March 9, 2020

Investment trend: Formosa sukuk could help GCC issuers diversify funding

categories : islamic finance

Formosa bond market's outstanding debt at $175 billion as of February 25, 2020

The expansion of Taiwan's Formosa bond market to include sukuk instruments could help Gulf Cooperation Council (GCC) issuers, including Islamic banks, to diversify their funding and widen their investor pool without increasing currency risk, according to Fitch Ratings.

Interest and discussion around Formosa and other funding sources is growing in the Middle East, but it has yet to come to its full potential has and a long way to go until it becomes an investment pattern.

“On the sukuk side, further growth in the market is likely, although sukuk are by definition specialist products, and long-standing structural constraints remain. These include a lack of standardisation and legal uncertainties relating to creditor treatment and enforceability in a distressed situation,” Bashar Al-Natoor, Global Head of Islamic Finance, told Zawya.

A Formosa bond is a bond issued in Taiwan but denominated in a currency other than the New Taiwan Dollar. They are issued by the Taiwan branches of publicly traded overseas financial institutions and to be traded must have a credit rating of BBB or higher.

The ability of GCC issuers to tap the Formosa market for sukuk could boost the overall global sukuk market, although it will take time for investor appetite to develop, and issuance is restricted to investment-grade issuers, the ratings agency said.

The Formosa bond market is nearly entirely US dollar-denominated, making it a good fit for GCC issuers given that GCC currencies are pegged to the dollar. It is also large relative to GCC local sukuk markets, which could benefit sukuk pricing and liquidity if Formosa sukuk grows in popularity.

The Formosa bond market had about $175 billion of outstanding debt at 25 February 2020, compared with total GCC local currency sukuk of about $100 billion, and a total global sukuk market of about $500 billion.

The Taiwanese initiative could also boost sukuk's recognition among global investors, which could help to tighten the pricing of sukuk relative to bonds.

Know the GCC issuers

Qatar Islamic Bank was the first institution to enter the market, issuing a $800 million sukuk in January 2020. This has a five-year maturity, was issued under the bank's senior unsecured trust certificate issuance programme (rated 'A' by Fitch) and is listed on the Taipei stock exchange.

“GCC issuers, including Government of Qatar, Qatar National Bank, First Abu Dhabi Bank and Arab Petroleum Investments Corporation, have increasingly tapped the Formosa bond market in recent years. This is in line with the trend to diversify funding options, with many GCC issuers issuing kangaroo, samurai and even panda bonds,” said Natoor.

GCC issuers, led by those in Qatar and the UAE, account for about 20 percent of total outstanding Formosa bonds.

Qatari banks have been incentivised to look beyond the GCC for funding since the economic boycott of Qatar began in 2017. Qatar's banking sector has the most diversified funding in the GCC, with non-domestic funding representing 43 percent of total funding at end-2019, Fitch Ratings noted.

“Most of this is from depositors in other GCC countries, asset managers in Saudi Arabia and the UAE, and Asian investors,” Natoor said.

Demand for Formosa bonds has been driven by Taiwanese life insurance companies seeking higher yields amid low interest rates. Near-term demand should remain high as insurers reinvest proceeds from maturing bonds.

About $15.5 billion of debt held by Taiwanese insurers matures in 1Q20, according to Bloomberg.

However, while overall Formosa bond market growth may continue apace, we expect the development of the Formosa sukuk market to be gradual, despite keen interest from GCC issuers.

Several potentially significant sukuk issuers, including Turkey, Bahrain and Oman, are barred from the market as they are below investment-grade. Moreover, it will take time for investors to familiarise themselves with Formosa sukuk, and Taiwanese insurers' ability to invest has been reduced by regulatory moves to limit their foreign-currency exposures.

Coronavirus impact

Natoor says it is difficult to estimate the impact of coronavirus on the sukuk market at this stage.

'However, many moving parts that we are observing closely in relation to the sukuk market. One scenario could be if the epidemic is prolonged, and result in reduced oil demand, leading to an extended production surplus and lower oil prices,' he said.

'If such a scenario unfolds, with a favorable interest rate environment and investors apatite, this could actually translate into increased need for external funding. Hence, we may witness a rise in sukuk issuances from GCC oil-exporting countries. However, uncertainties remain as to the future of the epidemic and its market impact,” Natoor told Zawya.

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