Dubai, UAE — Sovereign Sukuk, a financial instrument rooted in Islamic finance principles, has become a prominent tool for governments to raise capital, a report said.
The report by A&M Sovereign Advisory Services, “Embracing Sovereign Sukuk: Demystifying Sharia-Compliant Sovereign Finance,” said the sovereign sukuk was dominant within the overall sukuk market, boasting a value of around US$ 400 billion.
Interestingly, it often presents a more cost-effective alternative to conventional sovereign bonds, particularly for governments with lower credit ratings. This translates to lower borrowing costs, making sukuk an attractive option for financing economic development and various government needs.
For investors, the report clarifies a common concern: subordination to conventional bondholders. The document emphasizes that sukuk investors do not hold a subordinate position.
Structure and market of sovereign sukuk
The report explores the motivations for governments to issue sukuk, including factors like:
- More robust Investor Demand: Sukuk can tap into a wider pool of investors, including those seeking Sharia-compliant investment options.
- Reduced Borrowing Costs: As mentioned earlier, sukuk can offer lower borrowing costs compared to conventional bonds.
- Market Stimulation: Sukuk issuance can stimulate the Islamic finance market as a whole.
The report suggests that sukuk generally yield less than comparable bonds and exhibit lower volatility, potentially indicating a lower liquidity risk.
Restructuring sovereign sukuk: A complex landscape
While sovereign sukuk offers a compelling financing option, the report acknowledges the complexities involved in potential restructuring scenarios. Due to the relative newness of the market and the limited number of precedent cases, the process for restructuring sovereign sukuk remains relatively uncharted territory.
Additionally, many issuing countries lack well-developed regulatory frameworks to handle such situations.
The report further highlights the challenges associated with incorporating collective action clauses (CACs) within sovereign sukuk. These clauses, crucial for aggregating votes during a restructuring, add another layer of complexity compared to sovereign bond restructurings. Furthermore, any restructuring proposal requires approval from Islamic scholars to ensure compliance with sharia principles.
Benefits and challenges
“Embracing Sovereign Sukuk” underscores the potential benefits for governments seeking to raise capital in a sharia-compliant manner, while also acknowledging the complexities involved in restructuring these instruments. The report’s analysis of the market dynamics and potential cost advantages makes sovereign sukuk an increasingly attractive option for governments across the globe.
However, sukuk might have lower average yields than conventional bonds because the perception is that sukuk payments are tied to specific asset cash flows, potentially making defaults less likely. Additionally, some investors might believe sukuk holders have a stronger position during restructuring negotiations. Also, the high demand for sukuk, particularly from Sharia-compliant investors, can drive down borrowing costs for governments issuing sukuk.
Regarding restructuring sovereign sukuk, it is a complicated process that presents unique challenges. The complexity arises due to various factors, such as the contractual framework of the sukuk, the role of Islamic scholars in approving sharia-compliant restructuring plans, and the use of CACs. The lack of precedent cases and underdeveloped legal frameworks in some countries make the process even more complex.
Compared to conventional bonds, sukuk securities tend to exhibit lower yields, primarily due to their heightened demand from Sharia-compliant investors. However, this elevated investor demand also leads to lower market liquidity in the sukuk market, as evidenced by less volatile sukuk yields.