Sukuk’s journey on the Silk Road

Sharia-compliant instruments are differentiated from conventional finance through principles such as the prohibition of interest on debt or speculation, and profit and loss sharing.

However, in today's low growth/low interest rate environment, such instruments are not likely to be exempt from investors' risk/reward scrutiny. Vital questions include: Will the legal fees involved in due diligence studies erode the benefits sought by a corporate issuer? And how sukuk-friendly are the tax regimes in place in target jurisdictions? 

One of the thorns in Hong Kong's side, when it first started working on Sharia-compliant issuance pre-financial crisis, was the stamp duty exemptions the regulator eventually had to concede in a secular legal system to an investor category pursuing religious principles. Beyond the regulatory headaches, there is also extensive documentation and consequent high fees.

“With a vanilla bond, you have an underwriting agreement and the terms and conditions of the bond. The prospectus is basically an IOU with some extra bells and whistles on it,” explains Linklater partner, Andrew Malcolm, who advised the Hong Kong Monetary Authority on its two first issuances.

“A sukuk, on the other hand, has got these assets involved which are only here to provide the Islamic analysis but don't blend any kind of credit support to the transaction itself.  You've got immediate hurdles to get over, you've got the structure, then land here, a commodity purchase agreement there. But from a commercial point of view it's very much like window dressing,” concedes Malcolm.

Standard Chartered also argues that commercially, sukuks have the same risk/reward profiles as a conventional instrument.

“In a conventional bond, all you are doing is giving money on interest. In a Sharia sukuk, the structure is different because the underlying revenue source cannot be a bond with interest. So we need to go to the underlying asset/project itself to make it Sharia-compliant,” says Ahsan Ali, head of Islamic origination at Standard Chartered.

“We typically do it on a Musharakah structure, which is a partnership contract between the Sukuk issuing SPV and the project company to build an underlying project. The project company is solely responsible for building the project under a procurement contract. There is a leasing agreement under which the Sukuk SPV leases its share of the project to the project company, which pays rent for it.  This rent services both the coupon and the principal repayments over the tenor of the Sukuk,” says Ali.

“A syndicated Islamic project financing has a similar structure. For large projects, it is common that the funding is made up of multiple sources of financing such as ECA-backed financing or commercial loan tranches. It is possible to do project Sukuks in conjunction with other financing sources through inter-creditor agreements,” he adds.

TICKET TO DIVERSIFICATION

Sukuk presents an opportunity for sovereigns and corporates to diversify their portfolios, and for banks to contain levels of leverage, especially for Gulf Cooperation Countries (GCC), which tend to have maturity mismatches on their balance sheets, according to Mohamad Damak, head of Islamic finance at rating agency Standard & Poor's.

Furthermore, as for conventional project bonds, project sukuks offer the possibility to choose opportune timing to fix lending rates, and their tenors are infinitely stretchable to reflect asset life cycles. 

Sovereigns also pursue sukuk to create benchmarks in the industry.

The increase of issuance slowed last year because of oil price falls and less liquidity, geopolitical unrest in the Middle East, and the fact that the practice hasn't yet matched the infrastructure demands of longer-term tenors.

In April, the Malaysian government sold $500 million of 30-year Islamic bonds, the world's first sovereign sukuk with such a tenor, but, according to S&P data, out of the $114 billion of sukuk issued globally last year, only $24.5 billion had tenors of 10 years or more. “In the sukuk market we haven't seen that many issuances that go beyond 15 to 20 years. From a structuring perspective, however, you can go as long as you want,” says Ali. 

An added layer of complexity from an investor point of view resides in the principle of profit and loss sharing underlying some types of sukuk, which puts the investor, the bank and the issuer on an even keel when it comes to facing losses in case of a default, but not for the destruction of the underlying asset.

In musharaka sukuks, where two parties – a bank and its client or an investor and investee with an equity investment – the client/investee isn't the only party suffering the losses. 

“For Ijara transactions, however, there is no obligation for the sponsor to continue paying the Ijara charge in case of destruction of the underlying asset, because Sharia law prescribes that all the related contracts cease to exist. The sponsor is no longer obliged to pay the rent, and no longer obliged to buy the asset because it was destroyed; this risk doesn't exist for conventional finance,” warns Damak.

For some sukuks, there has been contractual obligation to cover such a loss event, even in its entirety. The sponsor may be asked to pay the shortfall between the principle amount of the transaction and the amount that would be paid by the company provided there was an insurance contract. According to Ali, this is rarely a problem as scholars have long been accepting conventional insurance agreements in jurisdictions where Taqaful, sharia-compliant insurance, isn't available. 

For some of the structures issued in the market, investors might be exposed to residual asset risk. Under such a scenario, from a ratings perspective, S&P says it needs to investigate the remoteness of the total loss event to decide whether the sukuk can be rated at the same level as its sponsor.

APPETITE AT HOME AND ABROAD

“Given the economic integration push driven by China, we could be no more than two decades away from a major shift for sukuk's role in the region,” says Malcolm.

He says Hong Kong's sukuk market's slow take-off is due to “that basic unfamiliarity and confusion factor”, a feature common to most new instruments. 

Although sources do highlight potential in tapping sizable pockets of the Chinese population, Beijing is cautious in its approach.
Several months ago, Linklaters received expressions of interest from a Chinese provincial government's representatives, asking how they would go about putting an Islamic-compliant financing mechanism in place, although the conclusion quickly emerged that Chinese regulations would make it extremely difficult at this stage. 

“Some western corporates' financing needs are increasingly being supplied by Islamic finance. And Western suppliers and exporters are also capable of providing Islamic financing solutions to buyers and importers from the Muslim world. Given China is interested in increasing its trade and investments in the Middle East and the rest of Asia, where many corporates seek Shariah-compliant financing,  China will have to provide Islamic financing solutions in order to be competitive,” he stresses.

Bangladesh and Pakistan are on the list of sovereigns to have expressed growing interest in Islamic finance solutions, according to Haneef.

In Malaysia, which has the deepest sukuk market in the world, demand has been driven by the government incentivising both the growth of institutional investors as well as new Islamic instruments, and this is the foundation for any such market to grow elsewhere, deems Haneef.

In Indonesia, the world's biggest Muslim nation, Finance Minister Bambang Brodjonegoro announced in May plans to set up a Sharia-compliant infrastructure bank with Indonesia, Turkey and the Islamic Development Bank as founding members, that would cooperate with the newly established China-backed Asian Infrastructure Investment Bank (AIIB) in its aim to integrate Islamic financing into its lending instruments.

The journey along the Silk Road may be a long and winding one, but it does have forward momentum.