Opinion: Global sukuk market unlikely to repeat 2017 performance

There was even activity from non-core Islamic finance countries, such as Hong Kong and, for the first time, Nigeria, which added to the record volume. We expect other non-core Islamic finance countries to continue to tap the market with Morocco and Tunisia both expressing intentions to issue sukuk in 2018, while the United Kingdom announced its intention to go to the market again in 2019 upon the maturity of its 2014 sukuk.

The exceptional performance of these bonds was driven by good liquidity conditions both in the GCC and abroad, alongside certain countries’ desire to develop their Islamic finance industries. In our view, some issuers, particularly those in Saudi Arabia, were able to choose sukuk over conventional bonds because they were less pressed for time to raise funds.

However, the outlook for sukuk in 2018 is more uncertain. While we still foresee significant financing needs for core Islamic finance countries such as the Gulf countries and Malaysia, tighter global liquidity conditions, mounting geopolitical risks, and slow progress on the standardisation of Islamic finance products will continue to hold the market back from its full potential. That’s why, in my view, total sukuk issuance is likely to decline to between $70bn and $80bn in 2018, despite the fact that the financing needs of some Islamic finance core countries will remain high.

Rate rises

What are the reasons for this? Firstly, global liquidity is likely to tighten in 2018. We expect the federal funds rate to increase by 75 basis points with central banks in the GCC likely to mirror any increase given their currency peg with the US dollar. Similarly, the European Central Bank has announced it will start reducing the pace of its asset purchases from January 2018, to €30bn ($37bn) a month from €60bn. We therefore expect liquidity from developed markets channelled to the sukuk market to reduce.

Positively, liquidity conditions in the GCC countries improved last year and muted economic growth and declining lending activity will shift banks’ attention from lending to capital market activities. However, regional and international investors may be more cautious given the resurgence in regional geopolitical risks.

This is significant given European and US investors accounted for 28 percent of sukuk investors in a survey of 34 international sukuk issues between 2014 and 2017.

We have seen funding outflows from Qatar’s banking system of an estimated $21bn as of September 30, 2017 – and we expect this trend to continue, albeit at a slower pace. While it is true that the Qatari government’s injection of $39bn has mitigated some of this risk, we believe investors’ perception of the cohesiveness of the GCC has changed. Recent shifts in Saudi’s power structure may have a similar impact on investors’ perception of the region; however, the reform programme could restore investors’ appetite in the medium term.

Regional and international investors may be more cautious given the resurgence in regional geopolitical risks”

Lastly, while there has been progress on the standardisation agenda, it is slow. The Accounting and Auditing Organisation for the Islamic Financial Institutions (AAOIFI) and the Islamic Financial Service Board (IFSB) issued several new standards in 2017 aimed ultimately at smoothing the process of sukuk issuance.

For example, a standard for central Sharia boards has been published, as well as a standard on disclosure requirements for sukuk. In my opinion, standardisation for cross-border sukuk issuance is not only achievable but will boost issuance volumes and restore the attractiveness of the instrument to issuers through a smoother issuance.

Sharia compliance

While sukuk issuance may decrease in 2018, there are a couple of interesting trends. These include the more stringent application of the profit-and-loss-sharing principle supported by several Sharia scholars.

While we do not opine on Sharia compliance, we are of the view that such a development could deprive the market of an important class of investors, the fixed-income investors, and ultimately lead to higher pricing. For a corporate entity or a sovereign fund, this trend is likely to reduce the attractiveness of sukuk due to legal complexity and higher costs.

We are also seeing a broadening of the investor base to include retail investors or waqf money, which some believe could lift sukuk issuance and reduce pricing by boosting demand. Although S&P Global Ratings’ role is not to advise waqf investors [Muslim endowments to good causes] about asset allocation, we observe that they are generally not after profit maximisation but rather the fulfilment of certain social objectives.

In addition, the lack of a specific regulatory framework to protect retail investors and ensure proper access to information about risks – as well as limited tax incentives – leads us to believe that the retail sukuk will continue to make a limited contribution to sukuk issuance.

The financing needs of core Islamic countries will remain relatively high in 2018. Nevertheless, we believe certain factors such as the tightening global liquidity, geopolitical risks and a lack of standardisation leads to an uncertain year for sukuk issuance globally.

First major sukuk of 2018

Dubai Islamic Bank (DIB) successfully issued a $1bn sukuk in February with a five-year tenor. It will mature on February 6, 2023. It is the first US dollar benchmark sukuk transaction from the GCC in 2018.

The issuance emanates from DIB’s $5bn sukuk programme and carries a profit rate of 3.625 percent. Experts believe this points towards a strong demand for DIB’s credit as well as the confidence which global investors have in the UAE’s largest Islamic bank.

The issuance received 120 orders from a diverse investor base as part of a $1.83bn order book indicating nearly two times oversubscription. The instrument will carry a dual listing on the Irish Stock Exchange and Nasdaq Dubai.

Mohamed Damak, Global Ratings’ Head of Islamic Finance, S&P