Beyond Bulls & Bears

Fixed Income

Sukuk’s Journey into the Financial Mainstream

Investors looking for fixed income exposure in their portfolios have tended to focus their attention on conventional sovereign and corporate bonds. Dino Kronfol, chief investment officer, Franklin Templeton Global Sukuk and MENA Fixed Income Strategies, thinks sukuk—bonds that comply with Islamic law—is steadily making its way into the financial mainstream. Here, he explains why this is no longer an overlooked asset class, and debunks some myths associated with this investment area.

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As the global debt market grew 9.7% in 2017 to reach an all-time high of US$237 trillion,1 we think that figure masks an even more interesting story: sukuk issuance rose 45% over that same period and reached US$97.9 billion.2

We think several factors could help boost the general perception of sukuk investment from a niche product into the financial mainstream. These drivers include large issuances by some of the Gulf Cooperation Council (GCC)3 countries, plus participation from other countries like Indonesia, Hong Kong, the United Kingdom, Pakistan and Turkey, along with a first issuance of a sukuk in Nigeria.

Sukuk Has Shown Low Correlation to Oil Prices

Notwithstanding this growth, we consider global sukuk to be a misunderstood asset class. Misconceptions to which sukuk is often subject to include assumptions that sukuk is susceptible to the headline risk associated with oil price volatility, or that it is solely concentrated in a few geographies.

While a bulk of issuances in the global sukuk universe used to come from the oil-rich nations in the GCC and Malaysia, another oil exporting country, our research shows that the asset class isn’t at the mercy of oil prices, and in fact, has a low correlation to oil.4 The three-year correlation of global sukuk to crude oil is at 0.095—the reality is that oil-price movement is unlikely to affect the global sukuk market.

We would also challenge the notion that sukuk is an illiquid asset class. Individual sukuk issuances are becoming increasingly bigger, and more are getting listed on exchanges as a means to complement portfolios. In our experience, we’ve seen a growing number of investors use sukuk as a potential portfolio diversifier, or to offer an opportunity to invest in areas of the market they might not be exposed to with more conventional bond holdings.

The Future of Sukuk in Asia, the Middle East and Beyond

Increasing foreign interest could be the key to further growth of the global sukuk market, in our view. With increased standardisation across the wider Islamic finance sector and growing presence in non-Muslim majority countries like the United Kingdom and the United States, we think more foreign investment in sukuk issuing regions will further develop the industry.

Appealing to a Wider Audience

China, for example, could play a part in the future of global sukuk, as global Islamic centres, namely Malaysia, tend to cater to Chinese investors.

Malaysia launched the first global sukuk issuance in 1990, and remains one of the largest markets for sukuk. Existing activity in Malaysia’s sukuk market has been mostly confined to local currency (Malaysian ringgit) issuance.

We think more foreign currency-denominated issuance could appeal to a wider audience on a global scale.

That approach, alongside a regulatory regime that’s supported by the central bank, could help Malaysia cater to the foreign demand we’ve seen and facilitate a truly global role in the sukuk market.

So, while the full extent of Chinese interest in this space isn’t yet clear, we expect to see Chinese real estate and financial services companies likely among the big issuers in the near term.

In our view, if Malaysia can tweak its sukuk market to meet foreign demand, it could be one of the sukuk success stories that solidifies Islamic finance into the mainstream.

Development of the Sukuk Market

The GCC, and Dubai in particular, is another exciting investment destination where we see real potential for the growth of sukuk.

While Malaysia continues to outnumber GCC countries in terms of sukuk issuances, mainly because it has a deeper domestic market with more developed insurance, pension and asset management industries, the GCC is an increasingly attractive hub for attracting foreign investment in Shariah-compliant investment products.

One vital reason is because GCC sukuk issuances are typically dollar-denominated or pegged to the US dollar.  We continue to see growing interest from local governments in issuing sukuks, as they are increasingly viewed as a viable option for funding and diversifying away from relying on oil revenue. Saudi Arabia raised $9 billion alone in its first ever dollar-denominated sukuk sale this past year,6 $1 billion more than what the government was said to be planning to issue initially.

Of the $180 billion in corporate issuances so far this year globally, around $10 billion of them have been from the GCC.7 Though the industry continues to grow, albeit at a slow pace, the Dubai government has set a target to make the city the Islamic finance capital of the world, and is taking steps to achieve this agenda. In our view, Dubai could become a leading global hub for listing sukuk.

Generally, the number of global sukuk issuances are on the rise. Total sukuk issuance in 2017 was valued at $84 billion, compared to $71 billion in 2016.8 In our view, we are on a positive trajectory and look forward to seeing how the sukuk market continues to develop against this positive backdrop. Though, we think more collaboration between regulators, governments and industry bodies alike could boost this investment area further into the mainstream.

The comments, opinions and analyses presented herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

Data from third-party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information, and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered by FTI affiliates and/or their distributors as local laws and regulations permit. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction.

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What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in developing markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with their relatively small size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Such investments could experience significant price volatility in any given year. Investments in the energy sector involve special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector.

1. Source: Institute of International Finance, April 2018

2. Source: Standard & Poor’s Global Ratings, January 2018.

3. The Gulf Cooperation Council is an alliance between six Middle Eastern countries: Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and United Arab Emirates (UAE).

4. Correlation measures the degree to which two investments move in tandem. Correlation will range between 1 (perfect positive correlation where two items have historically moved in the same direction) and -1 (perfect negative correlation, where two items have historically moved in opposite directions).

5. Source: FactSet, as of 31 March, 2018. Important data provider notices and terms available at www.franklintempletondatasources.com.

6. Source: Ministry of Finance – Saudi Arabia.

7. Source: Bloomberg, as of 31 December, 2017.

8. Ibid.