Islamic finance deals 2003-2004
ISLAMIC BANKING HAS had a groundbreaking year, particularly in the market for medium-term and long-term Shariah-compliant bonds. Islamic finance specialists believe the market for these instruments, categorized as sukuk, is now set for further rapid expansion as investors and borrowers worldwide start to understand its appeal.
The most significant recent transaction was the e100 million issue in July for the German state of Saxony-Anhalt, the first for a European borrower to be Islamically structured. But of almost equal importance have been the $250 million transaction for Bahrain's central bank, the Bahrain Monetary Agency (BMA), in June and the $750 million deal for Dubai's Department of Civil Aviation in August.
Bankers believe that in the next few months more sovereign and multilateral borrowers will raise money using the sukuk structure, which offers liquid asset-backed instruments, and that the next big challenge is to persuade private-sector borrowers from the Middle East and Europe to follow suit.
"The sukuk market has now developed a lot of momentum," says Iqbal Khan, chief executive of HSBC Amanah, HSBC's Islamic finance division. "At first it was seen as experimental, then as a novelty, but it is now moving towards maturity. It can now deliver size and competitive pricing, and provide access to a new and large investor base."
This has been possible because banks have developed more innovative structures. Competition for mandates, particularly between HSBC and Citigroup, which are both heavily committed to developing their Islamic finance business, has become intense in recent months. And the newest trend may be towards a greater use of regional Arab institutions as lead managers. Dubai Islamic Bank took this role for the Dubai Department of Civil Aviation bond – the first time a wholly Islamic financial institution has won such a mandate.
Alongside the banks, lawyers and management consultants have played an important role in expanding the sector. These have helped to establish legal and commercial frameworks that meet international standards. In addition, the Shariah boards, made up of Islamic jurists and scholars, which have to approve all transactions, are working constructively to ensure that the structures are in line with Islamic law.
Most important, pricing of Shariah-compliant instruments is now comparable to that available in conventional issues.
The sector has expanded extremely rapidly. It is barely two years since Malaysia broke new ground with the first sale of dollar-denominated Islamic bonds when it raised $600 million in a deal lead managed by HSBC. Malaysia's breakthrough international deal was followed in September 2003 by a $400 million bond for the Islamic Development Bank, a complex deal involving portfolio securitization of a large number and range of asset-backed receivables including real estate and aircraft. This deal was lead managed by Citibank. After that, in October 2003, there was a $700 million issue for Qatar, lead managed by HSBC.
The global sukuk market has now issued nearly $3 billion and the domestic currency market more than $2 billion, mainly in Bahrain and Malaysia, but there is enormous potential for further growth. The main challenge is to educate investors and borrowers.
"If you consider that the global Islamic sector has at least $230 billion in assets and is growing at 10% a year, and you compare that with the value of the outstanding issues, then you realize that we have only just begun to scratch the surface of the sukuk market," says Salman Al-Khalifa, director of the banking services directorate at the BMA.
A key factor in making the sukuk market attractive to Islamic investors is the current maturity structure of Shariah-compliant investment instruments available to them. Their short-term needs are met either by sukuk salams, the Islamic equivalent of treasury bills, or by murabaha finance, under which the bank buys an asset and transfers ownership to a third-party client, who usually provides collateral. Longer-term requirements are met by investment in leasing contracts, known as ijara.
Switching between sukuks and conventional bonds
The sukuk structure fills a gap. "Until the development of sukuks," says Salman, "there were very few opportunities to place money for between three and seven years – and there is an enormous surplus of cash looking for investable products in this range."
HSBC Amanah's Khan concurs. "The terms are moving out from three years to five, seven and 10 years and possibly even longer," he says. "That is bound to make them even more attractive to investors."
Equally important has been the appeal of the sukuk structures to non-Islamic investors. They are looking to diversify away from western sovereign and corporate issues and are showing greater interest in these Islamic issues, which offer attractive returns.
Investors who have already taken country risk, for example by buying conventional Qatar bonds, also find the structure attractive. The conventional 2009 Qatar bond was trading in the mid-30 basis points over swaps when the Qatar sukuk was marketed. It then widened to more than 40bp over when it became clear that the sukuk would price at around Libor plus 40bp.
Bankers say there was some selling of the conventional bond to switch into the Shariah-compliant structure, in particular from Middle Eastern conventional accounts. They say that a similar trend has been noted with the BMA sukuk, which came in at Libor plus 45bp, while the 2008 conventional bond traded in the high 30s.
"Some investors swapped out of the conventional into the Islamic issue and they are likely to swap back if, as expected, the trading price of the Islamic bond tightens," says Gilles Franck, head of debt capital markets, Europe, Middle East and Africa, at BNP Paribas.
Bankers say that these might have been important factors had these been corporate issues, where pricing is of overwhelming importance. But Middle East sovereigns also attach great importance to diversifying their investor bases and developing the global sukuk markets.
Islamic issues will become more attractive as the range of products increases and the instruments start to become as sophisticated as those in the conventional market. For example, says HSBC Amanah's Khan: "It is now possible for investors for the first time effectively to hedge their positions." Typically, this is done by taking out a takaful (insurance) contract.