What fundamentals are driving the renewed interest in Islamic finance? After all, it is not a 'new' phenomenon and studies estimate that there are billions of dollars in assets already managed in accordance with Shariah principles globally.
Ongoing liquidity issues in the US
In the aftermath of the collapse of Lehman Brothers and the financial crisis that followed, the US Federal Reserve pumped trillions of dollars into the US economy as a stimulus. If the economic commentators are to be believed, this has had little or no effect and the US remains in a 'liquidity trap', with historically low interest rates failing to stimulate investment and investors hoarding cash. In an environment where cash returns are negligible, Sukuk present an interesting opportunity for investors seeking to diversify.
Meeting of the minds
It seems that funds are fl owing into Sukuk by virtue of a 'meeting of the minds' between issuers (sovereign and corporate) who require long-term development capital, and western institutional investors (such as US pensions and investment funds) which typically have long-term investment goals and a preference for fixed income returns. Asset allocators now have significantly more research available by which to benchmark Sukuk as an asset class in their own right rather than simply an exotic distant cousin of the traditional bond.
Recent studies have sought to make a more forensic analysis of Sukuk by comparing their performance against a corresponding sample of conventional bonds with similar risk profiles in similar markets.
Unlike conventional bonds, Sukuk derive their value from underlying tangible assets, meaning they may often use cash flow and valuation models different from those adopted in conventional bonds. This might enhance their attractiveness to investors in highly intertwined Western economies.
Clarification of Shariah Principles
With the increased interest in Sukuk has come a better understanding of the Shariah principles that underpin their structure. The misconceptions that were once widely held about the nature of 'Islamic law' and its application to finance are now falling away. The role of the financial services sector in analysing and disseminating this information for Western economies has been crucial. Post-2008, institutional investors in the US and other mature economies, wary of having been burnt by previous investments, have been eager to avoid the same mistakes. An increased emphasis on due diligence and the growing investor appetite for alternative investments has produced a body of information and analysis in the market which can be easily accessed and digested by prospective investors. These information flows are laying the foundation for a wider acceptance and understanding of Sukuk and the underlying Shariah principles.
A safer harbor?
It is not surprising to see the comparisons drawn between conventional bonds and Sukuk from an investment perspective, despite the fundamental principles underlying each being markedly different. A deeper understanding of Shariah principles has however led to Sukuk being variously described as an 'ethical investment' in many commentaries. This is a useful comparison on various levels. Both conventional ethical investments (such as impact investments, microfinance initiatives and investments in clean tech or green energy) and Shariah compliant investments (such as Sukuk) emphasize moral and social principles. Both also emphasize the value of good and sound governance and its role in the responsible deployment of capital. This is particularly interesting as it comes at a time when many in the US and across other developed economies still attribute blame for the financial crises of recent years to moral, ethical and governance failures in the banking industry.
An access point for emerging debt capital markets
The debt capital markets of emerging economies have continued to mature as the number of bond issues continues to grow each year. Historically, the vast majority of emerging market issuers were sovereigns, but in recent years the issuer base has broadened and the quality and credit rating of corporate issuers now suggests that those debt capital markets are maturing at an increasing rate. Improvements to the legal and regulatory infrastructure of the financial markets in many emerging economies, combined with a willingness to adopt a more robust approach to prudential supervision, has increased the confidence and appetite of US and western institutional investors. Increasingly, Sukuk are becoming a proxy for investment exposure to the debt capital markets of emerging economies. Sukuk issuances by countries as far afield as South Africa, Luxembourg and Hong Kong would suggest international investor appetite is indeed well matched to domestic financing needs in the current market.
Cayman is uniquely placed to fortify its reputation as the pre-eminent jurisdiction for incorporation of issuers, particularly for Sukuk originated in the US. The Cayman government has previously proven itself to be flexible and open to Islamic instruments and we anticipate that this trend will continue in light of their increasing popularity.
The foregoing discussion and analysis is for general information purposes only and not intended to be relied upon for legal advice in any specific or individual situation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.