By Liau Y-Sing and Frederik Richter
KUALA LUMPUR/MANAMA, March 3 (Reuters) - Corporate issuers are eager to return to the Islamic bond market but a lack of secondary trading could distort the pricing of an estimated $45 billion worth of sukuk in the pipeline and deter future issuance.
The credit crunch and growing prospects of a global recession have virtually frozen sukuk markets worldwide, and the issue of distorted pricing could exacerbate issuers' reluctance to return to the markets, threatening a crucial source of funding for companies and governments.
"The problems would be in terms of the ability to price properly the sukuk," said Badlisyah Abdul Ghani, chief executive of Malaysian sharia bank CIMB Islamic, which is the world's top sukuk arranger.
"There is the issue of reluctance on the part of the issuer to issue in the sukuk market. If it's illiquid, then price distortion may occur, and it might reflect badly on them. It creates a benchmark for themselves."
Mohamed Damak, credit analyst at ratings agency Standard & Poor's recently estimated that globally pent up demand of more than $45 billion is waiting to be released by issuers waiting for more favourable markets.
A report by McKinsey released in November estimated that only about 25 percent of total outstanding sukuk is listed.
Secondary sukuk trading in Malaysia, which was the world's second-largest Islamic bond issuer last year, according to Islamic Finance Information Service, is thin relative to the conventional market.
The Malaysian sukuk market's liquidity last year, calculated as a ratio of trade relative to outstanding bonds, was 88 percent, versus 209 percent for conventional bonds, according to central bank data.
Islamic bonds are structured as profit-sharing or rental agreements, and their returns are derived from underlying physical assets such as real estate or commodities.
One reason for the lack of a secondary market is the limited size of the primary sukuk market. The total outstanding volume of sukuk amounts to just $100.07 billion, according to Thomson Reuters data.
"There are not enough issues in the market," said Steven Choy, chief executive of Cagamas, Malaysia's national mortgage company, which frequently issues sukuk.
"You can't find a replacement as and when you sell the one that you hold."
He said many sukuk investors hold on to them because of the good yields they offer. Due to the market's illiquidity, sukuk frequently offer higher yields than conventional bonds of the same tenor and credit rating.
"If you are holding good paper, why sell?"
Andreas Buelow, deputy chief financial officer for the
Middle East and South Asia at German insurer Allianz AG
The straightforward pricing mechanism of conventional bonds based on their face value and their yield, is broken up in the sukuk structure.
"To price a sukuk (for trading) you need to actually glance inside to see what's the value of the underlying assets," Buelow said.
Buelow said sukuk issued to finance real estate or infrastructure projects lacked the revenues that underpin returns, as actual construction starts only at later stages.
He said Allianz was eager to buy sukuk on the secondary market, but said the limited offer was an obstacle.
"The lack of long-term sukuk poses a real problem to us when we would like to offer education plan or retirement products," he said.
Insurers looking for long-term and stable investments are one of the back-bones of conventional bond markets.
The central bank of Gulf Arab state Bahrain in November launched an Islamic overnight repo facility for Islamic banks, but the lack of a secondary market is a concern for the central banks, as banks need to place ijara sukuk issued by the government as collateral.
As these are not being traded, banks wanting to make use of
the facility need to wait for upcoming government issues.
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