Last week, volatility rose again when on Friday, US Federal Reserve chairwoman Janet Yellen reiterated that rates would likely rise before the end of 2015 despite its earlier delay on emerging market growth concerns. While developed markets are seeing some slowing growth as a result of Chinese economic worries and slower inflation because of dramatic falls in commodity prices, these factors are only temporary. While last week, we noted that the delay by the Fed provides some breathing space for emerging markets to regain their footing, Chairwoman Yellen’s most recent comments suggest that this window is likely to be short.
IFFIm sukuk provides introduction for social responsibility-focused investors on Islamic finance
By Michael Bennett, Head, Derivatives and Structured Finance, World Bank
In the wake of the global financial crisis, interest in more ethical forms of finance has increased. The two fastest growing areas of ethical finance are Islamic finance and investment funds that follow sustainable investing standards. While these two areas have been largely distinct – involving different investors in different geographic regions – the International Finance Facility for Immunisation (“IFFIm”) has issued two sukuk in less than a year that have brought these two investor groups together.
IFFIm is an international organization that finances immunization of children, and related health systems strengthening, in the poorest countries of the world through Gavi, the Vaccine Alliance. Backed by financial support from nine sovereign governments, including the United Kingdom and France, IFFIm raises money in the international capital markets. This funding activity is handled by the World Bank, as IFFIm’s Treasury Manager, under the direction of IFFIm’s volunteer Board of Directors.
IFFIm issued its first sukuk in December 2014. That sukuk, a three year, $500 million issue, was the largest debut sukuk ever by a supra-national entity. This transaction, which was referred to as the “Vaccine Sukuk,” brought the concept of sustainable investing to the sukuk market. It marked the first time most sukuk investors ever had considered a transaction that provides both economic and social returns – it paid a competitive rate of return while also supporting the cause of child immunization in the developing world.
IFFIm’s inaugural sukuk was warmly received by the market and won numerous awards. The success of the issue led IFFIm and the World Bank to decide to return to the sukuk market again in September, 2015. While the marketing of IFFIm’s debut sukuk largely involved introducing sukuk investors to sustainable investing, for its second Vaccine Sukuk , the issuer also made a concerted effort to introduce the sukuk product to conventional sustainable investors. In many cases, those investors were considering a sukuk for the first time.
The second Vaccine Sukuk was joint lead managed by Standard Chartered Bank (which also acted as Global Coordinator), Emirates NBD, Maybank, National Bank of Abu Dhabi and NCB Capital. In addition to this very strong lead manager group, IFFIm also brought in two international banks with a dedicated sustainable investment focus, Morgan Stanley and Credit Agricole, to act as co-lead managers specifically to focus on bringing conventional sustainable investors into the transaction. This effort involved providing significant education to the investors on the nature of sukuk and an explanation of the underlying transactions that are necessary to make the structure Shariah compliant.
While the economics of the Vaccine Sukuk mirrored those of a floating rate note, the sukuk structure itself was new for most sustainable investors. In particular, they needed to understand the use of a special purpose vehicle (“SPV”) issuer in a sukuk structure. Many conventional investors equate an SPV issued security with an asset-backed securitization (“ABS”), and in some case have restrictions on the purchase of ABS paper. While the structure of the Vaccine Sukuk shared certain similarities with an ABS, the credit risk borne by the investors was wholly that of IFFIm, the double-A rated obligor. Ensuring conventional investors understood this element of the structure was a critical aspect of the marketing of the transaction.
In the case of the Vaccine Sukuk, the investor education efforts paid off for IFFIm. The second Vaccine Sukuk was a three year, $200 million issue that was over-subscribed 1.6 times. In the aggregate, the two Vaccine Sukuks raised $700 million, on orders of well over $1 billion, in less than one year. This high level of demand, from both traditional sukuk investors and conventional investors, including those with a sustainable investment focus, proves the convergence of Islamic finance and conventional sustainable investing is very possible.
About the Author:
Michael Bennett has spent fifteen years with the World Bank, splitting his time between the World Bank’s Paris office and its Washington, DC headquarters, with a primary focus on structured finance. Among other areas, he is responsible for the World Bank Treasury’s transactional work in the area of Islamic finance. He has also published numerous articles on Islamic finance topics, including on ethical sukuk, sukuk financing for green infrastructure projects, Islamic derivatives and the intersection of Islamic finance and socially responsible investing.
Amortizing IFC sukuk could offer model during a rising rate environment
Another World Bank-related issuer besides the IFFIm (above) returned to sukuk markets recently. The International Finance Corporation, the private sector development arm of the World Bank, issued a $100 million sukuk earlier this month which was its first since its $100 million offering (issued in 2009) matured in 2014. The IFC’s first issuance was a 3-year BBA deal in 2004 for RM 500 million.
The progression in the sukuk structures employed shows maturation of the IFC’s understanding of and familiarity with the Islamic finance industry. When its first sukuk was issued there was not much of a global market (Bahrain and Malaysia had only just begun issuing USD-denominated sukuk in 2001 and 2002, respectively) and so it went to Malaysia’s domestic market for its first issuance. By the time it returned to the market in 2009, the market had matured significantly although at the time the IFC issued its Hilal sukuk, activity was slow due to the impact of the financial crisis.
At the time, sukuk markets were searching for alternative structures to mudaraba sukuk (which had been widely misused in the mid-2000s) and the Islamic Development Bank and the IFC each made use of a wakala structure as an alternative to ijara structures that were widely used but not suitable for financial institutions. The wakala structure enabled the use of (tangible and intangible) financial assets for a sukuk. Wakala sukuk are now much more common and can help asset-light issuers increase transaction sizes from just using an ijara (which is limited by the value of the issuer’s tangible assets) by combining tangible assets (through the ijara structure) with intangible assets (like murabaha receivables).
The reason to look at the history behind the IFC’s participation in the sukuk market is that, despite small offerings, they have been ahead of the curve in where the market as a whole is headed. And in that context there are two points in their latest sukuk structure that are noteworthy: 1) it is a floating-rate, amortizing sukuk; 2) has a higher tangible asset requirement than many other similar wakala sukuk.
Starting on the second point, a 51% tangible asset requirement is common for wakala sukuk although it is not universal. For example, the Islamic Development Bank’s $10 billion sukuk program specifies a lower level (33%). Furthermore, the tangible asset requirement in many wakala sukuk (though not the IDB’s) is only applicable at the time of issuance. The IFC’s sukuk documentation sets a continuing obligation for the trustee to maintain tangible assets as a share of total assets of at least 40% and also specifically requires any intangible asset (read: murabaha receivable) that is substituted by the IFC be replaced by a tangible asset.
This is important because it retains the link between the sukuk and a tangible asset and limits the build-up of leverage risk. A related issue in the financial system to leverage risk is the risk faced by financial institutions and investors from future rising global interest rates. In a rising interest rate environment, sukuk will be affected equally to bonds because they deliver the same economic outcome and therefore embed the same interest rate and reinvestment risks as conventional bonds.
If the sukuk were an asset-backed securitization with a fixed pool of assets, then the returns on the assets (profit and principal) would simply be passed-through by the trustee and investors would bear all of the reinvestment risk. If rates fell, more of the portfolio would be refinanced and the sukuk would amortize faster, and investors would have to find alternative investments to generate yield. If rates rise, the amortization would occur slower, and the price of the sukuk would fall to reflect the lower yield on the assets (unless they were floating-rate) compared to new issuance of comparable quality.
Since the IFC sukuk is not a securitization, a standard asset-based sukuk structure combined with a floating-rate coupon would place all of the refinancing risk on the IFC (who would have to substitute new higher-yielding assets as existing assets mature). The partial amortization at the 2-1/2 year mark (made with payments collected from the underlying assets) shares some of the reinvestment risk with sukuk investors.
The pricing of the sukuk (at 10 basis points below 6-month LIBOR) could reflect comfort with this split of reinvestment risk but more likely reflects the premium in the market for high-quality issuance since 75% of the issuance was bought by banks with just 5% by fund managers. Based on the IFC’s previous track record, it is possible that this amortizing structure becomes adopted by other issuers to find a way to attract buyers concerned about rising rates without building in too much rigidity from floating-rate sukuk used to fund fixed rate underlying financial assets leaving all the reinvestment risk with the issuers.