The lure of Islamic bonds appears to be wearing off for conventional borrowers in the Gulf, even as the global industry grows, with high-profile defaults and rising costs souring their appeal.
On a global scale, Malaysia continues to dominate the Islamic finance market, which is based on financial principles from the Koran, and has led sukuk issues so far this year.
A Reuters poll in July estimates global sukuk sales at $23-25bn, similar to 2009, but down from earlier estimates.
“Dealing with sukuk defaults, standardising sharia interpretation, and increasing sukuk liquidity, we believe, are at the root of issues that could curb future growth,” said Mohamed Damak, analyst for Standard & Poors in a recent report.
“It is the solutions to these issues — likely in our view to be neither easy nor quick — that we believe will shape the direction the market takes.”
In the Middle East, Dubai has sought to establish itself as a global rival to Kuala Lumpur for the estimated and growing $1 trillion of Islamic finance business.
After a lacklustre start to bond issuances from the region, hit from November by Dubai’s debt crisis and global credit market volatility, international bond sales from the region have begun to pick up again, with sovereign, quasi-sovereign and corporate issuance.
According to SDC, a Thomson Reuters database, the Middle East has issued 15 international bonds for a total of $15.2bn so far this year, $5.5 billion of it in July alone.
But in that time only Saudi real estate firm Dar al Arkan has issued an international sukuk. No conventional borrowers have sold sukuk this year, and those in the pipeline, such as that of Qatar Islamic Bank, have not been able to come to market.
“There are likely to be various reasons for borrowers having held back from issuing sukuk, such as debates over sukuk structures, documentation issues,” said Chavan Bhogaita, head of credit research at National Bank of Abu Dhabi (NBAD).
Islamic finance had been seen as a hot market in the region, and foreign investors saw sukuk as a way to tap into abundant liquidity in the Middle East.
International demand was high, particularly from European and U.S. hedge funds, for perceived high-quality issues, such as the Dubai government’s $2.5 billion sukuk sale in October.
But the near-default in December of the dollar-denominated sukuk from Dubai property developer Nakheel sounded alarm bells.
Kuwait’s International Investment Group has defaulted on two sukuk payments this year, and The Investment Dar, which owns half of British carmaker Aston Martin, defaulted on a sukuk in May last year.
The effect has been not just reputational damage to the industry but also a stronger focus on structuring, costs, compliance, and the legal ramifications of default.
Islamic bankers say a number of mandated sukuk issuances are now being pulled from the market in the region, or are in the process of being restructured as conventional bonds.
Sukuk structures are usually more expensive due to the costs associated with sharia board approval, extra legal fees, and fees associated with the often complex structures.
While Islamic institutions accept the extra costs, other issuers need a good reason to opt for what is typically a longer, more expensive process.
“The dedicated pool of investors does bring depth, but remains comparatively rarefied in terms of number,” said Simon Putt, head of regional debt capital markets at BNP Paribas.
“The prevailing sentiment is that conventional bond issuance ticks all the right boxes in terms of size, maturity, cost and investor diversity.”
Moreover, costs have actually gone up in the wake of the financial crisis due to extra compliance procedures after a growing perception among Islamic investors that previous sukuk had not adhered to the strictest standards.
In some jurisdictions, such as the UAE, there are also additional fees related to the transfer of land.
“A number of clients I’ve spoken to say that they will do Islamic if it’s cheaper or if they can get a greater pool of liquidity,” said one Gulf-based Islamic banker. “But they just aren’t seeing an overriding commercial reason to do a sukuk if they don’t have to.”