information please contact Rory Todd at rtodd@applebyglobal.com
Standard and Poor’s estimates that 20 per cent of those investors, with billions to invest, would now spontaneously choose an Islamic financial product over a conventional one with a similar risk-return profile.
That has led to the increased use of the Sukuk, especially in the Gulf countries and Malaysia. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), defines Sukuks as “certificates of equal value representing after closing subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity.”
Introduced in varied structures and sizes, Sukuks worth $20 billion hit the market in 2006 and are expected to surpass $50 billion in 2007 as the companies seek to diversify their sources of financing. Although companies in Kuwait, Bahrain, Saudi Arabia and Qatar have all been actively using Sukuk financings over the years, Malaysia led the Sukuk issue market in 2006 with a share of about 60 per cent. That year also witnessed the first Sukuk that originated in the United States. The trends in 2007 clearly suggest that the United Arab Emirates, especially Dubai, have most likely taken over the lead.
Sukuk structures are being used for a variety of purposes and have evolved rapidly in response to the demands of issuers and investors. Sukuk issues have ranged from the simple sale and leaseback (Ijara) structures, such as the $1 billion Dubai Department of Civil Aviation Sukuk issued in November 2004, to the $2.53 billion trust finance Sukuk structure issued by Aldar Properties in March 2007, demonstrating the flexibility of Islamic finance principles.
Below are examples of some recent Sukuk issues that show and emphasise that Sukuk has matured into a diversified, internationally-acceptable instrument to raise corporate finance for acquisitions or working capital purposes, or to re-finance existing debt, or use in the transportation sector (especially in the shipping and aircraft sectors), real estate, construction and petrochemical projects in several countries.
German Sukuk (Saxony-Anhalt Sukuk)
In 2004, a €100 million Sukuk, structured as a Sukuk Al Ijara, was issued in the federal state of Saxony-Anhalt in Germany. The Federal Republic of Germany guarantees the debts of Saxony-Anhalt. The underlying transactions are a certain number of specified buildings owned by the Ministry of Finance. The master lease was sold for 100 years to a special purpose vehicle, incorporated in the Netherlands for tax reasons, which in turn rented it back for five years to the Ministry of Finance. The certificate holders receive a variable rent benchmarked to the EURIBOR over the rented period. The Sukuk is listed on the Luxembourg Stock Exchange. Incidentally, as of July 2007, the Saxony-Anhalt Sukuk remains the only sovereign Sukuk from a non-Islamic country to have tapped the market.
Sukuks by the Governments of Bahrain, Qatar and Malaysia
The Central Bank of Bahrain, on behalf of the Government of Bahrain, regularly issues Sukuk-Al-Ijara and Sukuk Al-Salam to finance various infrastructure projects in Bahrain. Malaysia’s Global Sukuk, launched in June 2002, was similarly backed by an Ijara lease on a single piece of government property. The money raised by the Government of Qatar through the $700 million Qatar Global Sukuk is being used partly to finance the construction of the Hamad Medical City.
First Airlines Sukuk - Emirates Airlines Sukuk
The first Sukuk issued by Dubai’s national airlines, Emirates, closed in July 2005. At $550 million, this was the single largest corporate Sukuk issuance at that time. The Sukuk has a seven-year tenor and is structured as a Musharaka. The proceeds of the issue, which is listed on the Luxembourg Stock Exchange, will be used to finance the new Emirates Engineering Centre and their headquarters building in Dubai.
First Ship Finance Sukuk – MT Venus Glory Sukuk/Al Safeena Sukuk
In 2005, ABC International Bank jointly with Abu Dhabi Commercial Bank arranged, structured and jointly underwrote a pioneering Islamic ship finance transaction through the issuance of a $26 million Al-Safeena Ijara Sukuk. At that time, Al-Safeena Sukuk was the first issue that combined Islamic equity with conventional debt for the same asset, which in this case was VLCC (called “Venus Glory”), owned by Pacific Star (Pac Star) International Holding Corporation, which in turn is owned by Saudi Aramco, the world’s largest oil exporting company.
Dubai Civil Aviation Authority Sukuk
The Dubai Civil Aviation Authority, a quasi-sovereign entity, broke the mould in 2004 by going down the Sukuk route instead of plain vanilla finance, by issuing a $1 billion Sukuk, the world’s largest single Sukuk issuance in terms of size at that time by any issuer. The proceeds were used to finance the building of a new international terminal and for the expansion of existing engineering and other infrastructure. The Musharaka was set up to develop a new engineering centre and a new headquarters building on land situated near Dubai’s airport that will ultimately be leased to Emirates. Profit, in the form of lease returns, generated from the Musharaka will be used to pay the periodic distribution on the trust certificates.
Bahrain Financial Harbour - Al Marfa'a Al Mali Sukuk
The Istisna'a-Ijara Sukuk, known as the Al Marfa'a Al Mali Sukuk, has been structured by the Liquidity Management Centre in accordance and in compliance with the principles of Islamic Shari'a. The Sukuk has a five-year term maturing in 2010 offering a quarterly profit distribution with the proceeds used to finance the development and construction of the Financial Centre which represents the first phase of the Bahrain Financial Harbour project comprising the Dual Towers, the Financial Mall and the Harbour House.
Dubai World Sukuk
In 2006, Dubai property developer Nakheel Group, developer of three palm-frond shaped islands off Dubai's coast, sold the world's largest Islamic bond after increasing its size by more than 40 per cent to $3.52 billion to meet demand. Nakheel will use cash from its Sukuk to fund projects in Dubai, which is leading a surge in Gulf Arab investment in construction and real-estate developments. The Sukuk has been listed on the Dubai International Financial Exchange.
DP World Sukuk
In 2007, global marine terminal operator DP World priced a $1.75 billion conventional bond and a $1.5 billion Sukuk. It is the first issuer to list both conventional and Islamic debt securities on the Dubai International Financial Exchange.
The $1.5 billion, 10-year Sukuk attracted demand globally, including from the United States. This was the first time U.S. investors had the opportunity to subscribe to a UAE corporate rated Sukuk. DP World's Sukuk is ground breaking and innovative because it is partly convertible to shares in the event the ports group lists through an initial public offering, thus becoming the first convertible instrument in the Islamic finance market. The issue is part of a large financing package being arranged for general corporate activities, ongoing business development needs, and expansion plans, including the financing of the purchase of the British rival P&O.
East Cameron Gas Sukuk
The first and only Sukuk to have originated from the United States tapped the market in 2006. The unique feature of the East Cameron Gas Sukuk was that it was the first ever Shariah compliant gas backed securitisation and was the first-ever Islamic securitisation rated by Standard and Poor’s. The $165.7 million Sukuk originated from Houston based East Cameron Partners, whose reserves are located in the shallow waters off the shores of the State of Louisana. The Sukuk was structured as a Musharaka structure in terms of the management of the assets and then a funding agreement between the issuer and the purchaser.
The initiatives taken by the governments of the UAE, Bahrain, Malaysia and the United Kingdom, to name a few, have acted as a catalyst for the evolution and growth of the Sukuk market and the development of Islamic Finance as a whole. The regulatory bodies within such countries have been actively introducing rules and regulations pertaining to the issuing and offering of Sukuks, which we hope in time will help provide standardisation, resulting in the maturation of the field.
From the financing structures focused mainly on plain vanilla type commodity-trading murabaha transactions to the complex structures involved in the Sukuks, Islamic finance has come a long way and Sukuks have emerged as high profile financial instruments. With top international banks, financial institutions, law firms and other financial services providers scampering for a piece of the cake in the Middle East, Islamic banking and finance has grown into a full-fledged practice area of its own. With a catalogue of successful issues worth billions of dollars reflecting the huge appetite for Sukuks, there are all signs pointing towards the long term success and growth of Sukuks.
For more information please contact Rory Todd at rtodd@applebyglobal.com
Seeking sukuk
While Malaysia continues to dominate sukuk issuance, some mega-deals announced in the past two years point to bright prospects elsewhere in the Islamic world
Billions of dollars worth of sukuk bonds have been issued this year, indicating a continuing boom in the use of fundraising instruments that comply with sharia (Islamic law). High oil prices and greater customer awareness are driving demand from Islamic institutional and private investors for investments that avoid the prohibited areas of riba (interest), gharar (uncertainty) and maysir (gambling). Issuance has already reached $41 billion worldwide, and is growing fast. Abdullah al Muajel, head of the sharia control department at Al Rajhi Bank in Riyadh, expects this to rise to $150 billion by the end of 2010.
To meet this demand, the sukuk market (see box) will have to expand into new areas - and a few large and innovative sukuk deals this year may point the way. January 2006 saw the launch of the largest sukuk to date, an issue by the Dubai Ports, Customs and Free Zone Corporation (PCFC), arranged by Dubai Islamic Bank, and listed on the Dubai International Financial Exchange. Intended to raise funds for PCFC's takeover of UK port operator P&O, through its Dubai Ports World subsidiary, the sukuk was oversubscribed more than four times, receiving a total of $11.4 billion in bids. This demand led PCFC to increase issuance from $2.8 billion to $3.5 billion.
But it is not just the size of the PCFC sukuk that has attracted attention of Islamic financiers. PCFC, in anticipation of an initial public offering (IPO) at some point in the future, structured it as a convertible sukuk. Up to 30% of the sukuk can be redeemed into PCFC shares if an IPO goes ahead in the next two years - otherwise, the sukuk produces a higher yield at redemption, 10.125% a year rather than 7.125%.
The deal was based on a musharaka (venture capital) arrangement. The two partners in the musharaka structure were PCFC, which contributed $1.5 billion in kind, and a special-purpose vehicle (SPV), PCFC Development FZCO, which contributed the $3.5 billion raised by the sukuk. The key to the deal was the SPV's establishment of an English law trust over its right to share the joint venture's profits - selling the trust certificates gave investors a share of profits.
With the trust certificates came the option to convert into PCFC stock. Normally, such a transaction would raise issues of gharar, but according to PCFC's sharia board, as the strike price and the stock were set in advance, there was no uncertainty in the structure.
The PCFC sukuk was listed on the Dubai International Financial Exchange (DIFX), which opened for business in September 2005 - PCFC was the first sukuk to list there.
Aabar Petroleum, an Abu Dhabi oil exploration and production company, listed the second sukuk - a fully convertible bond - on the DIFX in June. Harris Irfan, Deutsche Bank's Dubai-based director of emerging markets structuring, whose bank acted as bookrunner and lead manager, explains: "Aabar is the first truly convertible sukuk that converts wholly into the shares of the underlying company. There are scenarios in which cash would be offered instead, but essentially it operates as a conventional convertible - if it is in-the-money, you get the equity, and if it is out-of-the money, you get par."
The Aabar sukuk raised $460 million, with a fixed profit rate of 6.894%, based on the four-year dollar swap rate at the time of pricing. It will mature on June 28, 2010. The conversion price is $1.0895; Aabar's stock is currently at 3.43 dirhams ($0.934).
Convertible bonds are not unique to Dubai - the Malaysian market saw its first issue in 2005 - but they have not, so far, been widely issued in any market. Market participants say this is not because of difficulties with sharia (even though equity options are widely regarded as being unreal instruments, or 'promises', rather than actual assets). Instead, it may be due to a simple lack of experience among the structuring banks.
"It is actually an extremely difficult instrument to structure. It requires a lot of different skill sets and resources and technology to make it work. So far, very few institutions have demonstrated that they are capable of structuring and executing these complex instruments from start to finish," says Deutsche Bank's Irfan. "I think it is probably the Western investment banks, ironically, that are best placed to do the complex transactions, rather than the local and regional institutions, even though traditionally Islamic instruments have been the preserve of the local Islamic banks."
In spite of the difficulties in structuring some Islamic financial instruments, the industry is growing fast. The obvious explanation for the growth is the five-year oil bull-run. The rise in oil prices, from $28 in January 2001 to a record high of $78.65 in August this year, means there's plenty of liquidity in the region, with investors keen to place their spare cash in Islamic investments. "Just by internal growth in the region, the assets under management should grow drastically. I don't think it will be growth from foreign investors - it is not about bringing back money invested elsewhere, it is about internal growth of the wealth they already have," says David Ishoo-Mirzayoo, London-based co-head of Societe Generale's (SG) derivatives and solutions group for Europe, the Middle East and Africa.
While much of the growth may be endogenous, investors outside of the Middle East have also been showing interest. Some high-profile sukuk issues have attracted significant proportions of non-Islamic cash - investors in the US and Europe bought 20% of the inaugural $600 million sukuk issued by the Malaysian government in 2002, and 70% of the $400 million 2003 Islamic Development Bank (IDB) sukuk, for example.
However, the Islamic finance business in general - sukuk included - has a disadvantage compared with conventional financing, say analysts. "In most cases, Islamic banks will be competing with conventional institutions, but Islamic products are less commoditised and require more tailoring and oversight, and this leads to substantial overheads," notes Adel Satel, an analyst at Moody's Investors Service in London. "As a result, it is difficult for Islamic (pricing) to compete with conventional market interest rates. In addition, in most markets where Islamic banks have been established, they are small institutions, even by local standards, and this puts further pressure on their cost base."
The additional cost associated with structuring customised Islamic bonds means only a handful of issuers outside the Middle East and Asia have issued sukuk. The finance ministry of the German federal state of Saxony-Anhalt issued the first European sukuk in July 2004. Although the issue raised its target of $100 million, the German authority has no plans for another sukuk issue - and few other European issuers have followed its lead.
By the end of 2005, only a handful of sukuk had been issued in Europe, and all were on behalf of Middle Eastern borrowers - a 2003 sukuk issued by the IDB used a Channel Islands-based SPV; the 2005 $26 million Al Safeena tanker financing was structured in London by ABC International Bank of Bahrain; Taib Bank of Bahrain issued a £143 million sukuk in London in 2005 to finance the purchase of a London office building; and a Jersey SPV, Caravan I, was used for the 2004 securitisation of a Saudi rental car fleet.
Edgar Kresin, head of the Saxony-Anhalt treasury office, says its sukuk issue was a success - but only because the government had more than financial objectives in mind. "We use it as a kind of marketing instrument for our region in the Middle East," he says, adding that a sukuk would only make sense for a European sovereign or sub-sovereign issuer if it hoped to reap indirect benefits. The region's economic ministry, responsible for promoting inward investment in Saxony-Anhalt, launched a push for Middle Eastern investment alongside the sukuk.
Without this push, there is no reason to use a sukuk rather than a familiar conventional instrument, Kresin says: "You need another target beside just funding. It doesn't make so much sense just from a funding perspective, but from a strategic way of thinking it may make sense for a state."
One of the hurdles to growth is the lack of standardisation in the Islamic market. Sunni Islam, the larger of the two major Islamic sects, contains four major schools of legal thought. Hanbali, the most conservative, is commonest in Saudi Arabia and the Gulf states; hanafi, the largest, is most common in south and central Asia and Europe; Africa is dominated by the maliki school; while Malaysia and Indonesia tend to follow the liberal shafi school.
This matters because each regulator, bank and institution has its own sharia board. And opinions on legally permissible structures vary not only from country to country, but also from bank to bank. However, not all banks are equal: a sukuk by the IDB, based in Jeddah in Saudi Arabia, may have opened the way for a new wave of non-ijara (sale/leaseback) sukuk, says Mohammed al-Sheikh, co-head of the Islamic finance unit at the law firm White & Case in Riyadh.
The sukuk, issued in July 2003, was the bank's first, and raised $400 million (up from $300 million after oversubscription). Previous sukuk, issued by the Malaysian and Qatari governments, had relied entirely on real estate sale/leaseback as underlyings. Other IDB sharia-compliant assets, such as murabaha (cost-plus sale agreements) and istisna'a (cost-plus production agreements) would not normally have been permissible, as they are undertakings to pay as opposed to actual assets - the murabaha and istisna'a deals themselves are sharia-compliant, but their securitisation would not have been.
But, al-Sheikh explains, IDB managed to push the envelope: "The novelty of the IDB was that their sharia committee, a very respected committee, said that as long as the ijara component was more than 50% of the portfolio, you could put whatever else you wanted in. That has really created a push toward more sukuk issuance. It is not a binding precedent, but it is a precedent that gives comfort."
In fact, the IDB deal left room for further flexibility, setting an absolute limit of 25% ijara "under specific circumstances and for very limited durations", below which the sukuk would be dissolved. In the event, the portfolio was 66% ijara.
However, the existence of a central decision-making body would add even more clarity to the process. Deutsche's Irfan comments: "I believe it is healthy to have sharia boards that act across schools of thought. We have a board of five scholars who may have divergent opinions, and that actually helps us sell the product, because investors say the most conservative views must have been applied to the underlying transactions here."
Standardised documents could also help develop the market for simpler transactions - Irfan suggests a profit rate swap as one example. In an Islamic profit rate swap, first developed by the Commerce International Merchant Bank (CIMB) of Malaysia in June 2005, the two legs are fixed- and floating-rate sale agreements, with the floating rate based on the Kuala Lumpur interbank offered rate (Klibor). A notional asset is sold for a notional sum, and then repurchased for the notional sum plus a fixed profit rate - effectively an agreement to pay the fixed profit rate. A similar sale/repurchase arrangement underpins the floating leg of the swap, and the result is a fixed/floating rate swap that is sharia-compliant.
Launching the product in June 2005, CIMB's head of Islamic banking in Kuala Lumpur, Badlisyah Abd Ghani, told Risk's sister magazine, Asia Risk, that the connection to an interest rate did not make the deal un-Islamic. "But in terms of a benchmark, this can be whatever is agreeable between the two parties. Klibor is just a mathematical formula. It is just a number. The act of charging money on money (is unlawful) but the number itself is just a number. Klibor is just a way to agree terms, and there is nothing wrong in using it."
But the complexity of the profit rate swap documentation - "like Tolstoy's War and Peace" compared with the brief International Swaps and Derivatives Association documentation for a conventional rate swap, according to Julian Candiah, Singapore-based director of structured products and debt-capital markets at BNP Paribas - means that more standardisation is needed.
Looking further ahead, SG's Ishoo-Mirzayoo suggests, the next step will be a move from cash to synthetic deals. "The cash market on the conventional world has been replaced by the synthetic market ... cash collateralised debt obligations (CDOs) moving to synthetic CDOs. Well, the Islamic market is moving in the same direction - we are able more and more to repackage synthetically Islamic exposure for investors."
Structuring such products while staying within the boundaries of sharia is not easy. Ishoo-Mirzayoo declined to give details of how the products would be structured, but notes they have been traded on a non-public basis since 2005. "We are trading these, and we are not the only ones," he adds.
In fact, some dealers argue that any product can be made sharia-compliant, so long as an appropriate wrapper is used. "A sukuk is nothing more than an Islamic wrapper on an underlying, and you will see more and more development of Islamic wrappers on different underlyings," says Ishoo-Mirzayoo. "It all depends how conservative the underlying investor is. Some people are just happy with the (Islamic) wrapper, as long as the flows are Islamic, regardless of the underlying product; some others need to be much more conservative."
Even interest-bearing loans could be acceptable as underlyings for some clients, so long as the structure itself follows sharia rules. "Some investors look just at the top layer, some look all the way down to the underlying," says Ishoo-Mirzayoo. "It all comes down to one thing - there is appetite for yield, and it is very difficult to find yield in traditional Islamic markets."
And Deutsche's Irfan predicts sharia instruments will move away from the lease-based type, or sukuk al-ijara, and more to traditional profit and loss sharing systems like musharaka (venture capital) and mudaraba (trustee investment).
"You will probably see two strands of sukuk ... simple corporate and sovereign bonds, and bonds that have a story behind them - structured project bonds for example," adds Ishoo-Mirzayoo. "The latter type of instrument may be required for project finance, and naturally those instruments will be more prevalent in areas that have huge infrastructure requirements and a decent credit story - an ability to repay."
Meanwhile, the next big market could be Indonesia. Infrastructure companies, such as the Indonesian Satellite Corporation, have already issued several sukuk, and the government plans to follow, with a launch planned for early 2007. Its proximity and commercial links to the heart of the sukuk business in Malaysia should prove an advantage. The state energy company, Perusahaan Listrik Negara, is planning a $1.6 billion sukuk to fund power station construction and has named UBS as the arranger. The archipelago's need for infrastructure investment is acute and, with better corporate governance rules making investment in the country less risky, using sukuk to funnel Gulf cash to Indonesian projects could be a profitable business.
WHAT IS A SUKUK?
A sukuk is often described as an Islamic bond or Islamic security. A sukuk is a tradable certificate, which represents an investment in an underlying asset of the issuer and carries a fixed or floating profit rate (the equivalent of a coupon on a conventional bond). The commonest form of sukuk remains the sukuk al-ijara, based on the sale and leaseback of the underlying asset, but sukuk can also use financial contracts as long as the majority of the underlying is ijara.
Three possible financial underlying contracts are:
- istina'a, an agreement in advance for production of goods at a certain time and price.
- murabaha, cost-plus sales in which payment is deferred (thus the equivalent of buying on credit).
- musharaka, a venture capital agreement in which profits from the joint enterprise are shared according to a prearranged rate rather than in proportion to the investment.
Islamic investors may also use a mudaraba arrangement. This is the equivalent of a trust, in which funds are deposited with an agent who manages their investment in return for a fee.
Alexander Campbell
If you want to comment on this article, please email the Editorial Director, Nick Sawyer on nick.sawyer@incisivemedia.com
Billions of dollars worth of sukuk bonds have been issued this year, indicating a continuing boom in the use of fundraising instruments that comply with sharia (Islamic law). High oil prices and greater customer awareness are driving demand from Islamic institutional and private investors for investments that avoid the prohibited areas of riba (interest), gharar (uncertainty) and maysir (gambling). Issuance has already reached $41 billion worldwide, and is growing fast. Abdullah al Muajel, head of the sharia control department at Al Rajhi Bank in Riyadh, expects this to rise to $150 billion by the end of 2010.
To meet this demand, the sukuk market (see box) will have to expand into new areas - and a few large and innovative sukuk deals this year may point the way. January 2006 saw the launch of the largest sukuk to date, an issue by the Dubai Ports, Customs and Free Zone Corporation (PCFC), arranged by Dubai Islamic Bank, and listed on the Dubai International Financial Exchange. Intended to raise funds for PCFC's takeover of UK port operator P&O, through its Dubai Ports World subsidiary, the sukuk was oversubscribed more than four times, receiving a total of $11.4 billion in bids. This demand led PCFC to increase issuance from $2.8 billion to $3.5 billion.
But it is not just the size of the PCFC sukuk that has attracted attention of Islamic financiers. PCFC, in anticipation of an initial public offering (IPO) at some point in the future, structured it as a convertible sukuk. Up to 30% of the sukuk can be redeemed into PCFC shares if an IPO goes ahead in the next two years - otherwise, the sukuk produces a higher yield at redemption, 10.125% a year rather than 7.125%.
The deal was based on a musharaka (venture capital) arrangement. The two partners in the musharaka structure were PCFC, which contributed $1.5 billion in kind, and a special-purpose vehicle (SPV), PCFC Development FZCO, which contributed the $3.5 billion raised by the sukuk. The key to the deal was the SPV's establishment of an English law trust over its right to share the joint venture's profits - selling the trust certificates gave investors a share of profits.
With the trust certificates came the option to convert into PCFC stock. Normally, such a transaction would raise issues of gharar, but according to PCFC's sharia board, as the strike price and the stock were set in advance, there was no uncertainty in the structure.
The PCFC sukuk was listed on the Dubai International Financial Exchange (DIFX), which opened for business in September 2005 - PCFC was the first sukuk to list there.
Aabar Petroleum, an Abu Dhabi oil exploration and production company, listed the second sukuk - a fully convertible bond - on the DIFX in June. Harris Irfan, Deutsche Bank's Dubai-based director of emerging markets structuring, whose bank acted as bookrunner and lead manager, explains: "Aabar is the first truly convertible sukuk that converts wholly into the shares of the underlying company. There are scenarios in which cash would be offered instead, but essentially it operates as a conventional convertible - if it is in-the-money, you get the equity, and if it is out-of-the money, you get par."
The Aabar sukuk raised $460 million, with a fixed profit rate of 6.894%, based on the four-year dollar swap rate at the time of pricing. It will mature on June 28, 2010. The conversion price is $1.0895; Aabar's stock is currently at 3.43 dirhams ($0.934).
Convertible bonds are not unique to Dubai - the Malaysian market saw its first issue in 2005 - but they have not, so far, been widely issued in any market. Market participants say this is not because of difficulties with sharia (even though equity options are widely regarded as being unreal instruments, or 'promises', rather than actual assets). Instead, it may be due to a simple lack of experience among the structuring banks.
"It is actually an extremely difficult instrument to structure. It requires a lot of different skill sets and resources and technology to make it work. So far, very few institutions have demonstrated that they are capable of structuring and executing these complex instruments from start to finish," says Deutsche Bank's Irfan. "I think it is probably the Western investment banks, ironically, that are best placed to do the complex transactions, rather than the local and regional institutions, even though traditionally Islamic instruments have been the preserve of the local Islamic banks."
In spite of the difficulties in structuring some Islamic financial instruments, the industry is growing fast. The obvious explanation for the growth is the five-year oil bull-run. The rise in oil prices, from $28 in January 2001 to a record high of $78.65 in August this year, means there's plenty of liquidity in the region, with investors keen to place their spare cash in Islamic investments. "Just by internal growth in the region, the assets under management should grow drastically. I don't think it will be growth from foreign investors - it is not about bringing back money invested elsewhere, it is about internal growth of the wealth they already have," says David Ishoo-Mirzayoo, London-based co-head of Societe Generale's (SG) derivatives and solutions group for Europe, the Middle East and Africa.
While much of the growth may be endogenous, investors outside of the Middle East have also been showing interest. Some high-profile sukuk issues have attracted significant proportions of non-Islamic cash - investors in the US and Europe bought 20% of the inaugural $600 million sukuk issued by the Malaysian government in 2002, and 70% of the $400 million 2003 Islamic Development Bank (IDB) sukuk, for example.
However, the Islamic finance business in general - sukuk included - has a disadvantage compared with conventional financing, say analysts. "In most cases, Islamic banks will be competing with conventional institutions, but Islamic products are less commoditised and require more tailoring and oversight, and this leads to substantial overheads," notes Adel Satel, an analyst at Moody's Investors Service in London. "As a result, it is difficult for Islamic (pricing) to compete with conventional market interest rates. In addition, in most markets where Islamic banks have been established, they are small institutions, even by local standards, and this puts further pressure on their cost base."
The additional cost associated with structuring customised Islamic bonds means only a handful of issuers outside the Middle East and Asia have issued sukuk. The finance ministry of the German federal state of Saxony-Anhalt issued the first European sukuk in July 2004. Although the issue raised its target of $100 million, the German authority has no plans for another sukuk issue - and few other European issuers have followed its lead.
By the end of 2005, only a handful of sukuk had been issued in Europe, and all were on behalf of Middle Eastern borrowers - a 2003 sukuk issued by the IDB used a Channel Islands-based SPV; the 2005 $26 million Al Safeena tanker financing was structured in London by ABC International Bank of Bahrain; Taib Bank of Bahrain issued a £143 million sukuk in London in 2005 to finance the purchase of a London office building; and a Jersey SPV, Caravan I, was used for the 2004 securitisation of a Saudi rental car fleet.
Edgar Kresin, head of the Saxony-Anhalt treasury office, says its sukuk issue was a success - but only because the government had more than financial objectives in mind. "We use it as a kind of marketing instrument for our region in the Middle East," he says, adding that a sukuk would only make sense for a European sovereign or sub-sovereign issuer if it hoped to reap indirect benefits. The region's economic ministry, responsible for promoting inward investment in Saxony-Anhalt, launched a push for Middle Eastern investment alongside the sukuk.
Without this push, there is no reason to use a sukuk rather than a familiar conventional instrument, Kresin says: "You need another target beside just funding. It doesn't make so much sense just from a funding perspective, but from a strategic way of thinking it may make sense for a state."
One of the hurdles to growth is the lack of standardisation in the Islamic market. Sunni Islam, the larger of the two major Islamic sects, contains four major schools of legal thought. Hanbali, the most conservative, is commonest in Saudi Arabia and the Gulf states; hanafi, the largest, is most common in south and central Asia and Europe; Africa is dominated by the maliki school; while Malaysia and Indonesia tend to follow the liberal shafi school.
This matters because each regulator, bank and institution has its own sharia board. And opinions on legally permissible structures vary not only from country to country, but also from bank to bank. However, not all banks are equal: a sukuk by the IDB, based in Jeddah in Saudi Arabia, may have opened the way for a new wave of non-ijara (sale/leaseback) sukuk, says Mohammed al-Sheikh, co-head of the Islamic finance unit at the law firm White & Case in Riyadh.
The sukuk, issued in July 2003, was the bank's first, and raised $400 million (up from $300 million after oversubscription). Previous sukuk, issued by the Malaysian and Qatari governments, had relied entirely on real estate sale/leaseback as underlyings. Other IDB sharia-compliant assets, such as murabaha (cost-plus sale agreements) and istisna'a (cost-plus production agreements) would not normally have been permissible, as they are undertakings to pay as opposed to actual assets - the murabaha and istisna'a deals themselves are sharia-compliant, but their securitisation would not have been.
But, al-Sheikh explains, IDB managed to push the envelope: "The novelty of the IDB was that their sharia committee, a very respected committee, said that as long as the ijara component was more than 50% of the portfolio, you could put whatever else you wanted in. That has really created a push toward more sukuk issuance. It is not a binding precedent, but it is a precedent that gives comfort."
In fact, the IDB deal left room for further flexibility, setting an absolute limit of 25% ijara "under specific circumstances and for very limited durations", below which the sukuk would be dissolved. In the event, the portfolio was 66% ijara.
However, the existence of a central decision-making body would add even more clarity to the process. Deutsche's Irfan comments: "I believe it is healthy to have sharia boards that act across schools of thought. We have a board of five scholars who may have divergent opinions, and that actually helps us sell the product, because investors say the most conservative views must have been applied to the underlying transactions here."
Standardised documents could also help develop the market for simpler transactions - Irfan suggests a profit rate swap as one example. In an Islamic profit rate swap, first developed by the Commerce International Merchant Bank (CIMB) of Malaysia in June 2005, the two legs are fixed- and floating-rate sale agreements, with the floating rate based on the Kuala Lumpur interbank offered rate (Klibor). A notional asset is sold for a notional sum, and then repurchased for the notional sum plus a fixed profit rate - effectively an agreement to pay the fixed profit rate. A similar sale/repurchase arrangement underpins the floating leg of the swap, and the result is a fixed/floating rate swap that is sharia-compliant.
Launching the product in June 2005, CIMB's head of Islamic banking in Kuala Lumpur, Badlisyah Abd Ghani, told Risk's sister magazine, Asia Risk, that the connection to an interest rate did not make the deal un-Islamic. "But in terms of a benchmark, this can be whatever is agreeable between the two parties. Klibor is just a mathematical formula. It is just a number. The act of charging money on money (is unlawful) but the number itself is just a number. Klibor is just a way to agree terms, and there is nothing wrong in using it."
But the complexity of the profit rate swap documentation - "like Tolstoy's War and Peace" compared with the brief International Swaps and Derivatives Association documentation for a conventional rate swap, according to Julian Candiah, Singapore-based director of structured products and debt-capital markets at BNP Paribas - means that more standardisation is needed.
Looking further ahead, SG's Ishoo-Mirzayoo suggests, the next step will be a move from cash to synthetic deals. "The cash market on the conventional world has been replaced by the synthetic market ... cash collateralised debt obligations (CDOs) moving to synthetic CDOs. Well, the Islamic market is moving in the same direction - we are able more and more to repackage synthetically Islamic exposure for investors."
Structuring such products while staying within the boundaries of sharia is not easy. Ishoo-Mirzayoo declined to give details of how the products would be structured, but notes they have been traded on a non-public basis since 2005. "We are trading these, and we are not the only ones," he adds.
In fact, some dealers argue that any product can be made sharia-compliant, so long as an appropriate wrapper is used. "A sukuk is nothing more than an Islamic wrapper on an underlying, and you will see more and more development of Islamic wrappers on different underlyings," says Ishoo-Mirzayoo. "It all depends how conservative the underlying investor is. Some people are just happy with the (Islamic) wrapper, as long as the flows are Islamic, regardless of the underlying product; some others need to be much more conservative."
Even interest-bearing loans could be acceptable as underlyings for some clients, so long as the structure itself follows sharia rules. "Some investors look just at the top layer, some look all the way down to the underlying," says Ishoo-Mirzayoo. "It all comes down to one thing - there is appetite for yield, and it is very difficult to find yield in traditional Islamic markets."
And Deutsche's Irfan predicts sharia instruments will move away from the lease-based type, or sukuk al-ijara, and more to traditional profit and loss sharing systems like musharaka (venture capital) and mudaraba (trustee investment).
"You will probably see two strands of sukuk ... simple corporate and sovereign bonds, and bonds that have a story behind them - structured project bonds for example," adds Ishoo-Mirzayoo. "The latter type of instrument may be required for project finance, and naturally those instruments will be more prevalent in areas that have huge infrastructure requirements and a decent credit story - an ability to repay."
Meanwhile, the next big market could be Indonesia. Infrastructure companies, such as the Indonesian Satellite Corporation, have already issued several sukuk, and the government plans to follow, with a launch planned for early 2007. Its proximity and commercial links to the heart of the sukuk business in Malaysia should prove an advantage. The state energy company, Perusahaan Listrik Negara, is planning a $1.6 billion sukuk to fund power station construction and has named UBS as the arranger. The archipelago's need for infrastructure investment is acute and, with better corporate governance rules making investment in the country less risky, using sukuk to funnel Gulf cash to Indonesian projects could be a profitable business.
WHAT IS A SUKUK?
A sukuk is often described as an Islamic bond or Islamic security. A sukuk is a tradable certificate, which represents an investment in an underlying asset of the issuer and carries a fixed or floating profit rate (the equivalent of a coupon on a conventional bond). The commonest form of sukuk remains the sukuk al-ijara, based on the sale and leaseback of the underlying asset, but sukuk can also use financial contracts as long as the majority of the underlying is ijara.
Three possible financial underlying contracts are:
- istina'a, an agreement in advance for production of goods at a certain time and price.
- murabaha, cost-plus sales in which payment is deferred (thus the equivalent of buying on credit).
- musharaka, a venture capital agreement in which profits from the joint enterprise are shared according to a prearranged rate rather than in proportion to the investment.
Islamic investors may also use a mudaraba arrangement. This is the equivalent of a trust, in which funds are deposited with an agent who manages their investment in return for a fee.
Alexander Campbell
If you want to comment on this article, please email the Editorial Director, Nick Sawyer on nick.sawyer@incisivemedia.com
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