Islamic bonds were the 1950s-era Elvis Presleys of Gulf finance a few years ago: young instruments that seemed poised to usher in an exciting new way of thinking. Over time, they would change how companies and governments raised money, seed previously non-existent regional debt markets and exploit an untapped population of rich Muslim investors who baulked at the interest payments built in to conventional bonds.
Sukuk, as the bonds are called, played a catchy tune. At around the time the industry started to rapidly expand in the Gulf in 2004, there were about US$5 billion (Dh18.36bn) worth of sukuk issued worldwide annually, mostly in Indonesia and Malaysia. And as DP World, Dubai's global ports operator, and Nakheel, the property developer behind the emirate's Palm islands and World archipelago, jumped into the fray in 2005, 2006 and beyond, the sukuk's ascent to stardom appeared assured. By 2007, more than $31bn of sukuk was issued globally, according to Bloomberg figures.
The first real test for the industry in the Gulf came in November 2007, when Muhammad Taqi Usmani, a Pakistani cleric and prominent Islamic economist, said most sukuk were not, in fact, in compliance with Islamic law. Sukuk, as many people in the industry had privately acknowledged, used clever strategies - lease and repurchase agreements on property assets in most cases - to get around charging interest. They were bonds by another name, Mr Usmani said.
The pronouncement did not seriously curtail sukuk issuance but it did inject a new element of risk. If powerful standards-setting boards such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) in Bahrain eventually agreed with Mr Usmani, dozens of Islamic banks and other institutional investors in the region who heeded the body's rulings could be forced to sell.
And if the perception was that scholars could suddenly rule sukuk non-compliant, markets had to reflect that, pushing prices down and yields up. Another problem from the start was the way sukuk were advertised to investors. They were often billed as "asset-based" because of the property transactions embedded in the calculation of "profits", the Sharia-compliant equivalent of interest. But the presence of those assets in sukuk documentation was a mirage of sorts: in most cases, investors could not actually seize them if the issuer defaulted.
"Asset-based" sounded suspiciously similar to "asset-backed", an adjective commonly applied to bonds and other securities where investors do have recourse to a pool of underlying assets. "I would call it form over substance," says Khalid Howladar, a senior credit officer at Moody's Investors Service. "The ethical principles of Sharia say you should have a tangible share of an asset, vis-a-vis in conventional finance where you have a share of a debt. The real value of sukuk is that you have something backed by assets, so if you're an investor, in theory you're buying a share in something real."
The lack of "something real" behind sukuk was exposed when companies started to default on them. The Investment Dar, a Kuwaiti investment company, was first to default on a $100 million sukuk last May. It was followed by a default by the Saad Group, a struggling Saudi conglomerate, on a $650m sukuk. As investors started to digest their limited rights, chatter surfaced about a move to structures more explicitly backed by assets, much like sukuk from Tamweel, a Dubai-based mortgage provider that issued securities backed by home loans, and Sorouh, an Abu Dhabi-based developer that backed an issue with property. Both of those asset-backed sukuk have performed well during the global downturn.
The defaults in Kuwait and Saudi put a strain on the young industry but the real test was to come in December, when a $3.52bn Nakheel sukuk was due for repayment. Nakheel would have found such a large payment a challenge at a time when Dubai property prices had plummeted, many of its projects were far from completion and refinancing was out of the question. Speculation had it that the Dubai Government would repay, since no restructuring talks had been initiated over the summer. But in November, Dubai World, Nakheel's parent company, announced it would seek a payment standstill on its debts and restructure them.
Abu Dhabi eventually came to Dubai's aid, helping line up billions of dollars in financing for Dubai World and Nakheel and avoiding a sukuk default unprecedented in size and scope. Indeed, many analysts speculate that that assistance came partly out of concern over the survival of sukuk and the effect a $3.52bn default could have on Islamic finance in the region. Investors in three sukuk issued by Nakheel were repaid in full and on time under Dubai World's debt restructuring proposal, by far the best treatment any class of creditors received.
The resolution of Nakheel's sukuk, however, has not breathed life into the Islamic debt markets. Global sukuk issuance got off to a strong start this year but has since slowed. The total value of sukuk raised this year is likely to be about half of last year's $20bn. And it isn't at all clear what would spur a comeback. Would clearer Sharia rulings help? Would asset-backed sukuk prove popular? Is a resurgence in the world's largest economies needed first?
Sukuk in the Gulf, in other words, stand at an inflection point. Their ascension once seemed inevitable but now the question is: is this a minor hiccup in a stellar career - or a Vegas-era Elvis crooning his swan song? firstname.lastname@example.org