After a strong year for the Islamic bond market in 2017, this year is looking more uncertain amid geopolitical risks and economic uncertainties, according to S&P Global Ratings.
Islamic bonds, or sukuk, saw strong issuance last year at $97.9 billion, up 45.3 percent from the $67.4 billion issued in 2016, according to data from the ratings agency.
So-called "jumbo issuances" were seen in Saudi Arabia and other Gulf Cooperation Council (GCC) economies in 2017, whereas 2016 saw Islamic-majority Malaysia issue the most sukuk.
Sukuk is a form of financing that follows Islamic principles, making sure that the debt issuance is structured in a way that is Sharia compliant. It is used by Islamic governments and companies predominantly but is being opened up to retail investors.
Islamic religious law prohibits the earning of interest (which is seen as a form of usury) so traditional western bonds are not acceptable. Instead, Islamic bonds give investors a share in the ownership of an underlying asset rather than the ownership of debt and interest payments, as with conventional bonds.
Mohamed Damak, a senior director of financial services at S&P Global Ratings, said the first two months of 2018 had been marked by a good performance for local currency issuance and a drop in foreign currency issuance.
Still, Damak said that monthly performance was not a good indicator of annual issuance numbers and that 2018, as a whole, was expected to see a drop in sukuk issuance, with expectations for around $70-80 billion in total.
A muted 2018
Damak said this was due to a number of factors including central bank tightening (the raising of interest rates), likely to reduce liquidity in emerging markets that could've been channeled into sukuk, and geopolitical risks.
"Global liquidity in 2018 is going to tighten; in our view the (U.S. Federal Reserve) is going to tighten (raise interest rates) by 75 basis points in 2018 with three rate rises. Also the European Central Bank will also reduce the pace of its asset purchases which means the liquidity that used to be channeled from the developing markets to emerging markets will definitely reduce and become more expensive," Damak told a media briefing on Tuesday.
The second reason why sukuk issuance is expected to be lower in 2018, Damak noted, was the lower financing needs of GCC banks due to the stabilization of the oil price. S&P Global Ratings believes a barrel of oil would average $60 in 2018. Nonetheless, the GCC still face challenges in 2018, he said.
"For 2018, the main message is that we expect the stabilization of the financial profile of GCC banks, from the second half of 2018, but the key challenges for them are muted loan growth, the higher cost of risk and lower profitability."
A third reason that sukuk demand could be lower in 2018 was down to the recent resurgence in geopolitical risk, Damak said, "particularly the fact that Qatar was placed under sanctions by other GCC countries" which could "deter investors' appetite to instruments issued by GCC issuers in case of a significant escalation" of tensions.
Lastly, Damak noted that a fourth reason why Islamic bond performance could be lower in 2018 was due to the slow progression of the standardization in the sukuk market.
"Progress on the standardization has been relatively limited, although the main change in 2017 compared to previous years is that the standard setting bodies like the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and Islamic Financial Services Board have now understood that there is an issue with standardization and that this should happen to allow the market to grow at a more rapid pace."
Holly Ellyatt, Correspondent, CNBC.com