Sukuk have come a long way

Non-Muslim nations are issuing maiden sharia-compliant products. This year, Hong Kong, South Africa and the UK have been added to that list.

Islamic finance has come a long way since 2002, when Malaysia raised the first dollar-denominated Islamic bond or sukuk.

Non-Muslim nations are rushing to burnish their credentials as financial centres by issuing maiden sharia-compliant products.

This year, Hong Kong, South Africa and the UK have been added to that list. Next in line is Luxembourg, which (just like others) is seeking to tap increased demand for these non-conventional financial assets and further support its domestic policy goals for Islamic finance.

As investors become more familiar with these products pricing will improve, suggesting Islamic finance will be more competitive with more traditional forms of funding on cost.

“We expect the share of international issuance to increase, attracting more global investors and improving the depth and breadth of this relatively new sector,” said Khalid Howladar, Moody’s global head for Islamic finance. “Islamic financial flows are increasingly becoming global.”

Hong Kong’s AAA rated $1 billion five-year sukuk priced at 23 basis points above US Treasuries on September 10. The nearest sovereign or quasi-sovereign comparables are the Republic of Korea (rated A+) and Singapore investment company Temasek (rated AAA), whose similarly dated conventional bonds traded at a G-spread — spread between the instrument and US Treasury yields — of 48bp and 47bp, respectively.

To be sure, South Africa launched a $500 million 5.75-year sukuk on September 17, paying a 15bp premium above its conventional Eurobond — but still much tighter than the 20bp to 40bp premium that debut issuers would have to pay, according to a source familiar with the matter.

South Africa’s debut Islamic bond sale brings the amount of sukuk finance raised globally so far this year to $30.7 billion, up 38% compared with 2013 [See chart].

Moody’s expects governments to issue approximately $30 billion of sukuk in 2014, increasing the overall size of the sovereign Islamic bond market to around $115 billion by year-end.

The credit ratings firm also forecasts this strong growth to be sustained further ahead as both Islamic and non-Islamic governments increasingly tap or enter the market.

The UK was the first Western country to issue an Islamic bond, attracting orders globally more than £2 billion ($3 billion) for its £200 million sharia-compliant debt sale in June.

Luxembourg is currently raising a €200 million ($264 million) sukuk after it passed a law on real estate transactions in July that allowed for the issuance of Islamic bonds.

Friendly legislation

Hong Kong — which has a Muslim population of about 270,000, a fraction of Malaysia’s 18 million — weighed the possibility of developing an Islamic bond market as far back as 2007.

But it only amended its tax framework in July 2013 for common types of sukuk, levelling the playing field with conventional bonds by removing the additional profit taxes and stamp duties that could be incurred by investors. A bill was approved in March allowing the government to proceed with its debut sukuk.

Islamic finance specialists said Hong Kong now offers one of the friendliest legislations globally for the issuance of sukuk, which pay returns on assets to comply with sharia law’s ban on interest.

In Hong Kong’s case, the sovereign chose the simplest and most investor-friendly structure — the ijara, which is the sale and leaseback of an asset.

The proceeds from the sukuk certificates will be used by its special purpose vehicle, Hong Kong Sukuk 2014, to purchase certain properties owned by the government. Subsequent to the purchase, the borrower will enter into a lease agreement with the government.

Based on the terms of the agreement, the government will periodically pay an amount sufficient to fund distributions payable by the issuer to investors in the sukuk.

At the end of the Islamic bond’s term, the government will purchase the lease assets at the exercise price, thus providing the principal amount payable by the issuer to certificate holders.

If the dissolution is triggered by a total loss event and the insurance proceeds are not sufficient to cover the amount payable by the issuer, the government will pay an amount equal to the shortfall.

“The ijara structure is easy to explain and many investors are familiar with it,” said a source close to the deal. “Hong Kong wanted the least amount of resistance and wanted to market the story of Hong Kong and its role in developing Islamic finance, rather than spending [a] huge amount of time explaining the structure.”

China next step

Such structures could be potentially helpful for mainland Chinese borrowers. While the PRC has not yet perfected its own domestic legal and tax system to accommodate sukuk issuance, some Chinese companies are accumulating a growing stock of property in Hong Kong that could in the future be used to support the sale of Islamic debt.

Given their increasing appetite for US dollar-denominated debt, this new channel of liquidity would likely be  welcomed.

“The advantage for Hong Kong, and to a certain extent [for] some Chinese companies in Hong Kong, is that there’s a fairly robust stock of property that can potentially be used to support sukuk issuance,” said Karby Leggett, head of capital markets for Greater China and Northeast Asia at Standard Chartered.

Mainland Chinese property developers have accounted for 13%, or $18 billion-worth, of dollar-denominated bond issuance in Asia ex-Japan so far this year, according to Dealogic data.

Hong Kong’s entry to the Islamic market will prompt the setting up of investment funds in line with religious tenets and structuring sukuk, bankers added. And with this, the city will provide the asset class a unique opportunity and hopefully, a gateway into China.

“The opportunity on both the financing or investment side in China can be matched by growing liquidity in the Islamic finance market and Hong Kong could be the gateway to bridge or to connect these two exciting opportunities,” said Rafe Haneef, Kuala Lumpur-based chief executive officer of HSBC Amanah Malaysia.  

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