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Wednesday, 15 October 2014

Portfolios: GCC Sukuk Attractive Amid Rising Rates Prospects

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.
(Deutsche Borse Group / 14 October 2014)
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Lawmakers, sukuk debutantes open Africa to Islamic finance

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, the Middle East and southeast Asia, the industry has lagged in Africa, which is home to one in four of the world's Muslims. This year, however, 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 issue in September and Senegal raising 100 billion CFA francs ($208 million) in June.
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 $14 billion in issuance last year and the figure is $10 billion so far this year, said Megan McDonald, global head of debt primary markets at South Africa's Standard Bank.
Eventually, 15 percent to 20 percent of such issues could be sukuk, as the market will develop over the next two to three years, said McDonald, whose bank was joint lead manager of South Africa's debut sukuk issue.
"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 $2.2 billion in orders for its sukuk and has not ruled out tapping the market again, and interest in making issues is also coming from other state and national governments, McDonald said.
"The Treasury is open to coming back to the market. The sukuk programme is set up in such a way they can do that."
Islamic finance follows religious principles including a ban on interest and gambling; to obey these rules, contracts often attract double or even triple tax duties as they require multiple transfers of underlying assets.
South Africa spent over two years preparing its sukuk issue, mainly to secure legislative requirements for the deal, Lawmakers are now studying tax treatment to facilitate corporate issuance, efforts being mirrored elsewhere on the continent.
Countries studying tax treatment for sukuk include Morocco, EgyptTunisia, Nigeria, Senegal and South Africa, said Qudeer Latif, Dubai-based partner and global head of Islamic finance at law firm Clifford Chance.
"Certain jurisdictions have either passed or are in the process of passing new laws. Morocco is a good example of this."
Such legislation is prompting new entrants into Islamic finance, including two of Morocco's biggest banks, BMCE and BCP, which plan to launch Islamic subsidiaries.
At present, there are only 38 Islamic finance institutions on the entire continent, an August working paper from the International Monetary Fund showed.
Multilateral lenders are taking note, such as the Jeddah-based Islamic Development Bank (IDB) which is helping finance infrastructure projects in the region. This month, the IDB extended a small sharia-compliant tranche as part of a much larger financing package for a $2.6 billion power project in Morocco, the first cross-border financing of this type in the country.
The tranche was strategically important for the IDB as it showed Islamic finance can be used as a funding source for other African infrastructure deals, said Latif, whose firm advised on the transaction.
The Islamic tranche used an innovative structure which combined an istisna arrangement with a wakala structure, Clifford Chance said. Under istisna, a price is paid for goods that are subsequently manufactured and delivered on a stipulated date; the format is seen as suited for infrastructure and project financing. Wakala is a common sukuk structure in which an agent manages the assets underlying the issue.

The private sector arm of the IDB is also increasing its activities in Africa, helping to set up new sharia-compliant banks, leasing companies and insurance firms. 
(Reuters / 14 October 2014)
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