The Unexplored Potential of Sukuk
Relatively few corporate treasurers in organisations that operate outside the regions of Asia and the Middle East use Islamic financial products. Yet most of them will have gained some knowledge of the guiding principles behind them in recent years, as their use has steadily extended to western markets. A frequently-used analogy is to compare Islamic financial products with ethical investments, as both share common characteristics such as excluding any profit derived from alcohol, pornography, tobacco or gambling.
Islamic financial products are subject to regular scrutiny, with an annual assessment and certification by a Sharia board to ensure that each offering continues to comply with Islamic Sharia law. In addition to the excluded activities, Sharia compliance does not permit gains from interest paid on loans and the use of leverage. This may increasingly be regarded as an advantage by investors beyond the Islamic world, given the lack of understanding of the risks of complex debt-based financial instruments. Over-leveraging post-crash is not something that corporates or their treasurers want to get involved in.
The UK’s Financial Services Authority (FSA) is one of many regulatory bodies in the West to have welcomed the development of Islamic finance in newer non-traditional markets. In November 2007, the FSA published a paper setting out its role in developing the UK as “the major European financial centre for Islamic financial products and services”, while Callum McCarthy, its chairman at that time, wrote: “We believe in a ‘no obstacles, no special favours’ approach when authorising new financial institutions and welcome the development of this market as it provides certain UK consumers with financial products that are in line with their beliefs.”
Yet Islamic finance also has much to offer corporates across Europe and also North America. Of particular interest to corporate treasury departments is ‘sukuk’, a major element in a comprehensive suite of Islamic financial products. Sukuk are so-called asset based bonds: i.e. it is an instrument that pays a regular coupon but is not based on debt like conventional bonds, but rather on assets. Sukuk has already achieved prominence on several occasions. For example, in 2006 sukuk provided the financing for the purchase of international ports operator P&O by DP World of Dubai, and in 2008 motor manufacturer Toyota used sukuk in Malaysia for car financing.
Despite its origins, sukuk has come to be regarded as less of an Islamic product and more of an asset class that offers treasurers worldwide some additional funding opportunities. Malaysian banks, indeed Malaysian institutions generally, have been at the forefront in developing a wider audience for sukuk and the Middle East is fast catching up. The focus has now shifted to how sukuk can be made more mainstream.
Given that sukuks are based on assets and not debt, they could potentially become more widely used at a time when global economic performance is faltering and presenting more difficult economic conditions. Both the degree of risk and costs have risen in the past five years for companies seeking to raise funds through traditional means such as corporate bonds or equity.
There has been considerable debate in the past over permissible structures for sukuk and there is still a degree of variation in how rigidly the rules are applied; Malaysia is one of several countries that have more specific requirements. However, consensus has generally been achieved and the religious guidelines no longer appear to represent a controversial issue. As markets and regulators grow more familiar with sukuk, more banks are issuing them and they have become as accessible in London as they are in Malaysia.
In the current financial environment, sukuk offer a number of advantages as a means of accessing capital and funding, and compare increasingly favourably with traditional bonds.
Another further incentive to investigate the potential benefits has been the steady disappearance of the so-called ‘sukuk premium’, the term given for the additional cost that borrowers previously had to pay for issuing an Islamic bond rather than a conventional one.
Last month Deutsche Bank reported that while the premium had been common in the past, due partly to the fact that sukuk issuers relied on a smaller investor base and partly because sukuk structures were not as widely known as those for conventional bonds, this is no longer true.
Indeed for issuers with a strong credit rating, the cost of sukuk may now even be lower than that for conventional bonds and tenures have lengthened. Yet it should also be noted that even where a sukuk premium does still exist, the additional cost may be worthwhile if the conventional bond market is temporarily closed, as was the case in 2008-09.
The growth of sukuk is reflected in the issuance figures. After peaking in 2007, the size and volume of issues was not immune to the effects of the 2008-09 downturn but swiftly rebounded. According to Thomson Reuters data, total sukuk issuance worldwide reached US$11.2bn last year and that figure has already been surpassed in 2012 at US$12.8bn to date.
The majority of this activity, however, continues to be centred on the Gulf Arab region. Sukuk still has significant unexplored potential elsewhere. Given the continued adverse conditions in the markets of the West, coupled with what may be the unpromising outlook for the years ahead, more North American and European companies could usefully explore the option of sukuk issuance as one of a number of alternative means to raise funds.
It may not prove to be the answer in every case – the reasons for utilising sukuk should be strictly business-led and it could prove less pertinent for companies involved in business-to-business (B2B) transactions. It should also be borne in mind that sukuk is an element, albeit a major one, in a suite of Islamic financial products and, as an asset-based product, only one of a number of financing options.
Nonetheless, most corporate treasurers could benefit from greater familiarity with sukuk and exploring the fund raising possibilities that it offers. Companies could also find that using sukuk opens up more potential markets and business opportunities to them in Asia and the Middle East.
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