The Islamic bond market is likely to see a surge in subordinated debt next year as Islam-compliant banks seek capital to match their fast-growing assets.
This blossoming in bank-capital sukuk, or Islamic-bond, issuance should add a higher-yielding dimension to the senior unsecured paper that now dominates the Islamic market.
“I think the next level for the sukuk market will be hybrid, or subdebt, instruments which will help Islamic financial institutions establish efficient capital structures,” said Arshad Ismail, head of global sukuk at HSBC Amanah.
The Islamic banking division of the HSBC Holdings Ltd. was the leading bookrunner for sukuk issuance in the third quarter, according to the London-based Islamic Finance Information Service.
Islamic banks conduct their activities in line with the Quran. Sukuk are structured to comply with Islamic law, which, for example, bars interest. Instead, such bonds make coupon-style payments derived from underlying assets.
Regulators require the growing number of Islamic banks to set aside a minimum amount of capital, like their conventional counterparts, as a cushion against adverse events. Subordinated bonds, which rank below senior bonds, are the cheapest form of bank capital.
Subordinated bonds are commonplace in developed bond markets around the world, but the Islamic bond market has so far seen only one internationally acceptable bank-capital deal. Malaysia’s Malayan Banking Bhd. raised US$300 million in April for its new Islamic bank.
Maybank’s deal — seven times subscribed by investors from Asia, Europe, and the Middle East — was backed by hire-purchase contracts for goods, such as cars, that are compliant with the Islamic legal code, or Shariah. Mr. Arshad said deals could mimic that structure.
Behind the expected blossoming in bank-capital sukuk is a dramatic expansion in balance sheets at Islamic banks as more of the world’s 1.2 billion Muslims turn to banks that conduct business in compliance with their faith.
The General Council of Islamic Banks and Financial Institutions estimated assets at Islamic banks and in Islamic windows of conventional banks at $450 billion in 2005, and most agree that growth has been dramatic since then. Reliable numbers are hard to come by, however. Banks have been set up in and outside the Islamic world, and Shariah-compliant banks are broadening their range of products.
The growth should continue. In Malaysia, Islamic banks account for around 12% of total banking assets, and the central bank aims to boost that to 20% by 2010.
As assets expand, capital efficiency becomes increasingly important. Bank capital — typically set at a minimum of 8% of risk-weighted assets — is traditionally made up largely of shareholder equity.
Under current Bank for International Settlements rules followed by most countries, Islamic and conventional banks can issue a limited amount of cheaper Tier 2 and hybrid Tier 1 subordinated debt, which is faster to issue than equity.
In the conventional market, investors tend to like such paper because the subordination means they get an additional yield pickup with relatively little extra risk.
Bankers say it is possible conventional banks could also start tapping the subordinated-sukuk market to diversify their investor base and, potentially, gain cheaper funding than they might in the conventional bond market.
Either way, subordinated sukuk will add a fresh dimension to a market that is expected to expand again next year.
Malaysia — the source of around 62% of outstanding sukuk, but being chased by Persian Gulf states — will continue to be important in Asia. The Indonesian government next year could sell its first international sukuk.
A number of nations where Muslims don’t make up the majority could also throw their hats into the ring. The U.K., Japan and Thailand, for example, are working on paperwork to sell sukuk.
Issuance from the U.S. — where only one company has tapped the sukuk market — is likely to be essentially nonexistent, largely because the highly liquid local market provides no incentive to look elsewhere.