Kuala Lumpur: Islamic bond yields dropped to a seven-year low and investors predict further declines as growth in Asia and the Gulf that’s outpacing the rest of the world shores up demand for sukuk.

Average yields fell five basis points, or 0.05 percentage point, in July to 3.39 per cent, approaching the lowest level since January 2005, when they reached a record 3.33 per cent, according to the HSBC/Nasdaq Dubai US Dollar Sukuk Index.

South Korea unexpectedly cut interest rates last week, after central banks in China, the US and Europe eased monetary policy, prompting fund managers to hunt for higher-yielding assets. Sukuk sales have climbed 73 per cent in 2012 to $26.8 billion (Dh98.4 billion) from the same period last year as the decline in borrowing costs encouraged issuers such as Qatar and Dubai-based Emaar Properties PJSC to tap the market.

“Policy interest-rate cuts are lowering sukuk yields, together with falling inflationary pressure and cautious demand for risky assets,” said Soon Teck Onn, the head of investment funds overseeing about $250 million at Zurich/Malaysian Assurance Alliance in Kuala Lumpur.

“In view of a moderating global economic outlook, yields are likely to stay at record lows until we see inflation and the global economy rebounding.”

Emerging inflows

Inflows into emerging-market bond funds climbed to an eight-week high of $850 million in the week that ended on July 4, approaching $24 billion for the year, according to the latest research from EPFR Global. Funds favouring so-called hard currencies such as the dollar saw the biggest interest, the company said.

Growth in Islamic banking assets and supply of sukuk that’s insufficient to meet demand are helping drive the rally, said Malek Khodr Temsah, vice-president of treasury and investment at Bahrain-based Albaraka Banking Group.

Malaysia’s Shariah-compliant banking assets grew 24 per cent to $137 billion last year, or 22.4 per cent of the total, the central bank said in its annual report. In the UAE, assets increased Dh700 million to Dh1.74 trillion at the end of April from the previous month, according to official data.

‘Perfect storm’

Average yields on Islamic notes from the GCC are approaching record lows. Rates fell four basis points this month to 3.55 per cent, 22 basis points shy of the all-time low set on December 31, 2004, according to the HSBC/Nasdaq Dubai GCC US Dollar Sukuk Index tracking 33 bonds.

“The ever-tightening yields on Asian and GCC sukuk are the result of a perfect storm of ever-growing liquidity, increased sukuk participation by non-Islamic investors, and growth in sales that’s simply not keeping pace with the growth in balance sheets,” Albaraka’s Temsah said.

“Buoyed by this structural shift in favour of emerging-market debt, GCC and Asian sukuk yields continue to grind even tighter.”

Saudi Arabia, which plans to spend $500 billion to build homes, railways and roads in the largest Arab economy, announced in July the kingdom’s first mortgage legislation, spurring a rally in sukuk of Dar Al Arkan Real Estate Development Co.

The yield on the property developer’s 10.75 per cent 2015 Islamic notes reached a record low of 7.42 per cent on July 10.

Saudi sukuk

Saudi Electricity’s sukuk also gained. The yield on the state-utility’s 4.211 per cent notes maturing in April 2022 fell 13 basis points to 3.36 per cent, the lowest since the debt was sold in March.

Islamic bonds sold to international investors returned 5.4 per cent in 2012, according to an HSBC index, while debt in developing markets climbed 9.6 per cent, JPMorgan’s EMBI Global Composite Index shows.

The difference between average yields on sukuk and the London interbank offered rate, or Libor, widened five basis points last week and seven basis points for the month to 247 basis points, according to HSBC.

A rally in Malaysia’s dollar-denominated Islamic bonds last week drove yields to record lows, while rates on Indonesia’s sovereign debt slipped to levels last reached in April.