What is Sukuk and how may it disrupt bond issuance in the US?
Local governments may face higher borrowing cost on municipal bonds (munis) after a recent tax bill that lowered the corporate rate, making munis less attractive. Institutions such as banks, property and casualty insurance companies, and life insurance companies that usually subscribe to munis will start earning more money off other types of investments because their tax rate is much lower. All else being equal, the effective net benefit of owning municipals drops and the muni rates may have to go up to be competitive. Local governments may be able to maintain their borrowing cost post-GOP tax bill by diversifying their sources of fund via alternative financing such as Sukuk.
Bâton Global has extensive experience in the Sukuk issuances across different geographic regions. Combining our academic research and industry expertise, we’ve advised clients by providing specific strategies on ways to successfully navigate the challenges in Sukuk fundraising as an alternative source of funds.
Sukuk is an Islamic Investment Certificate that has similar economic characteristics to conventional bonds and has been accepted as a mainstream asset class by global investors. However, unlike conventional bonds, which merely confer ownership of a debt, Sukuk grants the investor a share of an asset, along with the commensurate cash flows and risk. Hence, Sukuk requires a minimum percentage of tangible or physical assets to structure it, which is readily available when the local governments are planning to issue munis. Sukuk securities adhere to Islamic laws which prohibit the charging or payment of interest, leading to partnerships being fully explored. Prohibiting interest payments can be a detriment of the issuing firm’s ability to secure the best financial terms.
The most common form of a Sukuk is a trust certificate where an Special Purpose Vehicle (SPV) is created. The underlying asset is transferred to the SPV at a predetermined price for the Sukuk to proceed. Next, the SPV will lease back the assets to the issuer and distribute periodic profit to the investors. At maturity, or on a dissolution event, the SPV will sell the assets back to the seller at a predetermined value.
Local governments will be able to diversify their investors base by issuing a Sukuk instead of just relying on the traditional financial institutions for their municipal bond financing. This is largely due to strong pent-up demand from the Islamic investors that are hungry for avenues to park their liquidity.
Dollar-based sovereign Sukuk issuances are extremely limited and this would ensure a robust order book, which provides the issuer with potentially tighter pricing than the conventional equivalent. A majority of the Sukuk investors are not affected by the tax bill, hence their effective net benefit of owning munis remain neutral. As a result, local government should be able to maintain their cost of borrowing while attracting investors to invest in their programs.
Sukuk issuances might be foreign for the US based issuer. However, it is becoming a norm in Asia and recently in Europe, as there is stronger demand for it from a large investor base. Leveraging Bâton Global’s expertise in this domain ensures issuers are maximizing their ability to leverage this alternative source of financing.