Issuers are becoming more creative in enticing investors. Convertible Sukuk, as NAZNEEN HALIM learns, is an option which is very much relevant in today’s bond market.

No matter how sophisticated a structure or instrument is, it always boils down to one factor – attraction. Issuers and market makers innovate according to market needs and wants, and in the fiscal universe, markets needs are aplenty.

A relatively new instrument to make an entrance into the world of Islamic bonds is the convertible Sukuk, which basically allows issuers to redeem their bond certificates for a portion of shares in the relevant offeror. If no qualifying public offer takes place within two years of the conversion, holders are compensated by a higher return.
Even in conventional markets, convertible bonds are rare. This is because the possibility of a future initial public offering (IPO) is uncertain, which inevitably translates to more structural complexities when the Shariah is involved.

Risky business?
It is a known fact that uncertainty, or Gharar, is an unwelcome factor when it comes to Islamic financing. Therefore, how do convertible bonds even come close to complying – due to the fact that they are based on the possibility of a future IPO happening – which could, in the real economy, remain just a possibility?

According to a Dubai-based lawyer, the structure of a convertible Sukuk is such that the conversion of the trust certificates is contingent, and the identity of the company into whose shares the certificates convert are made known to investors before the option is exercised, therefore eliminating any sort of uncertainty. Also, issuers are beginning to see increasing demand for IPOs in places such as the Middle East, thus creating more room in the market for convertible issuances.

Debut issuance
In 2006, the Islamic bond market saw its first convertible Sukuk in the form of Ports, Customs & Free Zone Corporation (PCFC)’s US$3.5 billion Sukuk Musharakah, which paved the way for future issuances such as Khazanah Nasional’s US$750 million exchangeable Sukuk and Nakheel’s massive US$3.52 billion issuance.

The PCFC convertible Sukuk Musharakah entitled investors to convert up to 30% of their equity shares of various PCFC entities in the event of future qualifying public offerings (QPO) within two years of the Sukuk issuance. Investors were also guaranteed a higher compensation should a QPO not transpire, or the option of exercising a “look-back option” which buys them an extra 12 months to participate in a QPO after the Sukuk’s maturity. According to a source close to the deal, the Sukuk particularly targeted Islamic investors in the GCC to fulfill growing demand.

However, not all is rosy when it comes to convertible Sukuk. When the credit crunch hit, Nakheel’s massive issuance was teetering on edge. The Nakheel bonds, which are part of its parent company Dubai World’s US$26 billion debt caused panic within the global investment community when news of a potential default arose. However, a lawyer close to the deal revealed that the bond’s structure is not the main factor behind this.

Phillip Lotter, senior vice president at Moody’s Investors Service commented: “Any kind of asset recovery by foreigners in Dubai is going to be extremely difficult and ultimately is going to be something that creditors would want to avoid. It has not been tested and you have a legal system that never had to cope with these kinds of questions.”

In recent weeks, however, bond holders have seen progress in the fate of the Sukuk, with Dubai world’s announcement that the bonds will be repaid in full and on time. Following the announcement, the value of both Sukuk surged by 25%, currently trading at 96.5% and 92.25%.

Market players anticipate more demand from investors for convertible Sukuk in the coming years, following these landmark issuances. Apart from the GCC, Europe is expected to give rise to more investors interested in such structures. The future, they say, is bright for this instrument.