Beyond Bulls & Bears

Is Islamic Debt a Salve for the Risk-Averse?

In times of uncertainty or crisis, it’s natural for investors to avoid what they perceive as risky assets and seek out so-called “safe havens.” The financial crises born in over-leveraged, developed markets of the past few years have helped spur interest in Islamic banking and finance, primarily in under-leveraged emerging markets. Investments compliant with Islamic law (Syariah or Shariah), including bond-like investments called “sukuk,” are growing in popularity not only in the Muslim world, but across the globe. Nor Hanifah Hashim, Franklin Templeton’s head of fixed income – Malaysia  based in the country’s capital, Kuala Lumpur, and Mohieddine Kronfol, CIO Global Sukuk and MENA Fixed Income at Franklin Templeton Investments ME, based in Dubai, UAE, explain why. Their key thoughts, in brief:

  • Shariah principles, particularly reduced exposure to leverage and risk-taking, make sukuk attractive to many investors.
  • Malaysia and the Arab countries dominate the sukuk market, but Western nations are also promoting Islamic finance.
  • Sukuk can offer investors diversification, given their generally low historical correlation to traditional investments.
  • The global sukuk market remains relatively insulated from most of the volatility in other financial markets.

Rising demand for Shariah-compliant investments from a growing number of Islamic banks and funds has led to the development of Islamic asset management, catering to a global Muslim population that numbers 1.6 billion, representing about 23% of the world’s population.1 Hanifah explains why both Muslim and non-Muslim investors are taking notice of Shariah-compliant vehicles, including sukuk.

“Sukuk are seen as an attractive alternative investment class because they have delivered comparable returns to conventional investments, with the added potential benefit arising from Shariah-compliant fundamentals that require ethical business practices, underlying productive assets, equitable risk sharing, social responsibility and avoidance of speculation. Sukuk can also provide diversification. While they are influenced by movements in other (traditional) markets, they have been generally less correlated; one reason is because sukuk generally have lesser banking sector exposure.. During the global financial crisis in 2008, for example, the lower banking exposure helped limit the downside of the sukuk portfolio slightly better than conventional investments did. So the difference in sector composition contributes to this diversification argument between a sukuk portfolio and traditional bond portfolio.”

So what are sukuk? For the uninitiated, sukuk are instruments used for financing that are similar to conventional bonds, but since the charging of interest is prohibited under Shariah, the structure is a bit different. The sukuk issuer sells a certificate based on the underlying asset to a group of investors, who then rent it back to the issuer for a predetermined fee. Thus, there is a communal aspect to the sharing of risk. The sukuk issuer makes a contractual promise to buy back the bonds at par value in the future. Sukuk are required to link returns and cash flows of the financing to the assets purchased, or the returns generated from the assets purchased.

Though not without risk (investment returns are not guaranteed and sukuk, like other types of bonds, are subject to credit risk), the principles surrounding Islamic financial transactions make them attractive to many investors, particularly lessened exposure to excessive leverage and risk taking. The 2008-2009 financial crisis stemmed from the misuse of complex derivative instruments, which are forbidden under Shariah, so Islamic financial institutions did not have exposure to such derivatives. Kronfol offers his view on why these investments are growing in popularity.

“From our perspective, sukuk are attractive because they are supported by strong macro and credit fundamentals, improving liquidity and a growing investor base in the Middle East and Southeast Asia.  Perhaps just as importantly, the global sukuk market has remained relatively insulated from most of the volatility in financial markets. Our outlook for global sukuk therefore remains constructive.”

However, these investments aren’t completely immune to outside factors, and can experience ripple effects when global liquidity tightens. Hanifah explains one of the main challenges.

“The global sukuk market is relatively young and has been growing, so there is a scarcity of supply to cater to the demand. This has led to relatively lower secondary trading compared with conventional bonds. As a result of the challenge on secondary trading, Islamic market liquidity has been relatively lower than its conventional equivalent. If we compare the conventional sovereign and Islamic sovereign bonds in Malaysia for example, conventional sovereign bonds have been more liquid than Islamic counterparts. However, in times of low interest rates where yield is king, there has been bargain hunting in the Islamic sovereign segment. That increases liquidity tremendously as Islamic sovereign bonds generally offer potentially higher yields than conventional equivalents. This has narrowed the liquidity discount seen on Islamic bonds in recent years.”

Malaysia and Indonesia

Malaysia has been a pioneer in Islamic finance, which operates side-by-side with conventional financial markets. The roots of Islamic finance in Malaysia date back to 1969, but have gained increased government focus during the past two decades. In 2001, Malaysia provided a framework under its first 10-year “Capital Market Master Plan” for developing both the conventional and sukuk bond markets, and in 2006, Malaysia launched the International Islamic Financial Centre (MIFC) to position Malaysia as an international hub of Islamic finance.

Today, Malaysia is the dominant market for the issuance of sukuk  (with about 60-70% of global sukuk outstanding) and has established a facilitative regulatory environment for sukuk through various initiatives that include the absence of withholding tax and capital gains tax, and no restrictions on investing in Malaysian ringgit bonds. In addition, Malaysia has introduced a wide range of foreign exchange and interest rate hedging instruments that have contributed to the deepening of the market, Hanifah reports.

“Malaysia’s bond market is the fourth largest local currency bond market in Asia after Japan, China and South Korea,2 and has sufficient depth to support robust issuance. In January of this year, a single sukuk issuance in Malaysia was record-breaking with an issuance size of RM30.6bn (or US$10bn) , and the longest sukuk tenor of 27 years. I think that speaks volume for the Malaysian market depth, as well as investors’ confidence in the local credit quality. Malaysia also has become an arena for foreign corporates to issue sukuk in domestic currency. We have seen issuers from the Middle East as well as other Association of Southeast Asian Nations (ASEAN) countries successfully issue their ringgit-denominated-sukuk in Malaysia to tap the domestic liquidity. The growth of Malaysia’s external trade and investment activities should enable greater cross-border investments in sukuk and further widen the global sukuk demand base and develop a robust secondary market.”

Malaysia’s national balance sheet and respectable growth rates also have captured investors’ attention. While many developed nations are dealing with unwieldy debt burdens, Malaysia has been running current account surpluses. Foreign reserves stand at more than US$130 billion.3  The government (public) debt-to-GDP ratio stood at 53.5% in 2011, and its external debt-to-GDP ratio (that owed to foreign creditors) was even lower4, Malaysia’s strong domestic savings rate is an asset5, and the International Monetary Fund (IMF) has forecast GDP growth of 4.4% this year.

Malaysia abolished its withholding tax on interest income/profits from bond holdings and sukuk in 2004, but Indonesia, another burgeoning sukuk market, still withholds 20% on both interest income and capital gains for bond holdings by non-resident investors. Hanifah says reducing this burden would promote Indonesian sukuk among offshore investors. That said, in her view Indonesia is another market that holds promise in the sukuk market.

“I think Indonesia’s confirmation that the tax treatment for sukuk is the same as conventional bonds is a step in the right direction to boost the sukuk market. It was previously difficult to issue sukuk in Indonesia due to tax and transfer of beneficiary ownership laws. More supportive regulatory initiatives are needed, and that should further spur Indonesia’s sukuk market.”

Indonesia’s growth rate has been impressive, and its economy has been praised for its fiscal progress and prudence in overcoming challenges. In the second quarter of 2012, Indonesia’s GDP rose 6.37%,6 the second-fastest of the G-20 nations (China being number one). Foreign reserves total more than US$136 billion7 and foreign direct investment (FDI) in Indonesia reached an all-time high in the second quarter. Its debt-GDP ratio stood at 24.5% last year, a dramatic drop from above 70% in 1997.8 On a visit to Indonesia In July, German Chancellor Angela Merkel praised Indonesia as a model of government debt management that the Western world might be wise to take notice of.

Global Interest Growing

The London Stock Exchange, Bursa Malaysia and Nasdaq Dubai house the largest number of listed sukuk today. In addition to the UK, other non-Muslim nations (including Germany, Japan and Australia) have been enacting measures to promote or list Shariah-compliant vehicles. The Islamic Financial Services Board, based in Kuala Lumpur, expects assets in Islamic finance overall to reach $2.8 trillion by 2015.9 

Kronfol says while Malaysia represents the largest domestic sukuk market, the “GCC,” the six-nation Council for the Arab states of the Gulf, is the dominant player in terms of international sukuk origination denominated in U.S. dollars, accessible and of interest to international institutional investors. He sees few signs of slowing interest in other markets too.

“We continue to see very encouraging signs in large emerging markets such as Egypt, Turkey and South Africa, focused on the development of their respective sukuk markets. Key financial centers such as London and Hong Kong are also publicizing their commitment to the development of Islamic Finance. The global sukuk market continues to grow at a rate more than five times faster than the world bond market, which has itself experienced rapid growth over the past decade, and I don’t see signs of this trend slowing down.”

In a world where investors continue to be risk averse, many may be taking a closer look at this difficult to pronounce, but intriguing debt instrument as they survey their fixed income investment options.

What are the Risks?

All investments involve risks, including possible loss of principal. 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. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets 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.

 


1. Source: Pew Research Center, January 2011: “The Future of the Muslim Population.” The Muslim population is projected at 1.6 billion in 2010, and expected to grow to 2.2 billion by 2030.

2. Source: Standard & Poor’s, “Development of Malaysia’s Bond Market is Still Assured Despite Global Turmoil,” February, 2012.

3. Source: Copyright © 2012 by International Monetary Fund. All Rights Reserved.

4. Source: CIA World Factbook, 2011 est.

5. Source: The World Bank, 2011. Gross Domestic Savings as a Percentage of GDP – 33%

6. Source: Bloomberg LP, “Indonesia Economic Growth Exceeds Estimates as Investments Surge,” August 6, 2012.

7. Source: CIA World Factbook, 2011 est.

8. Sources: The World Bank, Central Government Debt as % of GDP 2007:71.8% ; CIA World Factbook, Public Debt 2011: 24.%.

9. Source: Islamic Financial Services Board, 2011.