After a brief hiatus caused by insolvent American homeowners, the Islamic bond market is springing back to life with a $2 billion (£961 million) issue planned by Dubai Electricity and Water Authority and rumours of a big sovereign issue by a Gulf Arab government.
The sub-prime lending crisis in America temporarily shut down the market for sukuk, debt securities that comply with Sharia or Islamic law. Broadly, Sharia prohibits the payment of interest, as well as imposing other strictures against businesses linked to alcohol, gambling and investment in enterprises with high debt. It seems a little unfair, therefore, that a credit crisis that originated in excessive lending to hard-up Americans at extortionate rates of interest should have constrained Islamic bond issuers.
Sukuk are a new market. It is barely five years since the Malaysian Government issued the first bond, a $600 million issue. Since then, the market has grown rapidly with $16 billion issued last year, including two Dubai issuers: Nakheel, developer of the Palm island real estate and PCFC, the Dubai ports and free zone operator. So much pressure is building up from would-be issuers that Barclays Capital believes the $16 billion will rise by 50 per cent this year. In total, there is about $80 billion outstanding, of which half is Malaysian domestic bonds, with the remainder Gulf Arab issuers raising dollar funds.
According to Barclays Capital, less than half the buyers of Gulf dollar sukuk are Islamic institutions, which raises the interesting question as to why a non-Islamic investor should buy such specialised products.
The idea behind Islamic finance is that money has no intrinsic value and therefore no time value. Interest payments on money are forbidden and a lender is considered a partner in a business. So, Islamic loans are often structured as profit-sharing ventures and a common mechanism is ijara, a sale-and-leaseback of an asset. It could be real estate or an oil refinery, which is “sold” by the borrower to a special purpose vehicle, which then issues sukuk to fund the purchase and then rents the asset back to the borrower.
It is tortuous, but Islamic finance experts insist that the structure of an ijara sukuk ends up giving the same risks and rewards as a conventional asset-backed bond. Pricing is identical, although issuers pay for extra documentation for the Sharia approval process.
It is not entirely the same. There is no mechanism for default interest in a sukuk. There is a penalty for a defaulting issuer but it is paid to a charity, not to a borrower, because there is no recognised loss of value in late payment.
Why, then, are Western investors so keen to play this game?
There is an element of fashion that is flirting with novelty. No one knows what the underlying risks are in Islamic finance structures. There has never been a default on a dollar sukuk. The market is only a few years old, although expanding at a prodigious rate, but the institutions, the structures and mechanisms are entirely untested. The documents are mostly governed by English law but enforcement of a judgment in favour of a creditor would be down to local judicial institutions in the Gulf. There is little insolvency law in the region and virtually no precedent for the failure of a large company, utility or construction project.
What exists in the Gulf is an enormous fund of liquidity that is still looking for a home. Even as Western banks and funds are running shy of risk, the petrodollar funds are desperate for investment opportunities. The rent from oil at $90 per barrel is creating an embarrassment of riches and keeps the pricing of sukuk issues keen. Conservative estimates of the size of the Islamic wallet suggest that even a doubling of the rate of sukuk issuance would not satisfy demand.
For Western funds, Islamic bonds are an interesting play on the Gulf economy with potential access to equity. The Nakheel and PCFC issues are convertible into shares that will eventually be listed in public offerings on the Dubai stock exchange.
What would happen if a big sukuk issuer defaulted? You have only to ask the question to find the answer. Were a major Gulf construction, energy or leisure project to go belly-up, the repercussions would flow throught the Gulf like a tidal wave. The impact would be so severe that every effort would be made to prevent a default from becoming apparent. There would be favours granted and face-saving support mechanisms. Insolvency proceedings are almost unthinkable.
Behind most of these issuers is a sovereign guarantor, de facto, if not de jure. Ultimate ownership of the assets and major businesses of the Gulf remains with the Emir or the government and the idea that these entities could ever allow themselves to be associated with a bankruptcy is not tenable.
That gives less security than one might think. Ultimately, it is the fear of failure that keeps businesses solvent and in the runaway boomtown excitement of the Gulf, caution is a commodity sadly lacking.
Total change for French oil giant
The world is changing for Total, the French oil giant. For generations, the multinational and its sister Elf, which it swallowed in 1999, fulfilled their mission with the full support of government, keeping France fuelled and motoring.
Government assistance, in the past, was both explicit and covert. Elf, during the bad old days, was as much a diplomatic weapon as an oil company, running slush funds to influence ministers and foreign dicatators. Everyone understood that the job of filling France’s petrol tank was a dirty business, best left to the professionals.
Suddenly, the world has upended. President Sarkozy is calling for tough sanctions against Iran, where Total has investments, notably in South Pars LNG, a big gas development. The President seems oblivious to Total’s huge commercial interest in the country and is asking French companies to keep out while Iran pursues its nuclear ambitions.
Politics and oil were always closely linked in France, but not in this way.