Sukuk or Islamic bond financing still has the reputation of being a niche product. Despite this, it is showing signs of becoming a mainstream option to finance infrastructure projects.
The origin of the niche product comes from the fact that sukuk are inherently an alternative. Sukuk permit bond-like financings to be structured in a way that is compliant with shari’a law. (The singular form is sakk, meaning certificate.) With the growth of Islamic finance generally, sukuk generated a significant amount of interest in the early to mid-2000s, but suffered a decline after the twin blows of the worldwide financial crisis and the influence of Islamic scholarship that criticized the structures used at that time for their lack of adherence to Islamic principles. As markets have slowly recovered, interest in sukuk is once again growing.
This article describes what sukuk are, who is interested in them, how typical sukuk that might be used in project finance are structured, some inherent risks and mitigation mechanisms and key trends to watch.
Among recent developments of note, a consortium of two Australian solar companies announced that it will fund the first 50 megawatts of a planned 250-megawatt solar project in Indonesia entirely through sukuk issued in Malaysia that will include construction financing. Also of interest to the market is the joint venture between Saudi Aramco and Total that successfully launched sukuk financing with a 14-year tenor for the greenfield development of the Jubail oil refinery in Saudi Arabia. In April this year, Sadara Basic Services Company issued 15.75-year sukuk that were equivalent to US$2 billion in size to finance part of the development of a chemical and plastics production complex in Saudi Arabia.
These changes come at an opportune time. The Gulf Cooperation Council (GCC) nations have a large pool of underutilized sovereign capital. Islamic finance structures are an obvious fit for the region. There is a confluence of a generally-acknowledged need for infrastructure development and increasing political support for the development of Islamic finance as an alternative to conventional finance. The Emirate of Dubai in the United Arab Emirates has recently launched an effort to develop a vibrant sukuk market to rival those of financial centers with a longer track record of sukuk — particularly Malaysia and fellow GCC member Bahrain.
To date the absolute number of sukuk issuances remains a small proportion of bond issuances. But with some peaks and troughs, the trend is generally upwards. Issuers claim that recent sukuk issuances have been heavily oversubscribed — in some cases by as much as three and a half times — and that it is a lack of offerings that is holding up the market, not lack of demand.
Interest in Sukuk
Islamic investors with a mandate to invest in investment opportunities that comply with Islamic principles are the most obvious market for any Islamic product. But Islamic investors are by no means the only market for sukuk issuances. Issuers report that conventional investors have shown an appetite for sukuk. The most cited reason is that sukuk offer a means of diversification. Some conventional holders report being comforted by the fact that the Islamic banks who invest alongside them tend to hold their investments until maturity, creating a more stable investment for everybody else.
So-called ethical investors are an additional