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Tenor, Size, Format and Structuring: The Key to a Successful Debut Sukuk

With over USD33bn of issuances year to date in 2017 – from just under USD2.5bn in 2008 – the sovereign Sukuk market has grown rapidly over the past decade. Despite such progress, there remains room for further unprecedented growth. The market remains restricted by liquidity constraints, higher costs, and a lack of deep understanding of the Sukuk instrument. If proactive, however, borrowers can overcome these challenges in the pursuit of high-quality borrowing instruments.

Broadly speaking, the Sukuk market performed well in the first half of 2017. Issuance volumes increased by 37.7% in the first six months of this year as compared to the same period in 2016, underpinned primarily by the jumbo issuances by some Gulf Cooperation Council (GCC) countries’ governments. Sovereign issuers turned to Sukuk aiming to diversify their investor base. We expect to see more activity in the coming months, as the current hunt for yield clearly signifies that investors have liquidity to deploy.

To some extent, Sukuk continues to suffer from liquidity constraints borne of several interlinked challenges. The asset class continues to be underrepresented in major bond indices, restricting its exposure to global investors, whilst the nature of Sukuk investors – who often hold these securities to maturity – coupled with asset scarcity means the secondary market can seem thinner than comparable fixed income instruments, often requiring borrowers to pay investors a premium.

Broadening the Liquidity Pool: Exploring Demand

Two types of investors drive the demand for Sukuk: i) Sharia-sensitive investors ii) global investors or asset managers seeking diversification and attractive yields. The demand from Islamic financial institutions (IFIs) — the broadest group of Sharia-sensitive investors — in the Middle East and Asia is currently the foundation of global Sukuk demand.

To facilitate the growth of Sukuk market, there is a need for a new class of investors to come into the fold. The largest constituency of the investment universe – and the one persistently underrepresented in Sukuk transactions – is the long-term institutional investors (such as pension funds and insurers).

Although the size of the assets managed by pension funds in the Middle East could be considered small relative to other regions with a similar population size, pension reform efforts currently being undertaken in countries like the UAE and the Kingdom of Saudi Arabia are a strong indication that the demand for high-quality assets like Sukuk will grow exponentially amongst long term institutional investors. This will be compounded by a growing youth population – one of the largest in the world – as it enters the workforce.

Recent developments, especially in Asia, with pension funds increasing their focus on Islamic portfolios, give us cause to be optimistic. Alongside, the rapid rise of the takaful industry (sharia-compliant insurance), which in the GCC has grown in the high double-digits annually over the past five years, is also encouraging. All these factors bode well for the growth of a strong institutional local bid for Sukuk within regions where their popularity is already rapidly rising – along with growing demand for cross-border Sukuk issuance.

Optimising Demand and Pricing

Pricing and demand for a bond or a Sukuk primarily hinges on the scarcity value of the paper. It is also governed by the investor base and the tenor. In the past, we have witnessed some transactions being placed at competitive periodic distribution rates versus conventional instruments. The pricing benefit is seen largely with GCC sovereign and corporate issuers, due to the familiarity of GCC banks with local issuers and the scarcity of Sukuk paper in the market, compared to regional Islamic banks’ asset growth needs.

Striking a balance between the unique needs of different pools of investors, whilst optimising the tenor and deal size, is imperative for the success of any transaction. The needs of Islamic bank treasuries, which like other FIs are subject to regulatory restrictions on the duration for which they can hold securities on their balance sheets, are quite distinct from those of large pension funds and insurers that often seek longer-dated securities to match their liabilities.

How do you simultaneously capture these two distinct groups of investors? One of the approaches that the Sukuk issuers have followed in the past is to issue conventional bonds and Sukuk concurrently, across two tranches of varying maturities. This enables borrowers to maximise their allocations to sharia-sensitive investors like IFIs whilst also optimising for tenor demand from different pockets of the investment universe.

Due to the nature of their balance sheets, pension funds have a preference for longer dated securities, but they often participate across multiple tranches of an issuance if pricing is supportive, On the other hand, IFIs (and some asset managers, subject to market conditions) tend to prefer shorter-dated securities and are mandated to purchase sharia-compliant assets. That said, it may be beneficial for issuers to place a shorter-dated Sukuk alongside a longer-dated conventional bond.

This approach carries several benefits. Borrowers enjoy economies of scale in marketing a transaction to a much wider investment community than they would otherwise have access to, creating more opportunities for targeted diversification. Issuing across different maturities develops pricing tension, further aligning both sharia-sensitive and conventional investors, often reducing the premium paid on Sukuk vis a vis conventional issuance, and optimising overall pricing. Splitting an issuance across two tranches of differing maturities also gives borrowers greater flexibility in smoothing out their maturity profile.

Market Access: From Private Placements to Public Markets and Indices

An alternative practical strategy to widen the Sukuk investor pool is to make Sukuk eligible for more indices. This strategy has picked up traction recently and last year, J.P. Morgan decided to include Sukuk within the EMBI Global Diversified, GBI-EM Global Diversified, CEMBI Broad Diversified, CEMBI Diversified, and JACI indices and others are following suit.

While a number of factors determining index inclusion fall outside of a borrower’s direct control, borrowers can certainly manoeuvre their instrument towards index admittance. In many cases, broad-based indices tend to have a preference for securities of a benchmark size – commonly understood to be between USD500mn and USD1bn – and denominated in US dollars. Insufficient deal size is one of the more prevalent reasons for index exclusion, and for some borrowers, raising USD500mn or an equivalent in other currencies through a single transaction exceeds their financing needs.

This is where the private placement can prove to be extremely favourable. Private placements have risen to prominence over the past seven years in the conventional bond market, driven by long-term institutional investors seeking to secure large allocations and deploy liquidity in a highly targeted fashion. The format is well-suited for Sukuk. It allows sharia-sensitive investors, which tend to require slightly longer assessment periods, to secure various approvals and an opportunity to better understand borrowers’ credit story without the time pressure of execution of a public issue. It allows borrowers to take a targeted, bilateral approach to build a strong credit story with new pockets of the investment universe. Additionally, private placements are not hampered by deal-size requirements like the listed fixed-income market, which often requires deals to be in excess of USD250mn.

With a smaller pool of investors being targeted and a smaller deal-size being considered, executing a private placement also gives borrowers the flexibility to experiment with alternative Sukuk structures and the composition of the underlying asset portfolio. For example, while the sale and leaseback structure – al-ijara – is the most popular and widely understood variant of Sukuk, and has to some extent an advantage in its broad appeal and structural consistency, it isn’t necessarily well-suited to every borrower.

Structures may vary through regulatory variations around the transfer of legal title or the use of government assets. They may simply be modified dependant on the availability of leasable assets and infrastructure. In any event, exploring additional Sukuk structures that offer greater flexibility in the underlying and that rely on less tangible assets, like al-wakala Sukuk for instance, may be the answer – and in some cases, it is easier to test different structures through a smaller private placement.

Once financing needs grow to the point at which benchmark-sized borrowing is required, these transactions act as an important stepping stone into the public markets – and into bond indices.

Mainstreaming Sukuk: The Early Bird Catches the Worm

The mainstreaming of Sukuk – through continued issuance by GCC sovereigns as well as a host of non-traditional Sukuk borrowers like Hong Kong, the UK and South Africa – enables long-term institutional investors based outside majority-Muslim regions, to gain continuous exposure to the asset class. The growth of long-term institutional investors in regions where these instruments are already popular will only help fuel demand for Sukuk. As these instruments are gradually added to bond indices, traditional portfolio managers will also follow suit, making the asset class even more attractive – and liquid.

The aforementioned techniques will help borrowers develop stronger links with sharia-sensitive and long-term institutional investors, creating a crucial focal point for regular engagement –one of the best ways to ensure competitive pricing.

The long-term aim is to prevent borrowers from viewing Sukuk solely as a one-off instrument to be tapped when other alternatives are unavailable. The benefits of regular issuances – frequent engagement with a continuously evolving investment pool, creating a liquid yield curve, diversifying borrowing risk – outweigh the drawbacks of tapping this market opportunistically.

The need to tap into high-quality, resilient investment instruments increases during periods of market volatility but borrowers should not wait for the worst to come to pass before making a move. Making sure the necessary ingredients to support Sukuk issuances are in place long before borrowing needs become acute is essential; in the credit markets, as in most things, the early bird catches the worm.  

Middle East Global CEEMEA

Hussein Hassan, Ph.D., is the Global Head of Islamic Finance at J.P. Morgan. Dr. Hassan previously served as Head of Structuring for the Middle East and North Africa (MENA) and Global Head of Islamic Finance at Deutsche Bank and subsequently served as Global Head of Islamic Structuring for UBS and Head of Structuring for MENA.