Long-term sukuk outlook promising after weak 2008

The value of sukuk issuance dropped by more than 56% in 2008 and S&P doesn't expect the market to revive before the second half of 2009. However, several structural factors indicate longer-term growth should be rapid.
The market for Islamic bonds, or sukuk, declined sharply in 2008 as a result of global market turmoil, drying up of liquidity, widening of credit spreads, and a wait-and-see attitude among investors. Although difficult to measure, part of this decline could also have been due to comments about the Shar'iah compliance of some sukuk by the Accounting and Auditing Organisation for Islamic Financial Institutions.

Standard & Poor's considers that long-term prospects for the sukuk market remain strong, however. Although volumes dropped dramatically in 2008 (down more than 56%), the market attracted about the same number of issuers as the year before. Conservative estimates of the pipeline of sukuk that have been talked about or announced are in excess of $45 billion. Several factors support sustainable growth of this market, including the increasing popularity of Shar'iah-compliant products; government openness to Islamic finance; massive investment and financing needs in the Gulf; and issuers' desire to tap investors from the Middle East and Muslim Asia. Issuers from more than 20 countries have expressed interest in issuing, or announced their intention to issue sukuk, and Standard & Poor's anticipates that several new sovereigns will enter the market.

To date, Standard & Poor's has rated 27 sukuk (or sukuk programmes), the bulk of which are ijara (lease financing), or musharaka (venture capital financing). (Please see our "Glossary Of Islamic Finance Terms," published January 7, 2008, on RatingsDirect.)

Credit spreads on sukuk have followed the same trend as for conventional bonds, with a sharp widening in the past 12 months. Meanwhile, the average size of the sukuk issued last year declined significantly, partly due to the lower appetite of investors. At the same time, the US dollar lost its place as the currency of choice for sukuk, with only about 10% of issues raised in this currency. Standard & Poor's expects the sukuk market to continue being skewed toward issuances in local currencies, at least in the foreseeable future.

Growth to resume once markets normalise

The sukuk market experienced a dreadful year in 2008, largely as a result of deteriorating global market conditions. For instance, the Gulf Cooperation Council (GCC) countries, one of the two key markets for Islamic finance, experienced a major shift in liquidity flows. The liquidity inflow into the Gulf - mainly into the United Arab Emirates (UAE) and Saudi Arabia - started to reverse from the second half of 2008 when investors betting on the revaluation of the domestic currencies left these markets. This led to a significant downturn in local and regional debt and equity markets, including the sukuk market.

Overall, total sukuk issued globally dropped to $14.9 billion in 2008 from $34.3 billion in 2007. More than 45% of sukuk issued in 2008 were ijara, most probably as a direct consequence of the debate about Shar'iah compliance among some scholars.

Appetite for sukuk declined dramatically, along with that for international debt issuances, loan syndications, and other wholesale debt. We expect the sukuk market to revive only in the second half of 2009 or early 2010 - if and when financial market conditions start to improve. This delay is despite the fact that the pipeline for sukuk issuance remains healthy and the market is attracting interest from an increasing number of issuers in both Muslim and non-Muslim countries. Several structural factors indicate that growth in the longer term should be rapid:

ò On the demand side, investors from the Middle East and Muslim Asia are increasingly seeking to invest in products that are compliant with their religious beliefs. In addition, wealth accumulated when oil prices were high in the past few years means that their financial flexibility is still strong.

ò On the supply side, massive infrastructure projects in the Gulf require a huge amount of financing. Conventional borrowers are also seeking to diversify their investor base. They want to attract funding from investors as the crisis continues to widen and access to wholesale funding sources remains constrained.

ò The openness among governments and regulators to Islamic finance is increasing around the world. We observe this trend not only in Muslim countries but also in non-Muslim countries such as the United Kingdom, which is the European country most supportive of Islamic finance.

ò Financial institutions are seeking to better balance their funding, especially in the Gulf where short-term funding sources typically dominate and maturities are increasing on the asset side.

Last year clearly showed that the sukuk market is connected to global debt markets. Islamic finance is one component of global finance and is exposed to the ups and downs of international funding markets. Therefore, we expect the revival of the sukuk market to start more or less at the same time as that of the conventional capital markets.

Club of sukuk issuers is widening

One of the few positive developments for the sukuk market in 2008 has been its continuous geographic diversification. It is attracting issuers from an increasing number of countries and this trend is set to continue. Issuers from more than 20 countries have announced their intention to issue sukuk, or expressed an interest in doing so.

Therefore, Standard & Poor's expects the market to continue globalising. We expect more sovereign issuers to join the club in 2009 and understand that the Singapore, Indonesia, Kazakhstan and Qatar, among others, have plans to issue sukuk. Sovereign issuance should support the construction of a yield curve and introduce benchmarks for private issuers in these countries, boosting the growth of the sukuk market.

Malaysian and UAE-based issuers continue to drive the sukuk market, with more than 70% of total issuance coming from these two countries in 2008. Authorities' support for Islamic finance and openness to foreign investors are the key elements behind these figures. Other GCC and Asian countries are set to increase their contribution to the growth of the market in the future, thanks to huge financing and investment needs in the GCC, as well as sovereign issuance and support for Islamic finance development.

The largest sukuk in 2008 was issued out of Saudi Arabia by Saudi Basic Industries Corp. (SABIC) for a total amount of 5 billion Saudi Arabian riyal ($1.3 billion). The structure of this sukuk was very innovative. Under an asset transfer agreement, SABIC transferred certain rights and obligations for specific marketing agreements to SABIC Sukuk LLC, a 100% subsidiary. These represent SABIC Sukuk LLC's underlying assets, and it will hold them as a custodian for the benefit of the sukuk holders. The sukuk assets should generate the necessary cash flows to cover periodic payments to the sukuk holders. SABIC will be required to purchase the sukuk from the holders when they exercise their right to redeem their bonds. Therefore, we have equalised the ratings on the sukuk with those for SABIC.

Other large sukuk, denominated in local currencies, were issued out of the UAE, by Aldar Properties PJSC, Nakheel PJSC, Dubai Electricity and Water Authority, and Sorouh Abu Dhabi Real Estate. The sukuk issued by Sorouh (Sun Finance Ltd. Class A, B, and C) was the first sukuk with no credit enhancement that we have rated. We believe that the potential for asset-backed sukuk continues to be strong despite the currently weak investor interest in structured products.

US dollar no longer the currency of choice

The US dollar lost its leadership position with regard to sukuk issuance in 2008, with only about 10% of issuance in this currency. The credit crisis meant that sukuk issuers had to attract domestic investors instead of international investors and as a result issuers deserted international markets and concentrated on local markets where liquidity was more abundant and the appetite for Shar'iah-compliant instruments stronger.

In addition, investors betting that some GCC governments would de-peg their currencies from the dollar converted their funds into local currencies and placed them in local and regional debt and capital markets. In the end, the governments did not de-peg their currencies, however, and currently five out of the six GCC currencies are pegged to the US dollar. Standard & Poor's expects the sukuk market to continue being skewed toward issuance in local currencies for the foreseeable future, with only a limited portion being issued in dollars. Some of the sovereign sukuk to be issued in 2009 or 2010 will be both in local and foreign currencies (mainly dollars). Once market conditions return to normal, dollar-denominated sukuk will regain a stronger position, however.

Our role is to provide market participants with independent and objective opinions about the creditworthiness of issuers and issues - including those involving sukuk. We don't comment on the Shar'iah-compliance of a particular issue or issuer. Our ratings don't constitute a recommendation to sell, buy, or hold a particular security - whether it is Shar'iah-compliant or not. Instead, our ratings help investors to make informed decisions and issuers to access debt markets and benchmark their creditworthiness against that of their peers.

The authors of this article are both analysts at Standard & Poor's.
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