There are often articles written on the Islamic finance sector highlighting the exponential growth in the market, but are we paying enough attention to the range of products being offered to institutional as well as retail users? There seems to be little reference to the product range, which could potentially add value to the real Islamic economy by way of providing efficient methods of managing risk, saving, investing and borrowing. Jamil Mufti writes.
While equity funds have been in the Islamic market for quite some time, and setting up such a fund from a conventional framework is relatively easy with the use of an Islamic screen, fixed income funds have taken longer to penetrate the market. There are a number of reasons why Shariah compliant fixed income has taken longer to evolve, mostly stemming from a lack of assets and structures: sukuk, commodity murabahah, wakalah and profit rate swaps.
The Islamic fixed income space deserves particular focus as the evolution and depth of this market can improve liquidity management in the banking sector, portfolio diversification, investment of Takaful premiums, pension investments, and provide an alternative means of funding for issuers. The asset management industry has seen an increase in funds but inflows from both Muslim nations and pools of Islamic liquidity in foreign nations have the potential to increase as the asset class gains more recognition and Muslims become more aware of their obligations in financial management.
The growth of the sukuk market was stunted in its early years as structures had to be approved by Shariah boards and then issuers had to agree to borrow in an Islamic structure. Shariah boards have also been quite dislocated in the past due to regional differences in the interpretation of Shariah. However, in recent years the Shariah framework has become more cohesive with the help of regulatory bodies such as AAOIFI.
On the supply side, the impeding factor for issuers has historically been the costs surrounding a sukuk issue, as structuring such an issue is an added cost, while it was often the case that sukuk were issued at a premium to their conventional counterparts. This, however, is no longer the case and costs have decreased markedly making sukuk a real alternative source of funding, one which increases the size of an issuer’s funding base, as both Islamic and conventional investors can buy sukuk. The realisation of a wider investor base may also be the reason that sukuk now trades on par with its conventional counterpart.
Commodity murabahah and wakalah have helped the interbank lending market but have also added another method of effectively implementing a short duration or money market strategy, along with short-dated sukuk. Profit rate swaps have in recent years allowed for Islamic portfolios to hedge their exposure to market rate risk, but documentation remains a hurdle as bilateral agreements between counterparties can become lengthy processes. However, the International Islamic Financial Market has taken steps to standardise the documentation framework which is a step in the right direction.
The type of sukuk fund available is limited, not surprisingly, as the size of the market still remains small relative to the conventional world. The basic distinction is between short-dated liquidity funds and global funds, but there is scope to diversify the type of funds as the issuer-base increases, depending on investor risk appetite and current themes. In the last few years a number of debt issuers have come to market helping to diversify the geography, credit quality, and duration of the sukuk market.
Performance characteristics of sukuk funds show that they tend to be less volatile than conventional funds as Islamic investors are not generally quick to sell as reinvestment risk is high. The market is also not as skewed as it once was, so the US dollar sukuk market’'s GCC exposure has been diluted and is able to hedge (to a certain degree) the fall in the price of oil. However, in a world that is still reeling in global quantitative easing, yields are fairly low with credit quality having improved since the 2009 real estate crisis in Dubai.
As alluded to earlier, the sukuk market has many uses, but is still not benefiting many parts of the Islamic financial system such as the Takaful and pension market. This is mostly due to the relatively small size of these industries and the stigma attached to the sukuk market being illiquid. Although the modern Islamic market is still in its infancy, there is a will to expand the market. Both nations and companies need to fully understand the benefits of issuing in the sukuk format, regulatory authorities need to effectively implement the standardisation of profit rate swap agreements, and the retail market needs to be made aware that there is an Islamic alternative to investing.
Jamil Mufti is the portfolio manager with the Bank of London and The Middle East.
This article first appeared in Islamic Finance News (14 October 2015, Volume 12, Issue 41, Page 25). For more information, please visit the website at www.islamicfinancenews.com.