Choosing Islamic finance

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Governments in Muslim nations in the Middle East and Asia are increasingly turning to Islamic finance to raise funds, giving a necessary but perhaps not sufficient shot in the arm for the $1 trillion industry.

Deeper liquidity is essential to winning investors back to the Islamic finance market after the credit crisis sapped demand and issuance and triggered the first ever major defaults of Islamic bonds, or sukuk, this year.

While government backing would allow international investors to gain exposure in the fast-growing region via safer debt, it would highlight the risk of owning non-sovereign sukuk from firms with weaker balance sheets in an industry where regulation is less advanced than in the conventional bond marketplace. Sukuk are structured as profit-sharing or rental agreements and returns are derived from underlying assets because Islamic laws prohibits paying or earning interest.

Government involvement is just what the industry needs to avoid cutting off inflows from international investors after some defaults and a series of debt restructurings.

Dubai’s state-owned developer Nakheel is currently undergoing a restructuring of its $3.5bn sukuk, due to mature in December. Prices had taken a hit earlier this month on speculation its owner and government conglomerate Dubai World might offer equity to its Nakheel bondholders.

“I think without greater government help it’s doomed anyway. Risk is just too high. But there is a lot more risk appetite from investors and definitely the government implication is a huge help,” said Nathalia Barazal, fund manager at Lombard Odier Darier Hentsch & Cie in Geneva.

“I wouldn’t buy it unless it’s a big company, good balance sheet,” she said, adding that more government issuance might drive people away from debt from firms with weak fundamentals.

Barazal, who sold Nakheel’s December sukuk less than a fortnight ago, said she would consider an exposure if it were from a safer issuer and the type of sukuk which was attractive, for example, exchangeable convertible bonds.

“I would definitely get involved in the region, I don’t want to start with real estate... probably with exchangeable convertible bonds,” she said.

So far this year, four out of five sukuk deals have been issued by sovereign or quasi-sovereign entities.

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