Development and Management of an Islamic Debt Portfolio

by Latham & Watkins LLP

With The Islamic Financial Services Board reporting that assets in Islamic finance are expected to reach US$2.8 trillion by 2015 and the continued growth of the global sukuk market, opportunities for investors abound.

Latham & Watkins associate Lee Irvine spoke on this topic at the second annual Borrowers & Investors Forum, Southeast Asia, which was held in Singapore in late 2013. In this Q&A interview Lee offers key takeaways from the discussion.

What does the growth of the sukuk market mean for investors? How can they benefit?

Lee: Estimates suggest that total sukuk issuances for 2013 stood at about US$120 billion. The growth of the sukuk market is great news for investors, since it allows investors to diversify their portfolio and invest in credit, such as Islamic institutions which only raised funds in a Shari’ah compliant manner, that they would otherwise not have access to. The Saudi Electricity Company (SEC) sukuk, for example, gave investors a rare opportunity to invest in a dollar deal from a quasi-sovereign Saudi Arabian borrower, at a time when the Saudi government doesn’t issue international debt.

What where the high-profile deals of 2013? What do these deals suggest about the future of the market?

Lee: We saw a number of landmark deals in 2013, several of which Latham acted on, that really set the scene for the sukuk market in 2014 and beyond. In April 2013, Saudi Electricity Company, the largest utility company in the Middle East, successfully issued the world’s first international 30-year sukuk. The sukuk, with an issuance size of US$1 billion and profit rate of 5.06 percent, was issued to investors in the Middle East, Europe, Asia and the United States as part of a dual tranche issuance pursuant to which SEC also issued a 10-year US$1 billion sukuk with a profit rate of 3.473 percent.

With the effects of the financial crisis still being felt by some companies in the Middle East, there has been a growing awareness in recent years of the advantages of longer term funding options, particularly among those entities that require funding for long-term infrastructure and energy projects.

However, there has historically been a market perception that, with respect to long-term sukuk, the education needed to convince conventional investors in the US to invest in sukuk was time-consuming, and had little guarantee of success. Therefore, while both Qatar Telecom (Qtel) QSC and the Government of Dubai issued debut 30 year conventional bonds in 2013 in order to fund their long-term infrastructure needs, these were both conventional issuances. The Sukuk issuance by SEC demonstrated the investor appetite for long-term Shari’ah-compliant paper. The SEC sukuk was issued to comply with US Rule 144A, which allows marketing to onshore clients in the United States and the US investors, to the surprise of some market participants, emerged as an important source of funding for the 30-year sukuk, making up 27 percent of the order book.

The SEC sukuk has provided assurance to the market that US investors are becoming increasingly willing to invest in longer term sukuk. The success and volume of interest shown by global investors in the inaugural 30-year international sukuk of SEC means that the issuance will no doubt be replicated by other companies in the Middle East and Asia seeking to obtain longer term financing.

One of the biggest developments in the sukuk markets during the course of the last year has been the issuance of innovative sukuk instruments to raise regulatory capital amid increasingly strict regulatory capital requirements in the wake of the financial crisis. This started with the issuance in November 2012 by Abu Dhabi Islamic Bank (ADIB), one of the world’s leading Islamic banks, of US$1 billion worth of additional Tier 1 capital certificates, which was the world’s first Basel III compliant Tier 1 Sukuk issuance and continued into 2013 with Dubai Islamic Bank, Saudi British Bank (an affiliate of HSBC) and Asya, the largest Turkish participation bank, amongst others, all raising regulatory capital through sukuk issuances. While a number of conventional banks have issued capital instruments, incorporating the required characteristics of Tier 1 and Tier 2 capital instruments into an Islamic context presents a number of additional challenges. However, the successful issuances of these sukuk have paved the way for other banks in the Middle East and Asia, both Islamic and conventional, to follow and shown that sukuk issued for the purposes of capital raising can generate significant investor demand among both conventional and Islamic investors.

Another high-profile deal on which we acted last year was the successful issuance of an inaugural US$1.25 billion Shari’ah-compliant sukuk by Ooredoo Q.S.C., the Qatar-based international telecommunications company. The five-year instrument was issued under Ooredoo’s US$2 billion trust certificate issuance program, which was established in November 2013 and was the first sukuk issued in the Middle East that utilized the innovative “airtime” sukuk structure. The transaction signifies the market’s increasing acceptance of intangible assets as the basis for Shari’ah-compliant sukuk issuances and therefore represents a significant development in the rapidly evolving market for Shari’ah-compliant products in the Middle East. The recovery of global credit markets and investors’ increasing acceptance of sukuk as a mainstream debt instrument have spurred progress in the use of intangible assets. Issuers have also arguably become ‘braver’ in the type of assets they are using as underlying assets as the credit markets heat up (after the 2008-2012 credit crisis forced caution amongst investors) and issuers have more scope to tap into broader markets. The increased use of intangible assets in sukuk structures should serve to widen both the base of issuers, and the frequency with which they can access the sukuk market, and we would expect this to further strengthen the sukuk market over the next few years.

During the last year we have also witnessed a growth in cross-border Islamic bond issuances, with Gulf issuers tapping Malaysia’s highly liquid sukuk market, the world’s biggest sukuk market which accounts for appropriately 65 percent of all sukuk issuances. On 24 April 2013, Al Bayan Group Holding Company was the first Saudi issuer to issue a Ringgit denominated sukuk, with the issuance of RM200,000,000 Sukuk Wakalah due 2016 under a RM1,000,000,000 Malaysian Ringgit Sukuk Programme established earlier that month (it was also the first Malaysian Ringgit Sukuk Programme to be established by a Saudi issuer). Al Bayan Group Holding Company went back to the Malaysian sukuk market to raise further funds in November 2013, this time with an issuance of RM120,000,000 sukuk. The issuance by Al Bayan Group Holding Company and other GCC issuers is part of a growing trend of foreign companies accessing the Malaysian market as the ringgit becomes a growing, credible alternative to the US dollar for non- Malaysian issuers, with the amount issued in ringgit worldwide now exceeding the amount issued by Malaysian issuers in all currencies.

Asian and GCC Sukuk markets are becoming more interdependent as the number of cross-border transactions between the regions picks up and this is likely to continue, as GCC issuers look to benefit from Malaysia’s large and diversified pool of investors and available liquidity. It is expected that this will lead to a greater convergence between the sukuk markets in the Middle East and Asia and a more consistent approach between scholars as to the acceptability of certain sukuk structures.

What developments do you expect to see in the sukuk market in 2014?

Lee: Standard & Poor’s Ratings Services recently stated that they believe the sukuk market is likely to sustain double-digit growth in the coming two to three years and we have already seen the first public sukuk issuance in Saudi Arabia this year, with SEC closing a SAR4,500,000,000 sukuk on 30 January 2014. Following on from the successful issuances in 2013, I expect to see more issuers tapping the sukuk market as a broader range of underlying sukuk assets become accepted, with strong growth in the number of sukuk issued with the intention of raising Tier 1 and Tier 2 capital, particularly by banks in the GCC and Malaysia. I expect that, following on from the success issuances by Al Bayan, we will also see a growing number of foreign companies accessing the Malaysian market as the ringgit becomes a growing, credible alternative to the US dollar for non- Malaysian issuers.

In terms of new developments, this year will be an exciting time for the sukuk market. I expect to see regulatory efforts to accommodate Islamic finance by those countries that have not already adopted such measures, with a corresponding growth in the number of issuances from countries that have not historically issued sukuk, including those within Africa. I also believe that we are likely to see the establishment of additional industry bodies at national levels as countries compete to become the leader in the multi-billion dollar sukuk industry.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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