Index inclusion is expected to boost investor appeal of sukuk

Dubai: Recent decision of US investment bank JPMorgan to include Islamic bonds, or sukuk, in its emerging markets indices from October end this year is expected to boost global investor demand for these instruments and gradually increase volume and number of issuance.

Analysts say index inclusion will clearly bring about more liquidity in the sukuk market and make it more appealing to wider investor base other than the traditional ‘hold to maturity’ investors, mostly Islamic banks and financial institutions based in the Middle East and Asia.

Inclusion in the index is expected to come with certain minimum criteria such as credit rating and liquidity assessment of issuers which is widely expected to improve the credibility of sukuk as an investment option. With the improved liquidity and investor appeal, corporates are expected to issue index-worthy sukuk issues targeted at global investor pools.

“If confirmed, index inclusion should raise the profile of sukuk and support inflows from international institutional investors, including index tracking funds. This in turn may encourage issuers to supply index-eligible sukuk and support secondary market liquidity,” Fitch Ratings said in a recent note.

Conventional bonds

In the first half of 2016 sukuk issuance from key markets rose 11 per cent from a year earlier to $21.74 billion (Dh79.78 billion) according to Fitch. The dominance of conventional bond issuance by regional sovereigns, notably the recent issuance from Abu Dhabi and Qatar point the higher popularity of conventional bonds among international investors. Inclusion of sukuk emerging market indexes is expected change the global investor perception.

Investment bankers and rating agencies expect week global oil prices and shrinking government spending across the GCC to keep sukuk issuance at below-peak levels in 2016. According to rating agency Standard & Poor’s total issuance this year is expected to reach $50 to $55 billion, compared with $63.5 billion in 2015 and $116.4 billion in 2014.

On the demand side, the institutional demand for high quality assets are expected to keep sukuk demand high. As we get closer to the deadline of Basel III implementation, the lack of liquidity management instruments in Islamic finance is pushing this issue to the forefront. In 2015, the market saw $11.3 billion in sukuk issuance for liquidity management purposes accounting for 17.8 per cent of the total).

Disclosure requirements

Despite a potential increase in investor appetite for sukuk, investment bankers say increase in issuance will come with a lag due to the regulatory filing requirements and credit rating. Usually only the larger organisations are equipped to obtain a public credit rating and meet the documentary and disclosure requirements of issuing tradable securities. Borrowers with a weaker or complicated credit profiles, or those who want quicker access to funding, will continue to access the bank market.

On the demand side regulation and transparency will continue to be major challenges that will be faced by the sukuk market. “We believe the sukuk market’s growth rate will be determined by two factors: firstly, product-specific initiatives around regulation and standardisation of sukuk issuance, which have been notable in some jurisdictions, but have not always been harmonised across jurisdictions; and secondly, the broader attempts to deepen the investor base and improve transparency in the relevant national and regional debt capital markets,” Fitch said.

Sharia

Implementation of the Islamic Financial Services Act 2013 in Malaysia has clarified regulatory issues, and the central bank launched Islamic T-bills early this year, adding to a range of liquidity management tools for Islamic banks. Kuwait’s Capital Markets Authority announced a broad sukuk framework in November 2015, and the central bank in the UAE has proposed creating a Higher Sharia Authority to provide unified supervision and guidelines on Islamic finance-related matters.

Such initiatives, combined with efforts to improve corporate governance, financial reporting and enforceability in jurisdictions where Islamic finance is most widespread, support our expectation that sukuk issuance will increase gradually over the long-term as more countries create supportive frameworks.