Islamic bonds

Islamic bonds
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
http://www.risk.net/public/showPage.html?page=438758