MANAMA,(Reuters) – Western and Asian institutions hunting exposure to Gulf Arab economies are crowding Middle Eastern Muslims out of Islamic bonds, turning on its head a market traditionally driven by religious and regional factors.
As Islamic bond sales surge and yields fall, Middle Eastern investors are getting as little as 20 percent of the increasingly large and complex new issues, which no longer suit small regional investment banks looking for high returns.
“Sukuk have had so much success that everyone in the world wants this product, so it’s almost natural that the distribution now is about 20 percent for the Middle East, 80 percent elsewhere,” Jean-Marc Le Jeune, a director at Barclays said.
In December last year, only 40 percent of Dubai property developer Nakheel Group’s $3.52 billion sukuk sale, the world’s largest, was allocated to the Middle East, Barclays said.
Subsequent sales have seen the fraction shrink to as low as 20 percent, Barclays’ Islamic banking chief Arul Kandasamy said.
“What conclusions can you draw? One is that investors want to have credit exposure to the Middle East, and the fact that it’s a sukuk is neither here nor there,” he said. Last month, Dubai Ports World priced its non-convertible 10-year Islamic bond at 115 basis points over U.S. Treasuries with only a quarter of the money raised coming from the Middle East.
In 2006 its parent firm, Dubai’s Ports Customs and Free Zone Corporation (PCFC), priced its $3.5 billion two-year convertible Islamic bonds at 200 basis points over the equivalent U.S. dollar swap selling 80 percent in the region.
Bonds that can be later converted into stock usually offer lower returns, as do bonds with relatively short tenure.
Crucially, PCFC was not rated before going to market.
“Islamic bonds were priced a little bit higher, there was a risk premium to be paid. That has disappeared … It’s little a bit anecdotal, but I can assure you it’s fact,” Geert Bossuyt, head of Middle East structuring at Deutsche Bank said.
Islamic bonds, or sukuk, comply with Islam’s ban on interest and the trading of debt, and are backed by physical assets.
Initially driven by demand from the world’s 1.2 billion Muslims for investments that comply with their beliefs, bankers say the instrument is now seen as a conventional one, attracting the world’s conventional investors, who outnumber Muslim buyers.
Bankers’ estimates for global sukuk sales this year range from $27 billion to $50 billion, up from $10.2 billion last year, according to ratings agency Moody’s. Analysts forecast total investment grade European corporate bond issuance this year at up to 150 billion euros ($200 billion).
Strong interest from conventional investors has subsequently driven down the price of borrowing through sukuk, dampening interest among the Middle East’s Islamic investors, who typically look for higher yields, bankers said.
At the same time, borrowers have increasingly sought a credit rating before selling sukuk, a procedure used to attract buyers by giving an indication of ability to repay debt.
The practice has further lowered prices, bankers said, and was a key reason why DP World’s sukuk could offer lower returns than PCFC’s, bankers said.
“The pricing is one of the factors that drives some Islamic investors to shy away from low yield transactions. Conventional accounts in general look for low yield, low risk investment grade ratings,” HSBC’s distribution head Ihsen Khelef said.
“Now Islamic borrowers … when they go for sukuk issues, they go for a rating beforehand.”
Also deterring some Islamic investors is the size and complexity of some the larger sukuk sales. Many of the Middle East’s Islamic buyers are relatively small operations, who prefer to go for sukuk from small companies they know.
“You’d think that Islamic investors would be buying sukuk, but they’re not. The small deals yes, but the other deals, the properly structured international deals, they just don’t buy them. It’s partly yield, but also these smaller deals are companies that they know,” Kandasamy said.
Despite the cornering of the Middle East sukuk market by conventional buyers, Muslims are still going to be the market’s main drivers, if not buyers, in future, one banker said.
Demand that firms they invest in comply with Islamic law, or Sharia, is likely to mean more sukuk issuance.
“If you ask me today, the driver of the sukuk market are corporates or institutions that want to profile themselves as Sharia compliant,” Bossuyt said.
“Let’s say you’re a listed Saudi corporate … Islamic investors are very sensitive to whether you’re a sharia compliant or not … It’s not only the demand side, it’s also the offering side that makes a statement,” he added.
Demand from Muslims living in non-Islamic states may also give the industry a further boost, with talk of the United Kingdom, Singapore, France and others issuing sovereign sukuk.
“We see the governments of the UK, France, Germany, Canada and others considering issuing a sukuk to give access to government bonds to their own Muslim population,” Le Jeune said.