Dubai: Islamic finance, particularly fixed income instruments known as Sukuk, has come of age and is now an integral component of the mainstream global financial system. A decade ago, the Sukuk market was valued at $9.6 billion, issues were generally small in nature, and the market was concentrated amongst a handful of issuers; in 2013, the market topped US$269.4 billion, with an exponential growth in the number of large deals and increasing diversification of issuers. The Islamic finance industry is expected to continue growing at nearly 20 per cent per year, and the pool of investors interested in Shariah-compliant securities is expected to rise along with it. And while Islamic investors are the natural buyers of Sukuk, the appeal of Sukuk now extends far beyond the Islamic world. Some estimates suggest that conventional investors may account for as much as 40% to 60% of any individual Sukuk offering.
In our view, Sukuk may be attractive options for both Islamic and non-Islamic investors seeking to diversify their investment portfolios. Not only are the returns attractive relative to traditional fixed income assets, the volatility of Sukuk has historically been more subdued—something that could prove important in a rising interest-rate environment. Moreover, Sukuk provide exposure to some of the fast-growing and most financially sound economies in the Gulf Cooperation Council (GCC) and Southeast Asia, countries that are often underrepresented in many traditional bond indexes and funds. Due to their unique structure and market dynamics, Sukuk returns also tend to be less correlated with other parts of the global fixed income market. All of these factors, we believe, may make Sukuk an appropriate complement to investors’ existing equity or global bond allocations.
Innovation and Growth
In essence, Sukuk combine religious law dating back some 1,500 years with the latest developments in modern structured finance. Sukuk are fixed income securities that comply with Islamic law’s prohibition of paying or charging interest. Instead of basing payments on interest, payments are based on either profit sharing or rental or lease income—and they are typically backed by a tangible asset. The Sukuk market has surged from just US$121.5 billion outstanding in 2010 to US$247.6 billion in 2013, according to data from KFH Research. Impressive as that increase has been, it still pales in comparison to the demand for these investments.
New Sukuk issues are often many times oversubscribed, and given the growing acceptance of Sukuk outside of traditional Islamic markets and issuers, the asset class is reaching critical mass. Global consultants Ernst & Young predict that global demand for Sukuk will reach US$900 billion by 2017. The strong demand stems partly from the massive expansion in the assets of Islamic investors, and the relatively limited supply of Sharia-compliant investment alternatives. Islamic financial assets currently total more than US$1.8 trillion, and continue to grow at an annualised rate of nearly 20%. Furthermore, the strength of the asset class during the global financial crisis and Eurozone sovereign debt crisis, as well as the growth of the asset class beyond the Islamic world, is fuelling demand.
Sukuk market goes global
The bulk of Sukuk issuance still comes from Malaysia and the oil-rich Gulf States, but an increasingly wide array of countries and companies in other parts of Asia, Africa and Europe are seizing the opportunity to tap the Islamic debt markets to take advantage of the vigorous demand. Indeed, in June 2014, the United Kingdom (UK) became the first Western government to issue Islamic bonds. The yield offered was comparable to what the UK government pays on its conventional Gilts, with investors receiving rental income based on three government-owned properties.
We expect this trend to continue as a range of issuers looks to tap the large pools of Muslim wealth and liquidity around the world and policymakers see the benefits of complementing their financial architecture with Shariah-compliant securities and services.
Tangible progress is being made across the globe to support Islamic finance and further Sukuk issuance. Sixteen governments around the world have issued Sukuk since 2001, and more are likely to follow suit in the next few years. These deals, we believe, will further help to diversify primary market activity and improve secondary market liquidity.
Considering the huge infrastructural deficit facing Nigeria, and the challenges being faced by the Federal Government of Nigeria due to a decline in oil revenue amongst other related issues, it has become imperative for State Governments and corporates to access alternative financing techniques to meet their capital development needs.
Activities in the equities market in Nigeria have slowed down considerably from the levels seen during the equities boom of 2004 – 2008 which has compelled corporates and governments to embrace the debt market by floating bonds. From 1960 to November 2013, there have been 80 corporate bond issuances in Nigeria and 34 state and local bond issuances; with state bond issuances dominating the market in recent times.
This article examines the potentials for using sukuk as a tool for capital raising and infrastructural development in Nigeria and discusses the recent sukuk issuance by the Osun State of Nigeria under the State’s N60 Billion Debt Issuance Programme. The sukuk issuance attracted international acclaim by winning the IFN Africa Deal of the Year Award 2013.
Sukuk as a tool of Islamic Finance
Sukuk provides access to a vast and growing Islamic liquidity pool in addition to the conventional debt and are commonly referred to as Islamic Bonds. However, this representation is not entirely correct.
Sukuk is defined in the Rules and Regulations of the Securities and Exchange Commission (SEC Rules 2013) as investment certificates or notes of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or investments in the assets of particular projects or special investment activity using shariah principles and concepts approved by the Securities and Exchange Commission (“the Commission”). In simple terms, sukuk can best be called trust certificates.
In addition, under a sukuk structure, returns to sukuk holders (Investors) represent rights to receive payments from a trade transaction or ownership of a particular asset or business venture, while the returns to conventional bondholders represent the right to receive interest for borrowed monies.
Traditional bonds are not allowed in Shariah-compliant transactions due to their interest based nature as interest is prohibited in Islamic law as aforesaid. It is important to note that the underlying asset for a sukuk issuance must itself be Shariah-compliant. For example, a building does not qualify as an underlying asset for sukuk issuance if the major tenant will be a producer of alcohol.
The Commission explicitly recognizes the following sukuk structures under Rule 571 of the SEC Rules:
• Sukuk Ijarah – (lease contract)
• Sukuk Musharakah– (sharing contract)
• Sukuk Istisnah– (exchange contract)
• Sukuk Murabahah– (financing contract)
Legal Framework for the Issuance of Sukuk in Nigeria
Several Laws regulate the issuance of sukuk in Nigeria including the Investments and Securities Act 2007, the SEC Rules and the state law authorizing the sukuk issuance. The Commission in recognition of the development of Islamic finance introduced new rules on February 8, 2013 to regulate the issuance of sukuk in Nigeria. Rule 572 of the SEC Rules provides that all public companies (including SPV’s), state governments, local governments, and Government agencies as well as multilateral agencies are eligible to issue, offer or make an invitation of sukuk upon seeking the Commission’s approval.
The Rules apply to:
i. sukuk which are offered by local or foreign entities that are within the regulatory purview of the Commission;
ii. sukuk which are denominated in Naira or in foreign currencies; and
iii. sukuk which are listed, convertible, exchangeable, redeemable or otherwise.
From the wording of Rule 572, sukuk issued by private companies appear not to fall within the regulatory purview of the SEC. In a similar vein, a strict interpretation of Rule 567 will suggest that bonds issued by private companies will not be regulated by the SEC as this Rule specifically mentions only bonds issued by public companies, foreign public companies and supranational bodies. However, the SEC will exercise its supervisory powers over any instrument issued to the public by private or public companies.
In addition to the advisers who advise on bond issuances, an issuer of sukuk must appoint a Shariah adviser who shall inter alia advise on all aspects of the sukuk including documentation and structuring and who shall also issue shariah certification which outlines the basis and rationale of the structure and mechanism of the sukuk.
Osun Sukuk Company Plc.’s Sukuk Al –Ijarah – Blazing the Trail
The Government of Osun State (“OSG”) through a wholly owned Special Purpose Company, Osun Sukuk Company Plc issued on the 8th of October, 2013 the first sukuk in Sub-Saharan Africa worth N11.4 billion ($70.6 million) under the Osun State N60 Billion Debt Issuance Programme to fund the development of 20 High Schools, 2 Middle Schools and 2 Elementary Schools in Osun State.
The sukuk was issued at a rate of 14.75% per annum at N 1,000 per unit and matures on 8th of October, 2020. The issue which was rated A by Agusto & Co was successfully subscribed to by domestic investors with the price set through a book building process that lasted for 10 days.
Structure of the Osun Sukuk
The SPC, Osun Sukuk Company Plc is a wholly owned Special Purpose Company of the Osun State Government incorporated with an authorised share capital of N1, 000,000.00 (One Million Naira) with Ninety Nine Percent of the shares held by the Osun State Government and One percent held in trust by the Attorney General of Osun State on behalf of the State.
The sukuk was structured as an Al-Ijarah; with the Osun Sukuk Company Plc. issuing sukuk certificates to the investors.
In accordance with Islamic law principles, each certificate represents an undivided beneficial ownership interest in the sukuk assets (i.e. the Schools). The sukuk assets are however held in trust for the sukuk investors by the Issuer. The sukuk investors’ payment for the certificates represents the cost of construction of the schools. Holders of the Certificates have no recourse to any assets of the Issuer other than the sukuk assets. Since the sukuk holders are the owners of the assets (schools), they are free to trade the certificates in the secondary market. The land upon which the schools will be built was transferred by the OSG to the SPC and a Certificate of Title (Certificate of Occupancy) was issued to the SPC.
The Issuer under an Agency Agreement, appointed the OSG as its agent to inter alia engage a construction company to construct the schools, obtain all government approvals, manage the operational and financial aspects of the construction for a prescribed fee and transferred the agreed cost of construction to the OSG.
The SPC forward leased the schools to the State Government against rental payments which will be remitted to the Issuer to make distributions to the sukuk investors; thus earning income for the investors during the construction of the schools.
A Purchase Undertaking was executed by the OSG in favour of the Issuer to give assurances that at the end of the lease/maturity of the sukuk or upon the occurrence of an event of default or early termination of the lease under the Ijara Agreement, the OSG will purchase the sukuk assets; with the purchase price being used by the Issuer to redeem the sukuk certificates at maturity.
The Purchase Undertaking is essential in Islamic Finance as it creates a debt obligation on the part of the OSG which eliminates market risk on the part of the investors. A Sale Undertaking was also executed by the Issuer in favour of the OSG in like manner.
Sukuk – What Lies Ahead
The issuance of the first state sukuk by Osun Sukuk Company Plc attests to the huge potentials for Islamic Finance in Nigeria, while its subsequent international acclaim creates integrity within the market which has the propensity to promote foreign direct investment.
The Central Bank of Nigeria (CBN) has so far registered Jaiz Bank Plc. to provide full Islamic Banking Services and has licensed Stanbic IBTC Plc to operate an Islamic Banking Window. In addition, Sterling Bank Plc has also been given an approval in principle to operate an Islamic Banking Window.
With the right team of professional advisers, it is clear that focusing on substance over form can contribute significantly to the rapid development of the Nigerian economy through the issuance of Islamic Finance products. Nigeria should not miss out on this opportunity.
About the Author
Oladele is called to the Nigerian Bar and is a qualified solicitor in England and Wales. He currently heads the Banking and Finance law Practice of Kola Awodein & Co. Lagos, Nigeria. He obtained his Masters Degree (with Distinction) from the University of Warwick, UK. He has advised on several capital market transactions.
AFRICAN markets are gradually opening to Islamic finance, buoyed by governments’ debut sales of sovereign sukuk (Islamic bonds) and legislative efforts to make the sector more attractive for companies across the region.
Despite the strong growth of Islamic finance in its core markets of the Middle East and south-east Asia, the industry has lagged behind in Africa, which is home to one in four of the world’s Muslims. But this year a string of transactions is helping to broaden the sector.
Governments across the continent are using sukuk as a way to attract cash-rich Islamic investors, with South Africa making a $500 million (R5.6 billion) issue last month.
The Tunisian government could soon follow with a dollar-denominated deal that it hopes to place by year-end; Kenya is considering a sukuk issue.
Nigeria’s Osun State made a small local currency sukuk issue last year and Gambia has been issuing short-term Islamic paper in its own currency for years, but the region’s booming dollar-denominated bond market could hold the greatest promise.
The eurobond market in sub-Saharan Africa saw a record $14bn in issuance last year and the figure was $10bn so far this year, said Megan McDonald, the global head of debt primary markets at Standard Bank.
Eventually, 15 percent to 20 percent of such issues could be sukuk, as the market would develop over two to three years, McDonald said.
McDonald added: “We do expect to see others, firstly government-linked institutions in South Africa such as Transnet, Eskom and Sanral, which the Treasury is hoping can tap the market.”
South Africa attracted $2.2bn in orders for its sukuk and had not ruled out tapping the market again. Interest in making issues was also coming from other state and national governments, McDonald said.
“The Treasury is open to coming back to the market.”
Islamic finance follows religious principles including a ban on interest and gambling. To obey these rules, contracts often attract double or triple tax as they require multiple transfers of underlying assets. Countries are now studying tax treatment for sukuk.
While the ongoing conflict in the Middle East raises concern over the outlook for the sukuk market, the Islamic equivalent of bonds, portfolio managers remain positive both on fundamentals and technicals for sukuk, which also offer a potentially attractive alternative amid prospects of rising interest rates.
Issuers from the Gulf Cooperation Council emerge as the most popular.
As the Federal Reserve prepares to exit its zero interest rate policy, but with the "new normal" promising a still low-rate environment that could continue to starve investment managers for yield for some time, sukuk are considered as an attractive option for those whose mandate allows to test new boundaries.
At Franklin Templeton Investments, Mohieddine Kronfol, chief investment officer of Global Sukuk and MENA fixed income, told MNI that "the lower duration and persistent strong demand from Islamic financial institutions should continue to support the market and allow it to perform well relative to other fixed income sectors, particularly those that have higher average durations."
In a written commentary, he had also argued that "the volatility of Sukuk has historically been more subdued - something that could prove important in a rising interest-rate environment."
He added in his commentary that, "Sukuk provide exposure to some of the fast-growing and most financially sound economies in the Gulf Cooperation Council."
Similar to conventional bonds, the rising interest rate environment is definitely challenging the sukuk market, acknowledged Lim Say Cheong, Executive Vice President, Head of Investment Banking Group Al Hilal Bank.
"Escalation of interest rates/benchmarks over the next 12 to 18 months is inevitable but issuers will still need to borrow to diversify one's source of funding and investor base," he told MNI.
Besides, rates are unlikely to "go over the roof at a rapid pace."
At Azzad Asset Management, Ihab Salib, the lead portfolio manager for the firm's sukuk fund, the Azzad Wise Capital Fund (WISEX), argued that despite the prospects of rising interest rates, "due to the specifics of the sukuk market and the fact that most of the securities are closely held, one could argue the effects of rising rates may not be as pronounced in the sukuk world."
For mandates allowing portfolio managers to invest in sukuk, the GCC region is particularly in demand.
Konfrol is "constructive" for the sukuk market overall, "with the GCC serving as a strong anchor."
He told MNI that while all GCC countries are attractive, "we believe that the UAE, Saudi Arabia and Qatar present the most opportunities at the moment."
Developments in the Middle East, notably the coalition's bombings in Syria and the potential for a worsening of global geopolitical tensions have, however, put stress on the sukuk market.
Still, Kronfol expects a "very limited" impact overall.
"The unfortunate events in Syria have had very limited impact on financial securities in the region and this is expected to remain the case," he told MNI.
"Highlighting this insulation from regional geopolitical issues is the fact that at the height of the Syrian conflict in 2013, three of the worlds' best performing stock markets were in the GCC, led by the Dubai Financial Market," he argued.
Azzad Asset Management's Salib told MNI he particularly sees value in non-conventional issuers.
"As maiden issuers in the market, they need to price the sukuk generously so as to tempt investors," he commented.
Salib sees "some value in the Dubai complex" despite the spread tightening since the beginning of the year, especially the hospitality and retail sectors.
More generally, from a fundamental standpoint, the GCC, which includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates, "offers the market the greatest support," he commented.
"Being a low population, hydrocarbon rich region whose governments run fiscal and current account surpluses, the economic backdrop is extremely conducive," said Salib, who also pointed out the solid balance sheets of individual issuers, many of them government owned.
Sukuk are increasingly catching global investors' attention, especially as non-Muslim countries - such as the UK government in June and Luxembourg at the beginning of October, which was the first EMU sovereign to issue in a sukuk structure - are joining the pool of issuers.
Going forward, investors are expecting both demand and supply to increase.
From a portfolio standpoint, GCC and Southeast Asian countries "are often underrepresented in many traditional bond indexes and funds," Franklin Templeton's Kronfol said.
He told MNI that in a global bond portfolio, depending on investors' objectives and risk tolerance, "a single digit percent allocation may be reasonable, complemented by improving emerging market allocations in South East Asia and an increasing selection of credits that are diversified by geography, sector and capital structure."
When surveying opportunities within the sukuk market, "broadly speaking, we envisage the primary sukuk supply pipelines as still very much originating from sovereigns - we may see one or two new names from Africa - government-related entities (GREs) and corporates," said Al Hilal Bank's Lim.
"We may still witness a selective range of issuers from the GCC," he predicted.
"From the GRE and corporate perspectives, it may encompass the transport, property development, construction, and utilities," he added.
Lim cited a range of factors supporting demand.
"From the buyer and investor perspectives, the abundance of liquidity resulting from, among others, upcoming maturities, heavy redemption profiles across loans, bonds and sukuk originating from 5 years ago across the GCC/MENA regions, certain geopolitical tensions that have encouraged further inflow of funds seeking relative safe havens, new investment homes, as well as declining loan-to-deposit ratios of local and regional banks - as opposed to 4-5 years ago - creates a stronger momentum among investors as they continue to search for new investment opportunities," he told MNI.
So clearly, new supply would be welcomed and likely absorbed.
In fact, Salib stressed the lack of issuance altogether.
"Compared to our colleagues in the conventional bond market, sukuk issuance is understandably much lower, and with issues such as the recent Indonesian sukuk issue being in the region of 8 times oversubscribed, this is another challenge managers face when constructing a portfolio," he said.
He said it is estimated that Islamic financial assets globally are expected to exceed $2 trillion by 2016.
"The Islamic finance industry is expected to continue growing at nearly 20% per year, and the pool of investors interested in Shariah-compliant securities is expected to rise along with it," Kronfol said in his Beyond Bulls & Bears commentary titled "Sukuk: An Asset Class Goes Mainstream."
Citing research from Kuwait Finance House, Kronfol said the sukuk market topped US$269.4 billion at the end of 2013.
Zooming in to the sovereign sector, Moody's estimated in a September report that sovereign sukuk issuance would rise by $30 billion by the end of this year to $115 billion, with both Islamic and non-Islamic governments tapping the market.
"Moreover, we expect demand and liquidity in the market will improve as the sector attracts more global investors," the rating agency said.
The arrival of major non-Islamic countries this year - the UK, Hong Kong, South Africa, Luxembourg - indicates "a significant change in the potential size, depth and liquidity of this market," it added.
By Moody's estimate, the total sovereign outstanding accounted for 36% of the $296 billion outstanding sukuk as of July 2014.
"Demand from global investors will grow as they become more comfortable with this asset class and it will support their search for yield and portfolio diversification," Moody's also predicted.
On the issuer's side, Al Hilal Bank's Lim pointed out the increasing level of sophistication in the market, citing senior secured and amortizing Sukuk-type transactions and perpetual/hybrid capital type Sukuk instruments issued or structured by "pure corporates" in addition to the more traditional financial institutions.
In fact, his own institution, Al Hilal Bank, issued "the first of its kind Basel III language-compliant Tier 1 Sukuk" that was largely oversubscribed.
Azzad Asset Management, for its part, hopes "to be given a green light soon to use profit rate swaps which swap a set of fixed profit rate cash flows into floating rate cash flows."
"We are also looking to introduce a whole new asset class into the fund in the not so distant future," Salib said.
While issuers and the investor base are diversifying, maturities are increasing, Lim noted, from the 5-year "sweet spot" to 7- to 10-year or even 15-year instruments.