Sukuk pricing distorted by thin secondary market

Companies keen to tap the Islamic debt markets are staying on the sidelines, amid fears the illiquidity of the sukuk market could distort the pricing of new issues.

Corporate issuers are eager to return to the Islamic bond market but a lack of secondary trading could distort the pricing of an estimated $45bn worth of sukuk in the pipeline and deter future issuance.

The credit crunch and growing prospects of a global economic recession have virtually frozen sukuk markets worldwide. The issue of distorted pricing could exacerbate issuers' reluctance to return to the markets, threatening a crucial source of funding for a number of companies and governments.

"The problems would be in terms of the ability to properly price the sukuk," said Badlisyah Abdul Ghani, chief executive of Malaysian Sharia bank CIMB Islamic, which is the world's top sukuk arranger.

"There is the problem of reluctance on the part of the issuer to issue in the sukuk market. If it's illiquid, then price distortion may occur, and it might reflect badly on them. It creates a benchmark for themselves."

Mohamed Damak, credit analyst at ratings agency Standard & Poor's recently estimated that, globally, pent up demand of more than $45bn is waiting to be released by issuers waiting for more favourable markets.

A report by McKinsey released in November estimated that only about 25 percent of total outstanding sukuk is listed. Secondary sukuk trading in Malaysia, which was the world's second-largest Islamic bond issuer last year, according to Islamic Finance Information Service, is thin when compared to the conventional market.

The Malaysian sukuk market's liquidity last year, calculated as a ratio of trade relative to outstanding bonds, was 88 percent, versus 209 percent for conventional bonds, according to central bank data.

Islamic bonds are structured as profit-sharing or rental agreements, and their returns are derived from underlying physical assets such as real estate or commodities. One reason for the lack of a secondary market is the limited size of the primary sukuk market. The total outstanding volume of sukuk amounts to just $100bn, according to Thomson Reuters data.

"There are not enough issues in the market," said Steven Choy, chief executive of Cagamas, Malaysia's national mortgage company, which frequently issues sukuk.

"You can't find a replacement as and when you sell the one that you hold."

He said many sukuk investors hold on to them mainly because of the good yields they offer.

Due to the market's illiquidity, sukuk frequently offer higher yields than conventional bonds of the same tenor and credit rating.

"If you are holding good paper, why sell?" Choy said.

Andreas Buelow, deputy chief financial officer for the Middle East and South Asia at German insurer Allianz, said not only the size of the primary sukuk market, but also the structures of Islamic bonds certainly make it difficult to trade them and find the right pricing.

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