Infrastructure, debt, and the Islamic Bond
by Karen Lane
The Wall Street Journal
WHEN TEXAS-BASED energy firm East Cameron Partners wanted to raise cash this year, it turned not to banks or the domestic bond market, but to the Middle East. The result was the first bond backed by U.S. assets that adheres to Islamic laws against paying or charging interest. “I had never heard of sukuk before,” says Campbell Evans, the Houston company’s general manager, using the Arabic name for Islamic bonds. “I got a book [about it] and it seemed Byzantine. But at the end of the day, it worked for us.”
Islamic financing differs from conventional financing in its strict adherence to Shariah, or Islamic law, which calls for ethical and equitable financing, and bans speculation. Conventional bonds issued by companies or governments pay a fixed annual interest rate for the life of the bond, which can be as many as 10 or even 30 years, after which the principal is repaid. Some bonds are backed by assets such as mortgages or creditcard receivables. If the issuer defaults, the assets are sold to recoup some bondholder losses.
Sukuk are similar to asset-backed bonds, but instead of a fixed annual interest rate, payouts to investors over the life of the bond are derived from leases, profits or sales of tangible assets such as property, equipment or a joint-venture business. These leases, profits or sales can be structured to deliver the equivalent of a fixed annual interest rate, yet they technically aren’t the forbidden “interest” payment.
Western and Asian companies and governments are increasingly using Islamic bonds to tap a well of petrodollars in the Middle East. A rising queue of Persian Gulf-based borrowers are doing the same to raise cash overseas, particularly for large infrastructure projects needed to diversify their sources of economic growth.
As a result, the Islamic finance market is swiftly expanding globally. With both Islamic and conventional banks seeking a piece of the action, it is building bridges between Muslim and non-Muslim nations. According to London’s Islamic Finance Information Service, $16.9 billion in sukuk was issued between January and October this year, 43% more than the total in 2005. Analysts say there is easily $10 billion in the pipeline for the next few months. The market is relatively tiny. In the first half of 2006,new sales of international bonds and short-term notes totaled $1.2 trillion, according to the Bank for International Settlements.
New rating and hedging tools are expected to help the Islamic bond market expand faster. East Cameron Partners, Mr. Evans’s Houston energy firm, raised $166 million in its July issue to consolidate assets and fund development of gas fields. “The sukuk represented over and above what might be available in America in terms of being able to raise the cash at relatively lower coupons,” or payouts to investors, Mr. Evans said. “An Islamic bond would be easily placed with conventional investors, which can widen the investor base, whereas the opposite isn’t true,” said Roula Sleiman, senior associate at Lebanon’s Bemo Securitization SAL, which arranged the deal with Merrill Lynch & Co.
Malaysian borrowers, including state-owned investment company Khazanah Nasional, have marketed Islamic bond deals in the Middle East. So has the Pakistani government, selling $600 million in bonds in 2005. In Japan, Bank of Tokyo-itsubishi UFJ Ltd., the core banking unit of Mitsubishi UFJ Financial Group Inc., is allying with Malaysian bank CIMB Group Bhd. to sell financial services, including potential Japanese corporate sukuk. Islamic communities in the Gulf for centuries have looked close to home to raise capital. Now they are looking farther afield for Shariah-compliant funds to finance projects aimed at transforming the region into a tourism and business hub.
Dubai Ports, Customs and Free Zone in January sold 11% of its $3.5 billion sukuk—the largest ever—to European investors. Around half went into the hands of non-Islamic investors. “In the next two to three years, Bahrain, Kuwait, Qatar, Saudi Arabia, the United Arab Emirates and Oman are looking at more than $50 billion in [infrastructure] financing. I would say 30% of the $50 billion is likely to emerge as sukuk,” said Rafe Haneef, head of Islamic banking at Citigroup Inc. in Kuala Lumpur.
Banks, particularly in the Gulf, are loath to overexpose themselves to the property sector, while developers find that aping the stock markets is more expensive than raising debt. “Infrastructure is a perfect use of sukuk because you are raising funds that
are to be used for a specific project. Assets that you create can generate a return” to pay bondholders, says Neale Downes, a partner in Bahrain with law firm Trowers & Hamlins.
Borrowers outside the Middle East have made this discovery, too. Next year, China is expected to issue its first sukuk when Kuwait Finance House targets the Persian Gulf with a $200 million deal for a Chinese government-linked power company. Indonesia is in the midst of revising tax and other regulations to support both sovereign and corporate Islamic-bond issuance. One of the first sukuk to come to market could be a $650 million deal from Jakarta Monorail, aimed at easing the Indonesian capital’s gridlocked transport network.
Some Islamic borrowers are opting to list their deals outside their home jurisdictions. “Listing on a European exchange like the Irish Stock Exchange makes secondary trade easier from a regulatory point of view for European institutions,” says Gerard Scully, head of debt listing at the Dublin exchange, which last month got its first sukuk listing and is pitching for more. The London and Luxembourg exchanges also list sukuk.
There is geopolitical upside to the proliferation, observers say. It “gives people the chance to learn something positive about Islam, and it counters negative issues in other areas,” says Rodney Wilson, professor in the Institute for Middle Eastern and Islamic Studies at the United Kingdom’s Durham University. Cross-border sales of sukuk are prompting greater harmonization in the way the bonds are structured. Malaysia in the past has favored bond structures that don’t comply with the Middle East’s interpretation of Shariah, notably the deferred payment sale principle of bai’ bithaman ajil—whereby a bank buys an asset on behalf of a customer and sells it later at cost plus a profit margin.
In recent years, however, the Malaysian government has offered tax breaks to encourage the use of more globally accepted structures in a bid to become an Islamic financing hub. One is called the lease-based, or ijarah, structure. Say a petrochemical company wants to raise $350 million. It would sell a plant to a special-purpose company set up for the deal and then lease it back for five years. Investors or banks would lend the company the $350 million. Instead of interest payments, the investors would get proceeds from the lease payments. After five years, the special-purpose company returns the plant to the parent company, and the principal $350 million is returned to the investors.
Another globally accepted structure is called musharakah, a joint venture. The venture’s partners buy Islamic bonds and receive payments over the loan period based on the plant’s profit. In September, Malaysian toll-road operator Plus Expressways set a precedent by swapping outstanding 4.7 billion ringgit ($1.3 billion) in bai’ bithaman ajil debt for Persian Gulf-compliant funding to make the company eligible for inclusion in global Shariah stock indexes. “If you can commoditize products, your cost of issuance comes down,” said Mr. Downes of Trowers & Hamlins.
Cross-border investment should get a further lift from the use of credit ratings. The year-old Islamic International Rating Agency has developed Shariah Quality Ratings, designed to help Islamic investors better judge the standard of Shariah endorsements of an instrument or issuer.
Another catalyst for growth should be global standards for Shariah-compliant derivatives— financial products designed by investment banks to hedge the risk of Islamic debt. New York’s International Swaps and Derivatives Association and Bahrain’s International Islamic Financial Market are engaged in talks aimed at agreeing on such basic standards.
Adherence to Shariah prevents Islamic investors from using conventional hedging tools—interest-rate swaps, forwards or options—to offset fluctuations in interest rates and currencies. The few tailor-made hedging tools now in use have concentrated such risk into the hands of a small number of investors. Global standards would help spread it more evenly, bankers say. “For the Islamic market to exist in the proper manner, it must have all the relevant products that befits the financial market.
For every single conventional product, you want to have the equivalent Islamic product,” says Badlisyah Abdul Ghani, head of CIMB’s Islamic division. Bid Lifts Delta Air Lines Bonds US Airways Group’s announced intention to buy Delta Air Lines when it exits bankruptcy court drove up the price of its bonds Wednesday, a sign some creditors gave the plan an enthusiastic thumbs-up. After being rebuffed by Delta executives this summer, US Airways has brought its proposed purchase of the air carrier to the company’s many creditors by offering them $4 billion in cash and 78.5 million US Airways shares, for a total $8 billion based on Tuesday’s closing price of US Airways’ stock.
Those holding the company’s distressed bonds rejoiced in the idea. Delta’s 7.9% bonds due 2009 rose 21 points, or cents on the dollar, to trade at 61.5 cents on the dollar, according to MarketAxess, an online trading platform. The 8.3% notes due 2029 rose 21.56 cents to 61.75 cents on the dollar, MarketAxess showed. Those notes were the most actively traded Wednesday. Shareholders also cheered. US Airways shares rose $8.57, or 17%, to $59.50 as of 4 p.m. in New York Stock Exchange composite trading. “The prospect for everybody would be better because you’d have these companies combining and forming a much stronger entity which would eliminate redundancies,” said Margaret Patel, a portfolio manager at Pioneer High Yield Fund. “The prospect for recovery for bondholders would be improved.”
The elimination of overlaps from the merger, in flights and gates at both airlines for example, would allow for cost cuts that could strengthen both carriers’ operations, market participants said. US Airways said it believes the combination would generate at least $1.65 billion in annual synergies. A potential US Airways and Delta tie-up also lifted the bonds of Northwest Airlines, which like Delta is in bankruptcy protection. Its 10% bonds due 2009 were up 11.5 points to 78.28 cents on the dollar, according to MarketAxess. Treasurys Slip on Factory Data Robust New York-area manufacturing data knocked Treasurys lower Wednesday, and meeting minutes from the Federal Reserve’s latest policy-setting gathering ensured that the market ended in negative territory.
Most of the damage done to the market was done early, and it struck most hard at the short-dated issues on the yield curve. The Fed minutes exacerbated the slide. The lost ground helped push further into negative territory the spread between short- and long-dated Treasury yields, with the difference, -0.20 percentage point, at its widest point in nearly six years. At 4 p.m., the benchmark 10-year note was down 11/32 point, or $3.4375 per $1,000 face value, at 100 2/32. Its yield rose to 4.619% from 4.576% Tuesday, as yields move inversely to prices. The 30-year bond was down 16/32 point at 96 28/32 to yield 4.697%, up from 4.666%.
—Cynthia Koons and Michael S. Derby contributed to this article.
© 2006 The Wall Street Journal: