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Fri 10 Apr 2009 04:00 AM

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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.

Sukuk pricing distorted by thin secondary market
Sukuk pricing distorted by thin secondary market
Malaysia is the world’s second-largest Islamic bond issuer last year, according to Islamic Finance Information Service.
Sukuk pricing distorted by thin secondary market
Sukuk pricing distorted by thin secondary market
Holders are reluctant to issue in the current market, said Badlisyah Abdul Ghani, CEO of Sharia bank CIMB Islamic.

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.

To price a sukuk for trading you need to actually glance inside to see what’s the value of the assets.

"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.The straightforward pricing mechanism of conventional bonds based on their face value and their yield, is broken up in the sukuk structure.

"To price a sukuk [for trading] you need to actually glance inside to see what's the value of the underlying assets," Buelow said.

Buelow said sukuk issued to finance real estate or infrastructure projects lacked the revenues that underpin returns, as actual construction starts only at later stages.

He said Allianz was eager to buy sukuk on the secondary market, but said the limited offer was an obstacle.

"The lack of long-term sukuk poses a real problem to us when we would like to offer education plan or retirement products," he said.

Insurers looking for long-term and stable investments are one of the backbones of conventional bond markets.

The central bank of Gulf Arab state Bahrain in November launched an Islamic overnight repo facility for Islamic banks, but the lack of a secondary market remains a concern for the central banks, as banks need to place ijara sukuk issued by the government as collateral.

As these are not being traded, banks wanting to make use of the facility need to wait for upcoming government issues. (Reuters)

Sukuk — Islamic bond in a nutshell• Sukuk is the Arabic name for a financial certificate but can be seen as an Islamic equivalent of bond. However, fixed income, interest bearing bonds are not permissible in Islam, hence sukuk are securities that comply with the Islamic law and its investment principles, which prohibits the charging, or paying of interest. Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets.

• Conservative estimates by the Ten-Year Framework and Strategies suggest that over $700bn of assets are managed according to Islamic investment principles. Such principles form part of sharia, which is often understood to be ‘Islamic Law', but it is actually broader than this in that it also encompasses the general body of spiritual and moral obligations and duties in Islam.

• Sharia-compliant assets worldwide are worth an estimated $500bn and have grown at more than 10 percent per year over the past decade, placing Islamic finance in a global asset class all of its own. In the Gulf and Asia, Standard & Poor's estimates that 20 percent of banking customers would now spontaneously choose an Islamic financial product over a conventional one with a similar risk-return profile.

• With its Arabic terminology and unusual prohibitions, sukuk financing can be quite mystifying for the outsider. A good analogy is one of ethical or green investing. Here the universe of investable securities is limited by certain criteria based on moral and ethical considerations. Islamic finance is also a subset of the global market and there is nothing that prevents the conventional investor from participating in the Islamic market.

• In classical period sukuk - which is cognate with the European root "cheque" (which itself derives from Arabic) - meant any document representing a contract or conveyance of rights, obligations or monies done in conformity with the Sharia.