Islamic finance has reached a landmark moment. It is transitioning from a niche market, with issuances solely from Islamic financial institutions and Muslim nations into a broader financial market with an increasing number of non-Islamic participants. Since last year, we have seen prominent sukuk activity from entities outside of the Islamic world: from sovereigns such as the UK, South Africa,
Hong Kong and Luxembourg and from leading international financial institutions such as Goldman Sachs, Societe Generale and Bank of Tokyo Mitsubishi.
Credit rating agencies are playing an important role in the rapid expansion of Islamic financial market. Firstly, they increase awareness and education in IBF that – for most international investors – is still unfamiliar territory.
Secondly, they provide international credit benchmarks by which investors can compare the creditworthiness of, for example, sukuk instruments against their conventional counter arts, for instance, Canadian sovereign debt or Toyota corporate bonds.
ISLAMIC FINANCE IS PART OF THE WIDER CAPITAL MARKETS
Islamic finance is specialised and idiosyncratic but exists as part of the wider, global financial markets. Credit rating agencies such as Moody’s provide the financial markets with independent and valued views on credit risk. Moody’s rates and provides credit opinions on numerous entities, including banks, corporates and sovereigns and their bonds and other credit instruments. Islamic banks, along with Islamic insurers (takaful companies) and Islamic bonds or sukuk, fall within this rating universe.
Moody’s also produces research, offering insight into what is driving the capital markets, what developments are on the horizon, future expectations and – crucially – what the future credit risks might be. In this way, it promotes education and transparency that complements its ratings. It also engages in meetings and discussions with investors and issuers, allowing them to ask questions and dig deeper into topics of particular interest. The ratings agencies in general widely distribute knowledge and opinions about complex and volatile markets through their websites, media, forums, conferences and broadcasts.
Credit rating agencies also provide value through their global reach. Moody’s is a global institution with 28 country offices located from San Francisco to Dubai to Tokyo. This geographic breadth gives its credit specialists inside local markets direct access to on-the-ground information and local expertise. It also allows agencies to benchmark the credit risk of investments and issuers across different markets, countries and locations.
This global comparability is a key aspect of a credit rating. For each agency, their own rating methodologies provide global standards that help an investor compare, for example, the credit risk of US treasuries versus Malaysian sovereign sukuk, or the credit risk of sukuk issued by a property company like Emaar versus the sukuk issued by Qatar International Islamic bank.
A YOUNG, COMPLEX AND EVOLVING MARKET
Islamic finance is a young industry and its financing structures – which seek to satisfy the Shari’a rules – are still evolving. The complexity of some of the instruments used by Islamic financial institutions may disconcert new parties seeking to participate in the IBF market. Arabic terminology and structures that help give the sector its own identity may create challenges to understanding for those in countries beyond the core Islamic markets of the Gulf and parts of Asia.
As an example, many established asset management firms with some Shari’a-sensitive clients often seek information on the nature and risks facing Islamic financial products. By assigning a credit rating and providing a credit opinion, the agencies provide an independent opinion on the credit risk elements of these instruments, which can facilitate a greater flow of international funds into these complex markets.
Moody’s, of course, applies the same rigorous analysis to Islamic issuers and issuances as it does to all global market issuers and instruments, and its ratings follow the same global methodologies and standards. For an Islamic bank, being benchmarked to other conventional banks enables its shareholders, investors and even its own management to get an objective, third-party opinion on the relative credit-related strengths and weaknesses of the institution.
SUKUK ARE (STILL) HIGHLY COMPLEX INSTRUMENTS
IBF is a complex business. The fact that it is still in development creates many issues in terms of new business practices, documentation, operations, and regulations that need to be addressed by any institution trying to operate according to Shari’a principles. Sukuk instruments, in particular, are characterised by a lack of standardisation in their structures and are still in most cases simply fixed-income instruments. Moody’s has over 100 years of experience in fixed-income credit risk analysis, and its structured finance group focuses primarily on asset-backed instruments, which are closest to the ideal sukuk. It has expertise across the whole spectrum of instruments, from the simple to the complex, and it brings that experience and knowledge to the sukuk market.
Assigning a credit rating for unsecured sukuk instruments can be a lengthy exercise, particularly when compared to the more standardised conventional bonds. When a multinational conglomerate such as General Electric or a global bank like Barclays issues conventional, plain vanilla Eurobonds, they are likely to have the same basic legal structure, default events, payment obligations and investor rankings in case of default etc. In contrast, sukuk securities are structured esoterically to comply with Shari’a principles. The interpretation of these principles – and hence application in financial transactions – is subjective and can lead to wide and crucial variations in the legal structure and in the documentation. A credit analyst has to dig deeply into this extensive documentation to accurately assess the creditworthiness of the instrument.
RATINGS PROVIDE OBJECTIVE INSIGHTS
The complexity and fragmentation of the Islamic finance industry can limit market liquidity. Moody’s role is to provide independent opinions to the market. It focuses on credit risk and, as a key market participant in both conventional and Islamic financial markets, it is not predisposed to any particular market or product. This fosters transparency and adds genuine value and service to the Islamic industry.
This independent view on the sukuk credit risk also helps facilitate secondary market trading. Once a sukuk is assigned a rating, it is freely accessible by market participants via Moody’s website and the media.
BRIDGING TWO MARKETS
While the sukuk market is growing fast, it remains small with a cumulative sum of outstanding sukuk of around $297 billion and total issuance of around $110 billion1 for 2014. This figure is dwarfed by the conventional bond market, which issued $5.6 trillion worth of bonds in 2013 alone. However, the market is broadening its base beyond the Islamic world. Key sovereigns of non-Muslim countries have issued sukuk over the past year, as we have seen, and more are likely over 2015.
This market phenomenon, with conventional entities now operating more frequently within the Islamic capital markets, is creating a bridge between the two worlds and attracting a new segment of investors who are largely unfamiliar with the principles of Islamic finance. This addition of non-Islamic issuers could multiply the size of the market many times over since. Even in the GCC, conventional banks outnumber Islamic banks by more than five to one. This development could mark a step change in the size of the market and the possible number of institutions that will participate. For non-Islamic, global investment banks like Societe Generale and Goldman Sachs, issuing sukuk may be a way to raise funds, but it is also a means to engage participants in these newer segments as well as promoting the bank’s own capabilities in the sector.
As the market becomes more globalised, there will be a growing demand for Islamic finance-related credit ratings and insightful research. The rating agencies will support an improved understanding of the credit risks and market trends in this rapidly expanding sector.
