With the unparalleled success of Malaysia’s second global sovereign Sukuk issuance, SCOTT WEBER delves into the complexities of the benchmark offering and asks if it will succeed in kick-starting a stagnant market.

Continuing from last month’s case study in Islamic Finance Asia (Vol 3 No 5 page 53) Malaysia’s second global sovereign Sukuk has defied downbeat market expectations, successfully capitalizing on an investor exodus from troubled European markets. The dollar-denominated 1Malaysia global sovereign Sukuk has returned confidence to the Islamic capital markets and ultimately highlighted the scarcity of such offerings in the global marketplace.

Joint lead managers and book runners at Barclays Bank, CIMB Bank and HSBC seized the first available window of opportunity amid turbulent market conditions. Operating within tight time constraints to ensure the best return, they successfully closed the final order book with a broad spectrum of 270 domestic and international investors and a combined order total approaching US$6 billion. For an industry vehemently against risk-taking, it was a calculated venture.

The bold move paid off, with the final offering amount increased to US$1.25 billion in order to reflect the strength of the order book and favorable pricing. At the order books close, the 1Malaysia Global Sukuk had been heralded as a towering success and should place Malaysia in good stead to continue as the world’s Islamic financial hub and leading Sukuk issuer.

Issue confidence

Despite downbeat market conditions, the offering achieved its benchmark pricing with relative ease. Priced at 180 points above five-year US treasury securities, the final pricing settled at an annual 3.93% fixed-rate and record low yield of 3.87%.

The issuances success was partly attributable to the geographical and institutional diversity of the investors. The joint lead managers and book runners were selected because of their strong conventional investor networks and aided by the issuances’ 144A/Reg-S status, allowing the paper to be traded in the US. The net was cast with a global reach to guarantee a favorable return.

Significantly, having 26% of the allocation taken up by Middle Eastern investors highlights an increased understanding of sovereign Malaysian risk, as well as a current dearth of such investments within the GCC.

Sovereign strength

The majority of sovereign Sukuk issued being asset based rather than asset backed means that payments to investors were ultimately dependent on the credit ratings of the obligor rather than the performance of the underlying asset.

Above all else, investors were looking beyond the rate of return from the rental of the 12 government-run hospitals that underpinned the offering. The assigned ratings of A- by Standard & Poor’s and A3 by Moody’s mirror Malaysia’s credit worthiness, liquid domestic capital markets and strong external position as an external net creditor.
Huge demand and low coupon rates for Malaysia’s sovereign bonds clearly reflect the confidence of global investors in Malaysia’s macroeconomic fundamentals. Emphasizing the increasingly proactive government strategies that ensure the Malaysian Islamic finance industry remains in a strong position to capitalize on returning market liquidity.

Market catalyst

With only one other international Sukuk issued in 2010, Dar al-Arkan’s US$450 million Sukuk, investors have been starved of a benchmark offering to reignite trading. Therefore, markets have remained in hibernation waiting for the storm surrounding the credit crisis to alleviate. With trading thin on the ground, borrowers were looking at extra premiums in order to attract investors to the specialist Islamic finance market, with looming concerns over sovereign guarantees.

Initial borrowing is benchmarked against sovereign debt. Seen as relatively risk-free, this pre-empts quasi-sovereign or state-owned entities to the market. Corporate borrowers then follow by offering similar offerings at higher yields to counteract the increased risk.

Standard practice for corporate issuance results in offerings between 30-50 base points above sovereign issuance. Without pertinent sovereign deals in the market it is increasingly difficult for the corporates to follow.

This is further compounded by major constraints surrounding the lack of market liquidity and a non-existent secondary trading market; a situation that can only be remedied through a critical mass of issuances led by sovereigns, corporates and financial institutions. As a result, Sukuk must also adapt and reform in order to meet borrowing requirements while improving market credibility by ensuring strong returns and investor confidence in a struggling sector.

The Sukuk market in the GCC is expected to remain stagnant throughout 2010, but will revive itself in 2011 as better economic conditions prevail. Because of a lack of money available in the market, Islamic finance once again has to court investors. Currently, credit tightness from the banks has meant that they are only willing to allow short-term borrowing. With the cost of financing currently very high, it will take a price fall for the Sukuk market to become appealing once more.

However, investors simply cannot sit on their money indefinitely and will eventually have to approach the markets once again. With the first green shoots of recovery showing, the market is expected to re-emerge in the latter stages of 2010 to recover in 2011.
Prevailing uncertainty

Lack of market stimuli, weighted down by low market expectations and a lack of investor return, has seen Sukuk issuance in 2010 drop. This is primarily due to prevailing uncertainty in domestic markets. However, as the markets begin to show signs of recovery, confidence is returning.

However, it has been commented that the Sukuk is failing to keep pace with the rest of the industry’s growth with estimates of only US$15 billion of Sukuk issued so far this year. It brings into question claims of the Islamic finance industry’s year-on-year growth rate of 15%.

As in previous years, Sukuk issuance has totaled US$23.3 billion in 2009, US$14.1 billion in 2008 and the record US$31 billion brought to market in 2007, according to Standard & Poor’s 2010 market outlook.

Last year, 75% of all Sukuk brought to market were by states and/or semi-sovereign entities, with governments alone accounting for 45% of that total.

Real impact

According to the Malaysian Finance Ministry, “the issuance was to serve as a profiling exercise for the further development of the domestic and international Sukuk market”, thus establishing a new US dollar-denominated pricing guideline for corporate fund-raising.

In other words, it was a pure marketing exercise for Malaysia, showcasing itself as the driving force of the Islamic financial world. Its issuance should allow 2010 to end on strong sector growth. However, a long-term issuance is still needed in the Sukuk market.

Malaysia is set to increase annual development by 23% to RM142.4 billion (US$44 billion) in 2015 as infrastructure projects previously shelved come online and require financing.

This is coupled with legislative measures in Saudi Arabia that will see the establishment of a domestic Tadawul Sukuk market. Driven by a proposed US$400 billion program of investment on basic infrastructure projects, the future looks bright for future Sukuk issuances.

Ultimately, since its debut issuance in 2002, Malaysia has led Sukuk issuances across the board and is forecasted by the government to grow 6% this year, after shrinking by 1.7% in 2009.

Where Malaysia and Saudi Arabia lead, the Islamic finance industry will follow.