By Hani Ibrahim, Head of Debt Capital Markets at QInvest
Islamic Finance News
On the 19th of October 2016, the Kingdom of Saudi Arabia (KSA) priced its inaugural international bond issuance, raising US$17.5 billion. There is no question that this was a landmark global transaction; the largest debut debt capital markets transaction, the largest emerging markets bond issue and the largest syndicated sovereign bond. However, one fact was notable only by its absence: there was no Islamic tranche as part of the issuance, unlike the recent sovereign issuance from Bahrain. So why did the KSA issue its jumbo debut issuance in a bond format and could it not also issue in a similar size and tenor in the Sukuk format? HANI IBRAHIM delves further.
Much of the attention was on the KSA’s desire to diversify away from natural resources and ‘open up’ to international investment. However, what could have been a milestone for the growing Islamic finance market was instead lost in the bulging global bond market. It’s a story that is seen frequently, as with Qatar’s bond issuance earlier this year. Despite record growth for Sukuk issues up to 2012, since then, they have declined each year. While some of the reasons for this have been well documented, there is potentially something more fundamental at play. The challenge is not necessarily one of supply of new issues because sovereigns and corporates alike are seeking funds, but rather one of investor demand. Is greater diversity of the Sukuk investor base the solution?
Cast an eye down the list of investors in the KSA bond, and the issue becomes apparent. In the 10-year bond, Middle East investors represented 24% of the issue, but only 9% in the 30-year one. According to Bloomberg, the average life of a bond in the US is 5.7 years, in the Middle East and Africa it is 3.4 years. These statistics show a clear preference for shorter dated paper from the region. Looking at the type of investors, a large part of the demand for new bonds in North America and Western Europe has traditionally come from institutional pension funds and fund managers. Again, the KSA bond provides a good example. In the 30-year bond, fund managers accounted for 65% of investors, followed by other institutions at 29% and banks at only 5%. Contrast this to a typical Sukuk issuance where banks often take up between 50% and 70% of any issuance.
There are two reasons for banks being a large proportion of Sukuk investors. Firstly, Islamic banks have little, if any, alternatives to Sukuk to manage their liquidity and maintain a position of liquid assets. Secondly, the pension fund and fund management industry in the MENA region is underdeveloped, has limited resources and even less of an allocation to fixed income.
By contrast, North America and Western Europe have a long heritage of pension funds and fund managers. They have deep pockets and a large appetite for fixed income. According to the OECD, private pension assets reached US$38 trillion in 2015 and, on a weighted average basis, accounted for 123.6% of GDP for OECD countries. The OECD also revealed that on average in 2014, private pension funds allocated 51.3% to bonds and bills. This dynamic is significant as it allows a whole industry of fixed income issuance to be built around it. The California Public Employees Retirement System or CalPERS is a significant investor itself with close to US$60 billion in income-generating assets. In fund management, North American managers together manage around US$36 trillion of assets with significant allocation to yielding assets. For example, BlackRock currently has around US$5 trillion in assets under management with 32% allocated to fixed income and, together with the likes of Vanguard and Pimco, make up some of the largest holders of North American and European bonds. These fund managers and pension funds are the primary feature at new bond roadshows and can easily be the cornerstone of any potential issue. The size of the financial firepower held by these institutions is a significant multiple of the total size of the Sukuk market which stood at US$417 billion as at October 2016.
For the Sukuk market to have any chance of getting close to the bond market, the region needs a greater diversity of investors devoted to long-term, income-generating investments such as Sukuk. Such investors can provide an important base to fuel the growth in this industry. For example, pension funds with their long-term liabilities could stimulate demand for longer-dated Sukuk or the issuance of project Sukuk, both of which see significant demand from US pension funds in the bond space. To facilitate this, there would need to be a change in the mindset of regional sovereigns which ultimately control the state pension funds and sovereign wealth funds. Such institutions in the Middle East currently have limited, if any, allocation to fixed income and certainly nowhere near the allocation of institutions such as Pimco or CalPERS. However, without meaningful change, landmark transactions such as the KSA bond sale will probably continue to pass over the Sukuk market.
Hani Ibrahim is the head of debt capital markets at QInvest and can be contacted at hibrahim@qinvest.com. Toufic Fawaz, a vice-president and Jonathan Surr, an analyst, assisted in this article and they can be contacted at TFawaz@qinvest.com and JSurr@qinvest.com respectively.