International Finance
Islamic Finance Magazine

The changing landscape of Islamic bonds

The global Sukuk industry is worth more than $2.4 tn and grew by 11.4% in 2019

The global financial landscape has gone through some dramatic changes in the last few years. The lessons we have learned from the 2008 recession point to the fact that we need to have an innovative financial architecture that is not only capable of supporting governments and businesses but also is effective, timely and predictable so that it can help enhance the stability, wealth, social well-being and environmental sustainability, thereby securing long-time growth of the local economy. The last 12 months have seen developments in the global Islamic finance industry which is fueled by a dynamic Sukuk market and a significant investment in fintech and innovation. The Middle East, Africa and South Asia (MEASA) region continue to be a significant contributor to an industry, which is worth more than $2.4 trillion and grew by 11.4 percent in 2019.

Dubai International Financial Centre (DIFC) is home to 46 active authorised firms that qualify as Islamic financial institutions and operate as an Islamic window. Over the last year, DIFC recorded an increase in Islamic assets in the value of Islamic contracts during the first quarter of 2020 when compared to the same period in 2019. While the sector has received a strong boost last year, the effects of the Covid-19 pandemic has had far-reaching implications on the financial sector, including Islamic finance. Even though experts have predicted that the growth in the sector will be slow, there is still enough room for the sector to support countries, banks, companies and individuals impacted by the Covid-19 pandemic to move forward with environmental, social and governance (ESG) goals.

After a strong performance in 2019 due to higher-than-expected Sukuk issuance, experts believe that Islamic finance industry growth will slow in 2020- 2021 due to lockdown measures. The primary reason why the Sukuk market performed so well during 2019 is because of the good performance in the Gulf Cooperation Council (GCC), Malaysia, Turkey and Indonesia. In 2020, these numbers slowed down primarily due to the government-imposed restrictions to contain the spread of Covid-19. This slowdown has been counterbalanced by economic support from various central banks to help their banking systems navigate the difficult environment.

Before the world economy was devastated by the Covid-19 pandemic and oil prices skyrocketed, the market was poised to perform really well in 2020. Due to the stretched financial conditions, it is expected that e Islamic finance countries won’t be using Sukuk as a primary source of funding despite their higher financing needs. However, some other experts have predicted that the Covid-19 pandemic offers an opportunity for more integrated and multifaceted growth with higher standardisation, a stronger focus on the industry’s social role, and greater use of fintech. This can be achieved through better coordination between the industry’s different stakeholders.

ESG principals have become more and more relevant both globally and in the Middle East specifically. While the modern formula for Sukuk has been present for decades, recently, the markets have registered growth of innovative Shariah-compliant financing structures that align with ESG principles. It is known that Shariah-compliant assets have a lot of potentials to be ESG-compliant, green or sustainable Sukuk. The proceeds from the green Sukuk are used exclusively for the funding of eligible sustainability projects or to finance investments in renewable energy or other environmental projects.

Social Islamic Finance can cause a difference
It’s no secret that the Covid-19 pandemic has caused a significant slowdown of the global economy and its effect can be felt in core Islamic finance markets, which has seen a spike in unemployment. Initially, the shock was well-absorbed by migrant population structure in the Gulf and governments’ support packages, but a large number of stakeholders lost a portion of their income. Experts have predicted that four Islamic finance social instruments, in particular, can help core Islamic countries, banks, and corporations; which are, Qard Hassan, Social Sukuk, Waqf and Zakat.

Qard Hassan can provide a breathing space until everything resumes its stability. One example of this is when the GCC countries’ central banks provided free liquidity lines to financial institutions to provide subsidized lending to their corporate and small and midsize enterprise clients. Social Sukuk can help support the educational system amid the current slump and attract ESG and Islamic investors. Waqf can provide affordable housing solutions or access to health care and education for people who have lost a significant portion of their income. Zakat, on the other hand, can help compensate for lost household income because of the pandemic. All these factors, along with green Sukuk could help put the industry more prominently on ESG investors’ radar.

Streamlining the issuance of Sukuk
For issuers, Sukuk issuance remains more complex and time-consuming because of conventional bonds. When oil prices crashed in 2014, the core Islamic finance issuers needed faster access to capital markets compared to what they typically use. During the first five months of 2020, the total volume of Sukuk issuance dropped 38 percent compared to the same period in the previous year. The only exception noted were the ones that already had established programs or can tap a recent issuance. Even though the market has developed a certain way of doing transactions, but a global standard of doing transaction rules that would be acceptable to all stakeholders is still missing. The various standard setters of the industry like -the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the Islamic Financial Service Board (IFSB), and the International Islamic Financial Market (IIFM) have come together to drive this agenda. Recently, the UAE Ministry of Finance, the Islamic Development Bank, and the Dubai Islamic Economy Development Centre (DIEDC) came together to develop an international legislative framework for Islamic finance that has the primary goal of speeding up and reducing discrepancies around the globe.

Countries that have adopted the AAOIFI standards might think that some Sukuk structures are primarily used in core Islamic finance countries. This points to the necessity for a urgent review of some of the existing standards and the adoption of an inclusive approach. Many have mentioned that the adoption of the above mentioned process would ultimately lead to the standardization of the full spectrum of Sukuk. It will also factor in the requirements of regulators, Sukuk issuers, and investors. Once Sukuk issuance becomes comparable with conventional instruments from a cost and effort perspective, it will easily find its place on issuers’ and investors’ books.

Central banks from around the world have already taken necessary steps to boost banks’ liquidity in core Islamic finance countries. Therefore they are unlikely to issue Sukuk as liquidity management instruments in 2021. Instead, they want banks’ increased liquidity to reach corporations which will decrease the risk of a long-lasting economic downturn resulting from Covid-19 and rising oil prices. Since the world economy is still volatile, it has led to higher financing needs for sovereigns, but most of them are turning to conventional markets due to the complexity of issuing Sukuk.

Reports suggest that Sukuk issuance volume fell by 27 percent in the first half of 2021. In the current environment, the defaults among the latest Sukuk issuers that have low credit quality will most likely increase. Additionally, over the next few months, some Sukuk may be issued to help economic recovery rather than solely to serve investors’ financial interests.

Issuance is likely to remain low until economies recover
As Covid-19 continues to spread in many Islamic countries, it is a known fact that policymakers will prioritise restarting the economy and limiting the overall impact of restrictions had on productive capacity and employment. Even then, the massive events of 2020 will remain a primary issue for all major Islamic finance countries. During the first six months of 2020, the market saw a 27 percent drop and issuance volume is expected to reach $100 billion at best this year compared with $162 billion in 2019, constituting a 40 percent decline. Due to rising oil prices and the impact of the Covid-19 pandemic, several central banks launched liquidity programs to help corporations to preserve the productive capacity of their economies. Due to this, local banks were able to meet most of the economies’ financing needs. Additionally, the need for corporate financing has been reduced, since they are delaying investments and reducing capital expenditure in the uncertain environment.

Investors are becoming increasingly interested
Over the past few months, market conditions have been extremely fragile because of the Covid-19 pandemic. Looking at the brighter side, several countries have been successful in containing the virus. This, along with lifting major restrictions has contributed to some stability to global capital markets that has seen an uptick in issuance. For example, the Indonesian government issued a $2.5 billion global Sukuk in June 2020, including a $750 million “green” tranche. One of the tranches has a 30-year maturity and received positive responses from investors based on its pricing. The Sukuk issuance was heavily oversubscribed, proving that even during an extremely volatile market, issuers with a good credit rating can still have access to the market.

Additionally, the volume of foreign-currency-denominated issuance has increased by 11.3 percent mainly due to increased issuance from the Islamic Development Bank as part of its planned increase in lending. Reports suggest that Bahrain also stepped up its foreign currency issuances to support liquidity and favours Sukuk to help raise funds. Experts suggest that this will continue unless the sector encounters an unexpected setback. Experts have wondered why governments in the Gulf and other core Islamic finance markets favoured conventional capital markets instead of issuing Sukuk. That is primarily because Sukuk issuance is still more complicated than issuing conventional bonds. Only when the processing of both become broadly comparable, especially from a time, cost and offer perspective, then only would governments view Sukuk as an efficient source of funding on a regular basis.

Given the current shocks faced by the global economy, analysts have identified that credit risk is also rising. As a result, we might get to see higher default rates among Sukuk issuers, especially those who have lower credit quality or come with business plans that depend on supportive economies and market conditions. This will also test the capabilities of the legal documentation process used during Sukuk issuance and will also provide insight into the outcome for investors. Usually, investors don’t have access to the Sukuk’s underlying assets when a default takes place, except when those assets were sold to the special purpose, which, needless to say, is more of an exception than a norm. The defaults happening from the side of investors will bring the debate on the standardization of legal documents back to the forefront.

Another interesting trend that has been observed is the use of innovative structures to finance economic recovery. One of them is the issuance of $1.5 billion worth of Sukuk by the Islamic Development Bank (IsDB). Reports suggest that the proceeds from this Sukuk will directly go to the IsDB’s member countries to help them cope with the impact of the pandemic, particularly focusing on sectors like healthcare and small and medium-sized enterprises (SMEs).

Another example is the issuance of Prihatin Sukuk in Malaysia. Going by some market sources, the closest conventional instrument to this Sukuk would be a war bond and the main idea behind this is to issue a zero periodic-distribution-rate Sukuk and use the proceeds to help restart the economy. Not only will this be majorly attractive to investors from a financial perspective, but it also will appeal to the local investors that are keen to contribute to the economic recovery. It is also expected to appeal to many local or foreign investors that have ESG objectives and the proceeds from this Sukuk will support microenterprises run by women, improve broadband internet coverage for schools in rural areas, and provide research grants for the treatment of infectious diseases.

Even though it is a part of sustainable finance, green Sukuk will likely remain on the sidelines while governments in core Islamic finance countries deal with the impact of the pandemic. But if there is any indication that green Sukuk can help accelerate the economic recovery, then there is a good chance that we may see a resurgence in issuance.

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