Islamic bonds (sukuk) are set to become the big hit of the Middle East’s financial markets this year as low costs, a contracting European banking industry and a rising tide of religion across the region spur interest from borrowers and investors alike.

Dubai gave the segment a lift last week when investors climbed over themselves for two issues of sovereign sukuk worth $1.25 billion. The strong demand was reflected in pricing of 4.9% for the five-year bond, a record low for dollar-denominated bond issued by the emirate, and 6.45% for the 10-year issue.

Sukuk issues were already on the ascent in the first quarter when the global total grew to $43 billion from $21 billion in the final three months of 2011, according to figures from Saudi Arabia’s National Commercial Bank (NCB). In the Gulf Cooperation Council (GCC) countries, the value of sukuk issues reached $8.6 billion in the first quarter, up from $3.3 billion in the previous quarter, it said.

NCB says the best growth is yet to come. “Global sukuk issuance this year appears on track for another all-time record, with last year’s $85.4 billion set to be comfortably exceeded even under the more cautious projections. In view of current trends it appears likely that aggregate issuance will clearly exceed $100 billion this year,” it said in an April 22 report.

Malik Muhammad M. Al-Awan, sharia adviser to Malaysia’s Hong Leong Islamic Bank and Hong Leong MSIG in Malaysia, told a conference this month that sukuk financing could reach as much as $125 billion in 2012.

Sukuk (Arabic for “legal instruments") are securities that comply with Islamic law, or sharia, by not paying interest. They mimic the cash flow of conventional bonds by paying holders the equivalent of rent together with a promise by the issuer to buy back the principal amount. Malaysia is by far the world leader in sukuk issues, accounting for about two thirds the global market, but the Middle East is catching up.

One reason, said Capital Economics’ Middle East Economist Said Hirsh, is that Europe’s financially troubled banks are paring back lending in the Gulf. He estimates they provide about 10% of total credit to non-bank borrowers in the Gulf, much of it short-term debt that they unlikely to roll over as they retrench. Local banks will be able to pick up only part of the slack, he said.

“Sukuk issuance could therefore become an attractive option, given the low yields and strong demand from investors,” Capital said in a report last week. “The rapidly growing sharia-compliant fund management industry is still struggling to find suitable assets to invest in.”

Malaysia has emerged as the world leader in sukuk financing, with the GCC countries a distant second, despite their being the home of Islam and enjoying a combined economy many times larger than Malaysia.  Saudi Arabia hosts the world’s biggest Islamic banking industry.

NCB attributes Malaysia’s leadership to the fact that Kuala Lumpur both encourages sukuk and regulates it, with a central sharia-compliance board, favorable tax treatment and well-develop trading markets. By contrast, GCC countries have taken a much more laissez faire approach – no regulation of sharia compliancy and no specialized regulations for the market – that has slowed development of new products, says NCB.

Trading in the organized secondary markets in the Gulf region is small. Saudi Arabia’s Tadawul market, the biggest, saw only six transactions worth 369.8 million Saudi riyals ($98.6 million) in the first quarter, which was nevertheless almost five times its level in the previous three months. But Saudi Arabia is taking the lead in sukuk as the government encourages companies to raise investment funds, overtaking the UAE in the first quarter of 2012.

The kingdom issued its first sovereign-backed bond – a $4 billion fundraising for its state aviation agency in January – and private companies tapping the market. Last week, Saudi Electricity Company (SEC) completed a $1.75 billion dual-tranche sukuk issue in what was called the largest international debt bond ever out of the kingdom. Earlier this month, Banque Saudi Fransi, a Saudi Arabian lender part-owned by France’s Credit Agricole SA, set up a $2 billion Islamic bond program as part of plans to diversify its sources of financing.

Saudi Basic Industries Corporation (SABIC), one of the world’s leading manufacturers of chemicals, got approval last December for a sukuk issue of up to $5 billion. It issued its first sukuk bond only in 2006.

Elsewhere in the Gulf, sukuk issues are on the way as well. In Dubai, Emirates Islamic Bank, a unit of Emirates NBD, sold $500 million of securities in January and a month later the mall and hotel operator Majid Al-Futtaim Holding sold $400 million. But Capital Economics doubts that Dubai’s government-related companies will be able to tap the sukuk market even though they have some $12 billion debt coming due this year because investors are skeptical about their restructuring plans.

Outside the Gulf, the appeal of Islamic finance is growing in the rest of the Middle East and North Africa as Islamists increase their political powers in elections, according to a report last months by TheCityUK’s Islamic Finance Secretariat.

Egypt, where Islamists dominate the newly elected parliament, is weighing issuing a sovereign sukuk worth some $2 billion as it tries to plug a financing gap, while Tunisia, where the Islamist Ennahda Party won elections last year, has set up a working group to study how to develop Islamic finance in the country and may issue a sovereign sukuk bond to help cover a budget deficit.

The Banker magazine estimates that only 12% of Muslims worldwide use Islamic financial products, with the percentage as low as 4-5% in Egypt and Turkey.

“Leading countries for Islamic finance should provide fertile ground for future growth, although the long-term impact of political unrest on development of Islamic finance in some Middle Eastern countries, such as Egypt, remains to be seen,” the TheCityUK report said.

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