Published: May 4, 2017
Islamic finance volumes fell off a cliff last year, but bankers are predicting a substantial increase in activity as more sovereigns from major Islamic finance hubs are turning to the international markets.
Islamic syndicated financing levels plunged a whopping 44% last year compared to 2015, with US$10.9bn of loans signed compared to US$19.3bn the year earlier. Sukuk issuance fell year-on-year too, albeit less sharply than in the syndicate loan market. Global sukuk issuance fell 18.4% in the third quarter of 2016 to US$39.8bn from US$48.8bn in the same period of 2015, according to Thomson Reuters data.
“The drop is mainly due to modest economic growth amid oil price decline and the higher cost of funding on the back of interest rate hikes,” Amir Riad, head of corporate finance and investment at Abu Dhabi Islamic Bank told EMEA Finance.
Now, the technical environment is looking positive for more loans from the Middle East this year, as there is around US$15.3bn of Islamic debt maturing in 2017.
“Hence, we expect the market activity to pick up as borrowers look to refinance these maturities,” said Riad.
Meanwhile, the same shaky business environment that dried up Islamic funding in the last year also helped M&A funded by Shariah-compliant finance flourish. The ADIB, for example, led a US$67mn seven-year Islamic finance facility to support Tristar’s US$90mn acquisition of Emirates Ship Investments Company in early 2016.
“Attractive equity valuations are offering corporates opportunities to acquire assets,” said Riad. “Islamic banks have capitalised by offering Sharia-compliant acquisition finance facilities to fund these transactions.”
Real estate pros
Away from renewing old loans, the construction and real estate segment will continue to be one of the major non-oil sectors to borrow Shariah-compliant money in the Middle East.
“[Real estate] fits naturally to Sharia-compliant funding solutions,” said Riad.
This is because Islamic finance generally needs to be secured against a physical asset for Islamic scholars to label a deal complaint.
ADIB arranged US$814mn-equivalent of Islamic financing for the sector in 2016, and expects to do about the same this year.
The focus on real estate lending by Islamic banks is part of the reason they are expected to outperform conventional banking rivals in terms of profitability, according to a recent report from Moody’s.
The ratings agency said on March 14 that the profitability of Islamic banks in the Gulf Cooperation Council region will outpace that of their conventional peers for the second year running in 2017.
Moody’s attributes some of the higher profitability to the fact that Islamic banks tend to have higher yielding assets on their books, given their focus on retail and real estate lending.
“Islamic banks will be able to maintain their profitability in 2017, as lower funding costs will support their margins against a backdrop of rising interest rates,” said Nitish Bhojnagarwala, an analyst at Moody’s. “While improvements in their risk management and asset quality will further ease the pressure on their cost of risk.”
The Shariah-compliant market in the Middle East is also developing into new areas, with export credit agency financing expected to become more prominent as major government infrastructure projects begin to take shape, such as the Dubai Metro and Dubai Expo.
“ECA backed by Sharia-compliant financing is relatively a new development in the market,” Riad said. “We expect Islamic banks to play an expanded role in this sector and to see further development and innovation of Islamic ECA financing.”
In 2015, Emirates Airlines printed the first ever sukuk to have backing from the UK’s ECA, when it raised US$913mn of Shariah-compliant debt that comes due in 2025.
Oil on the up
Another technical factor supporting primary market volumes is the oil price recovery. Oil has risen substantially from its January 2016 lows and was bid at US$51.60 a barrel on March 14 – almost a 30% rise over 12 months.
This has put the oil price just a touch below budgetary breakeven amounts for a few Middle Eastern economies such as Kuwait and Iran.
However, this is still well below the breakeven oil price for some of the economies where Islamic finance is prominent.
The United Arab Emirates needs oil to be at US$71.70 a barrel for the sovereign to break even on its 2017 budget, while Bahrain needs oil to sell for at least US$93.10, according to International Monetary Fund predictions.
Saudi Arabia needs oil to be at US$70.20. The sovereign last year patched up some of the holes in its budget by printing the largest-ever emerging market bond with a US$17.5bn bond issuance across a range of maturity tranches. It was the sovereign’s first ever international offering.
While the Saudi trade was conventional, there hope that it could kick start more issuance in the sukuk market.
“You have seen a big move from sovereigns from the Middle East into the conventional space, and it is natural for issuers to then look at sukuk,” said Ravij Shah, head of debt capital markets for the Middle East, Turkey and Africa at BNP Paribas. “There is capacity there for the market to grow and this year could be pretty big for sukuk.”
Saudi Arabia has already sent a request for proposals to banks for an upcoming international sukuk issuance.
Away from the sovereigns, the first few months of 2017 saw more than US$2.5bn raised in the Middle East and North Africa Islamic capital markets, according to Riad at ADIB, with books oversubscribed by multiple times.
Kuwait’s Warba Bank made its first foray into the Islamic borrowing since the bank was created in 2010. The bank printed a US$250mn perpetual non-call five Additional Tier 1 sukuk on March 7, with the deal attracting books of around US$1.3bn, despite the bank’s low profitability.
“We would highlight that there is somewhat of a risk that the bank has a relatively low profitability profile… which could negatively affect any future profit distributions on the planned AT1 sukuks,” said Mitsubishi UFG analysts.
MUFG said Warba Bank posted US$8.4mn of profits in the 2016 financial year, up from US$3.3mn in FY2015 and a loss of US$13.2mn in FY2013.
Investors were offered a premium for the extra risk. The bonds, which printed at a 6.5% coupon, offered a 20bp premium in yield terms over fair value, according to MUFG analysts, who used the debt of Boubyan Bank and National Bank of Kuwait as comparable curves.
Nonetheless, the oversubscription on Warba’s maiden voyage to the markets does not appear to have been a one off. Equate saw an 8.4 times oversubscription for its US$500mn 2024 sukuk at the end of February, Dubai Islamic Bank saw more than US$2bn of demand for its US$1bn February 2022 trade and Investment Corporation of Dubai pulled in orders to cover its US$1bn 10-year sukuk three times over.
“Like the rest of EM, once the sovereigns come, it paves the way for quasi-sovereign issuances,” said a third banker who did not want to be named. “We don’t really have a deep domestic Saudi sukuk market anymore, so a lot of those issuers will have to come to the international market.”
Saudi issuers are looking more intently at international markets because the Saudi Arabia interbank offered rate has risen so sharply in the last 18 months, making domestically sourced loans, which are priced off of SIBOR, substantially more expensive.
Three month SIBOR was around 0.75% in mid-2015, but rose to more than 2.3% in October last year, according to data company Trading Economics, as consistently low oil prices bit into interbank funding costs.
Riad at ADIB said that the bank expects more supply in sukuk in 2017 because of a range of factors including broader international investor understanding of the product, a push by issuers to seek alternative forms of finance, more sovereign issuance, bank treasuries allocating more money to buy sukuk and the standardisation of sukuk documentation and execution.
“The need to standardise legal structures and Sharia interpretations along with the need to create innovative structures that cater to clients’ needs will continue to be a key development aspect for the Islamic finance market in the near future,” said Riad.
The UAE is considering creating a new Sharia advisory board to facilitate standardisation, Riad added.
In terms of economics, sukuk are still attractive to issuers with an outstanding conventional curve.
“Sukuk continue to trade inside conventional curves, so there is the potential for arbitrage there,” said Shah at BNP Paribas. “We are nowhere near overcapacity yet, so the arbitrage will remain for the time being, though how big the spread will partly depend on the number of new issues – it’s down to supply and demand, and whether supply picks up.”
Another promising development was Africa Finance Corporation’s, a leading pan-African multilateral, maiden sukuk, which raising US$150mn on January 24. The sukuk was the highest-rated ever from an African institution, the privately placed Murabaha sukuk received an A3 senior unsecured rating from Moody’s. Investor demand reached US$230mn allowing the firm to upsize its initial funding target of US$100mn. Emirates NBD Capital acted as sole global coordinator, and participated with MUFG and RMB as joint bookrunners and joint lead managers.
Supply in the international Islamic finance market – like many US dollar based emerging market financial products – is expected to pick up before the US Federal Reserve completes multiple rates rises this year.
The Fed made on March 16 the first of what is expected to be three rate hikes this year, bumping its core interest rate up by 25bp to 1%.
“Ahead of further rate hikes we expect borrowers to access the bank and capital markets sooner rather than later,” said Riad at ADIB.
This is because bond issuers are keen to lock in lower spreads now, before underlying rates move up and drag spreads with them.
“Corporates will benefit on the back of more liquidly traded sovereign and GRE benchmark curves but ultimately, [rising rates mean] there will be a yield increase that borrowers will have to adjust to,” said Riad. “One of the easiest ways to reduce funding costs is by accessing a larger pool of investors and liquidity, hence we would expect borrowers to look more favourably on accessing Sharia-compliant structures adding Islamic and conventional tranches to their facilities to help lower their finance costs down.”
Riad said: “We are starting to see dual tranche financing gaining traction for sovereign and GRE financings.”
It’s not just the timing of issuance that is expected to change because of rising rates, but the maturity of the debt being placed is being influenced as well.
“In the rising rate environment, we are witnessing an increased demand for customers to extend the duration of their financing maturity profiles and access longer dated funding to avoid more costly financing terms,” said Riad. “Islamic financing markets are adjusting and showing robust support to invest in longer dated assets.”
A sharp lengthening of maturities has already been seen in non-Islamic finance markets, particularly among European sovereign issuers.
Austria last year brought its longest-dated syndicated bond ever last year when it raised €2bn of debt maturing in November 2086. Italy, Spain, France and Belgium sold 50-year bonds, while Belgium and Ireland placed 100-year debt privately. Clearly, the demand exists for long maturity debt.
Saudi Arabia, which sold much of its blockbuster debut bond to the same investors who would buy European sovereign debt, is considering a maturity as long as 15 years for its sukuk. Sovereign, supranational and agency bond syndicate bankers consider anything more than 10 years to be very long maturity. The sukuk market looks like it is on the verge of going mainstream.