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Sukuk in MENA: Two tranche or not to tranche?

This year has so far seen a rapid expansion in bonds and to a lesser extent sukuk issued from the GCC, largely led by many of the region’s sovereigns and financial institutions. Speed, standards, and liquidity concerns are keeping some issuers from tapping into the sukuk market to achieve their funding objectives, analysts suggest.

Oct 17, 2016 // 9:43AM

GCC sovereigns have led deal flow in the region this year as many continue to see their deficits under pressure due to subdued oil revenues. In February this year, Bahrain raised US$600mn via five and 10-year bond re-taps, followed by a US$435mn privately placed sukuk in May and a US$2bn dual-tranche Islamic and conventional deal in October. In April, Abu Dhabi raised US$5bn from its first international bond sale in years. In May this year Qatar hit the market with an eye-watering US$9bn split into 5, 10 and 30-year tranches. Oman successfully raised US$2.5bn in the country’s first dual-tranche bond offering in June this year, pricing a US$500mn sukuk shortly after.

Investors are still waiting with baited breath for a landmark bond issuance out of Saudi Arabia, which is rumoured to range between US$10 and US15.5bn, and Kuwait, which could raise up to US$9bn to help shore up government spending.

So far, conventional bond issuances are up over 50% this year, with deal supply boosted by a combination of persistently low oil prices, subdued tax takes, and depleted bank system liquidity – a particularly acute problem in Qatar and Saudi Arabia.

Boubyan Bank, DP World, Emirates Islamic, Ezdan Holding, MB Holdings, Sharjah Islamic Bank, Meydan, Sipchem, QIIB, Ahli United Bank Kuwait and Al-Hilal Bank are among some of the high quality names to tap the Islamic investor base through either straight sukuk or dual conventional and Islamic deals. But despite some notable deals hitting the market, sukuk volumes have simply not kept pace with the conventional bond sales in the region, and are nowhere near the volumes seen in 2014.

“In a sense it is interesting to see that Islamic finance in the GCC is down slightly on last year, but it is most likely due to how the dynamics of the market are evolving. The windows for issuing are getting narrower – this year we’ve seen record conventional deal volumes but they have all been concentrated around particular windows,” says Anita Yadav, Head of Fixed Income Research at Emirates NBD in Dubai. Those windows have cropped up at the end of Q1, in the weeks before Ramadan, and at the beginning of September.

“Issuers are increasingly saying that they can’t afford the legal costs? and time premiums that come with issuing a sukuk.”

One of the reasons some issuers may have been dissuaded from including Islamic tranches within their deals this year is because of the thin bank liquidity environment, Yadav explains.

“Governments are already reducing their deposits with banks, and I believe some institutions are under political pressure to put the emphasis on attracting liquidity from outside the region into these economies, rather than soaking up too much liquidity domestically. The region is already capital deficient.”

The environment hasn’t been particularly kind to some of the region’s Islamic lenders, many of which have engaged in workforce rationalisation exercises as the fight for deals becomes fiercer. Towards the end of August Emirates Islamic, the Sharia-compliant lending arm of Emirates NBD, cut about 100 back-office jobs in a bid to save on operational expenses while its parent trimmed 250 jobs related to its SME lending business. Union National Bank, which is backed by both the governments of Dubai and Abu Dhabi, trimmed about 50 jobs towards the end of the summer. In October Abu Dhabi Islamic Bank has reportedly cut more than 200 jobs, mostly to its retail business, over the past four months; that’s nearly 10% of the bank’s workforce.

Mohamed Damak, Head of Global Islamic Finance at S&P Global Ratings is predicting total issuance of sukuk to sit somewhere between US$50bn and US$55bn globally this year, which is considerably lower than 2015, which saw US$63bn – down from US$116bn in 2014, largely due to the absence of the Malaysian Central Bank. In the GCC, volumes could reach around US$15bn this year, down slightly from US$17bn in sukuk deal flow through 2015 and US$18bn in 2014. The first eight months of this year have seen just US$9bn in sukuk issued across the GCC, down from US$12.7bn seen during the same period in 2015. These figures include Islamic tranches as part of dual conventional and Islamic deals.

“If you look at 2016, a lot of market commentators were initially expecting a windfall of issuance given the drop in the oil price and the financing needs of some countries in the GCC region, but most of these financing needs have been responded to through bond issuance rather than sukuk,” Damak says.

Speed is one of the overriding factors in all of this. It can take as little as four hours to price and place a bond in the market; sukuk, despite their popularity in the GCC and among other regions globally, can take upwards of three to four weeks. Sovereigns, which many thought would lead sukuk deal flow in the GCC, have overwhelmingly opted for conventional formats like 144A/RegS.

“If you put yourself in the shoes of a Minister of Finance of an oil exporting country and you need US$1bn to pay all of your contractors, payments which are already seeing delayed payments in many cases, you aren’t going to wait up to a month longer or include an Islamic tranche just so you can soak up additional liquidity from an Islamic investor base,” Damak says.

However, Damak also says this has resulted in the debate around standardisation being put firmly back on the table. The importance of sukuk documentation standardisation has been talked up in the past by a range of organisations, but some, like the Islamic Corporation for the Development of the Private Sector (ICD) are looking to redouble their efforts both to promote sukuk, by helping first-time issuers, and help develop standards and best practices across documentation, risk management, and execution. The International Islamic Financial Market (IIFM), an Islamic finance standards setting body, has also published a number of important standards for treasuries including a Master Agreement for Treasury Placement (MATP), Tahawwut (Hedging) Master Agreement (TMA), Islamic Profit Rate Swap (Mubadalatul Arbaah) templates, an Inter-Bank Unrestricted Master Investment Wakalah Agreement (UMWA) and a Master Collateralised Murabaha Agreement (MCMA). In addition to the development of specific guidelines and standard documentation on Ijarah Sukuk, the standards body is also actively working on draft guidelines for Islamic cross currency swaps (ICCS), FX forwards, a credit support agreement (CSA) and a risk participation agreement (RPA).

The immense financing requirements of GCC issuers will undoubtedly provide a boon to the Islamic finance industry, particularly as we move into a higher interest rate environment in the US. From 2016-2019, total spending on GCC projects (including infrastructure) is estimated to be about US$330bn, of which US$50bn is estimated to be allocated specifically for infrastructure and transportation projects. In addition, GCC corporate entities’ refinancing needs are significant – approximately US$23.6bn is expected to be refinanced between 2017 and 2019, according to figures from S&P Global Ratings. A sizeable portion of the required funding could come from sukuk.

Hussein Hassan, Global Head of JP Morgan’s Islamic Finance business, is more optimistic than both S&P and Fitch, which are forecasting relatively subdued sukuk volumes this year. He says that after a quiet start to the year, he has seen interest pick up significantly and the remainder of the year looks like it will be strong, driven by these immense funding requirements in the region and the need for investor diversification.

“Rather than declining, I would actually say we are seeing more interest in sukuk and Islamic tranching than ever before,” he says, pointing to the fact that most of the issuers the bank has worked with this year have never done these kinds of transactions before.

“It has been a useful tool for reaching the widest possible investor audience, and being as effective as possible in targeting key accounts. Investors looking at Islamic assets typically like shorter dated paper, so it makes sense for issuers looking for longer dated money and a smooth maturity profile to do a longer tenor conventional tranche – say 10 to 20 years – and a shorter tenor Islamic tranche, maybe between 5 and 7 years,” Hassan says.

As the macroeconomic environment improves, we may see sukuk flows improve into next year. Oil prices, while still depressed, have stabilised and visibility on the trajectory of prices for next year is improving (we are likely to see US$50-US$65 per barrel through 2016, according to a range of bank analysts). The interest rate environment is also stabilising, with a December Fed rate hike increasingly priced into assets and one hike on the cards next year; this is broadly supportive of EM issuances, both Islamic and conventional.

“As the environment stabilises we will likely start to see a range of issuers come to market to refinance conventional credit using sukuk with different tenor ranges,” Hassan concludes.

Middle East Macro Islamic Finance

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