Islamic Bond Decree Cripples Sukuk, Threatens U.A.E. Developers

By Haris Anwar

Sept. 3 (Bloomberg) -- The fastest-growing part of the global bond market is faltering, and it has nothing to do with subprime mortgages or the credit crunch.

Sales of Shariah-compliant debt, which financed Dubai's Palm development, the world's largest man-made island where David Beckham and Donald Trump have homes, fell 50 percent in 2008 and prices dropped an average 1.51 percent, according to HSBC Holdings Plc index data.

The so-called sukuk market, which has doubled each year since 2004 and grown to $90 billion, is declining after a Bahrain-based group of Islamic scholars decreed in February that most bonds ran afoul of religious rules. Only one that complies with the edict has been issued, pushing up borrowing costs on projects including $200 billion of real-estate developments in the United Arab Emirates capital.

``In times of distress, the first thing investors sell are the credits they don't fully understand,'' said James Milligan, Dubai-based head of Middle East fixed-income trading at HSBC, the biggest underwriter of sukuk bonds in the Gulf last year. ``This has hit spreads hard in the region,'' he said, referring to the relative level of the Islamic bonds' yields.

The bonds satisfy Islam's ban on interest by allowing investors to profit from the exchange of assets, rather than money. Sales of the debt fell to $11 billion from January to August, from $21 billion in the same period of 2007, according to data compiled by Bloomberg. They peaked at $38.6 billion last year, growing from virtually nothing six years earlier, the International Monetary Fund said. The decline in prices is worse than the 1.25 percent drop in U.S. corporate bonds, HSBC data show.

No Guns

Banks sell sukuk by using assets to generate income equivalent to interest they would pay on conventional debt. The money can't be used to finance gambling, guns or alcohol.

The Accounting & Auditing Organization for Islamic Financial Institutions ruled in February that bonds don't meet religious requirements if they haven't transferred ownership of collateral to holders. About 85 percent of sukuk failed this test, the board said.

The judgment meant the value of the underlying collateral may decline amid falling real-estate prices, rather than being paid at face value in a default as in a conventional asset-backed securitization.

As demand for Islamic-compliant bonds waned, yields rose to 2.94 percentage points more than the London interbank offered rate, or Libor, near a record and compared with 2.43 percentage points for an equivalent non-Islamic bond, Bloomberg data show. The spread was 1.08 percentage point a year ago and about double that in February.

`What's Compliant'

``I wouldn't add anything to'' our ruling, said Sheikh Muhammad Taqi Usmani, chairman of the accounting board and a retired justice of the Pakistan Supreme Court. ``We're just pronouncing what's compliant to Shariah and what's not,'' said Usmani, who advises HSBC, Dow Jones & Co. Inc., the Bharain Monetary Agency and the Islamic Corporation for the Development of the Private Sector.

The ruling was intended to introduce ``unified rules'' to the market, said Mohamad Alchaar, secretary general of the board, whose rulings are binding in six Arab countries.

Sorouh Real Estate Co., Abu Dhabi's third-biggest property company, sold 4 billion U.A.E. dirham ($1.1 billion) of bonds on Aug. 13, the first sukuk that's ``fully compliant'' with the Shariah Board's ruling, according to Robin Ward, a director of structured finance at arranger Citigroup.

Shariah Scholars

Citigroup's London-based panel of Shariah scholars is led by Sheikh Nizam Yaquby, former chairman of the accounting panel. Yaquby, who advises about 40 financial institutions on Islamic financing rules, declined to comment when contacted by Bloomberg News.

``This is a true Islamic sale,'' said Ward. ``You need a tangible asset, and in this case, we had a freehold of land. There's no recourse back to the originator, which is the way previous sukuk have been done.''

The clincher for getting the board's approval, said Ward, was transferring ownership of the underlying asset when the bonds were sold. The bulk of the debt paid interest of 200 basis points more than the one-month Emirates interbank offered rate, according to Citigroup.

``In essence, the previous sukuk structure was replicating a western bond where you get your money back and that's it,'' said Majid Dawood, chief executive officer of Yasaar Ltd., a Dubai- based consultancy that advises Paris-based Societe Generale SA, Royal Bank of Scotland Group Plc in Edinburgh and Dublin-based Bank of Ireland Plc.

10 Percent Drop

More than half a trillion dollars in worldwide credit writedowns and losses squeezed lending in the Mideast as the Dubai Financial Market Real Estate Index of property-related stocks dropped 19 percent since January. Morgan Stanley analysts predict a 10 percent decline in property prices by 2010.

``The sukuk market has been very tough this year,'' said Kuala Lumpur-based Nor Hanifah Hashim, who manages about $1 billion in an Islamic fund at CIMB, the world's largest underwriter of the debt. ``People are adjusting to the new rules and you need to have very good quality of assets to attract investors.''

Most issuers are still able to sell non-Islamic debt. Mideast companies raised $50 billion this year in loans, compared with $73 billion during the same period of 2007, Bloomberg data show.

``If you look at the big capital raisings, most have been done through the bank market,'' said Philipp Lotter, a senior credit officer at Moody's Investors Service in Dubai. The Islamic board ruling ``added an additional layer of uncertainty. Certain investors will not invest in sukuk,'' he said.

Dual-Currency Loan

Investment Corp. of Dubai, a state-owned holding company, said last week it was raising $5.6 billion in a dual-currency loan, while Abu Dhabi National Energy Co., the state-controlled energy company known as Taqa, borrowed $3.15 billion for three years last month to refinance debt.

``Investors are trying to get used to the new structure and studying new requirements,'' said Gaurav Agarwal, chief financial officer of Tamweel PJSC, the United Arab Emirates' biggest mortgage provider, which plans $500 million in asset-backed loans by year-end. ``Borrowers are raising money through bilateral loans until the sukuk market becomes hot again.''

Tamweel's last pre-ruling sukuk was one-third backed by completed property and two-thirds backed by projects under construction. Those proportions would have to be reversed now, said Agarwal.

``The sukuk market is clouded by considerable uncertainty and nervousness,'' said Chavan Bhogaita, head of credit research at HSBC's Middle-East unit. ``Spreads have been widening, sukuk have been underperforming conventional bonds and investors have been shying away.''

To contact the reporter on this story: Haris Anwar in Dubai on Hanwar2@bloomberg.net