Q&A: Sukuk market and oil

Mohieddine Kronfol, CIO, Global Sukuk & MENA Fixed Income Franklin Templeton Investments gives his outlook for 2016 on Sukuk market and oil.

1. What is your outlook on the sukuk market in 2016? 

Global Sukuk markets continue to be well positioned in the context of the global fixed income market, supported by an environment where growth is moderate, with multiple sources of risk and abundant liquidity. Global Sukuk markets continue to benefit from a strong and stable demand base, a steady stream of new issuers, and an exciting growth and development story that supports increasing diversification and potentially competitive risk-adjusted financial performance. Over time, global Sukuk could have risk and return characteristics that are unique to the asset class; able to perform throughout all phases of the business cycle.

For 2016, we tend to agree with the consensus view that global Sukuk issuance volume will be significantly below the last few years’ USD100 billion mark, perhaps up to 40% below, with the amount of global, investable Sukuk closer to the USD 30 billion mark. This will partly reflect the decision by Bank Negara to halt the issuance of short term domestic issues through public markets, as well as the difficult environment for emerging market and risk assets that may persist. Where we differ from consensus is the importance we place on issuance numbers. We view issuance volumes as one of many metrics with which to gauge the health of the Sukuk market, which in our view remains extremely constructive. 2015 was a very good year in terms of the quality and diversity of issuance. We saw Malaysia and Indonesia delivering on ambitious external Sukuk issuance, the first USD-denominated corporate issuer out of Indonesia from Garuda, the Hong Kong government issuing its second sovereign Sukuk under a different format to pave the way for local corporates to follow suit, and the GCC issuance pipeline bringing innovative structures and a variety of credits, such as the Emirates Airlines Sukuk backed the UK export credit agency. 

2. How much more sukuk activity will we see from oil exporting countries seeking to bridge their funding gaps, as a result of the drop in oil prices? 

We think we should see an increase in issuance from Sukuk issuing sovereigns as well as banks looking to shore up capital and address slower deposit growth. GCC governments have reacted to growing budget deficits with a mix of reserve drawdowns, subsidy cuts and reform, spending plan revisions and a more active stance with respect to bond and Sukuk issuance. Saudi authorities, for example, tapped the domestic debt market in June 2015, their first issuance in 8 years, and announced in October of the same year a SAR 20 billion Sukuk, which should significantly advance the pace of local and external Sukuk market development. Collective GCC budget deficits in excess of USD 100 billion will improve the outlook for issuance in 2016, and, in our view, trigger increased interest from local and regional investors that continue to harbor strong preferences for equity and real estate investments, often at the expense of their portfolios’ risk budgets. 

3. How much has investor appetite for Middle East debt been impacted by the drop in oil price? 

We would expect headwinds from lower oil prices, namely subsidy cuts, reduced spending and potential taxation, to work for the benefit of regional debt markets. 

4. Have the flows changed in the secondary, regional and global markets, since the drop in oil prices almost two years ago? 

The Sukuk market and related trading activity has been on an improving trajectory, supported by larger issues and a wider acceptance of Sukuk into the mainstream. Global fixed income markets, however, are increasingly moving out of the traditional broker dealer banking community, and into institutional investors, mutual funds and “shadow banking” participants, increasing the potential for systemic tail events or risks in the process. We do not think the risk is acute at the moment nor specific to Sukuk, but we do spend time thinking about potential mitigating factors and valuations.  

5. Will the cost of funding increase especially in oil exporting countries given the increase in budget deficit and shortage in liquidity in addition to the expected increase in the interest rates? How can these countries overcome these challenges? 

We see the potential increase in benchmark rates having the highest impact on the cost of funding given the currency pegs in place across the GCC. We would not describe the current situation as a shortage of liquidity in GCC banking systems even as we acknowledge that liquidity formation is significantly slower than the previous five years.  The region remains liquid and governments will be able to tap this liquidity through domestic issuance. We must not forget that governments can continue to draw on accumulated reserves to stimulate growth. With weighted average debt to GDP at less than 10% and accumulated reserves more than double GDP, forecast growth should be well above most developed markets and GCC bonds and Sukuk should continue to outperform most other fixed income sectors.