There is no denying that the Islamic capital market is increasingly attracting global attention as an alternative means of raising capital and investing, as the array of sharia-compliant products continues to expand, offering high-quality and financially efficient structures in the international market. New products and innovative solutions continue to be developed, as key markets active in Islamic finance, such as Malaysia and the Middle East, support development and promotional efforts, and Islamic finance continues to garner acceptance and recognition across the globe.
Malaysia, a global centre of excellence within the Islamic capital markets sphere, is at the forefront of developing Islamic-based financial and capital market products, and was the first country to witness a sukuk (Islamic bond) issuance, when Shell MDS Malaysia released the first ringgit-denominated corporate sukuk, worth RM125m ($30.9m).
The sukuk is built around an alternative concept to conventional bonds. Based on Islamic principles of finance, sukuk are essentially against any form of usury, which is the charging of interest on money lending. The sukuk concept discourages investments in industries that generate their income from interest, such as conventional insurance and conventional financial services. Conceptually, sukuk also encourage people to invest in a socially responsible manner, avoiding investments in industries that promote perceived vice, including, but not limited to, alcohol, smoking, adult entertainment and gaming.
Sukuk are defined by the Securities Commission Malaysia (SC) as “certificates of equal value which evidence undivided ownership or investment in the assets using sharia principles and concepts.” The difference between sukuk and conventional bonds is primarily in the relationship between the issuer and the investor. With a sukuk, the sharia contract utilises the principles of sale, lease and partnership between the issuer and the investors to enable the latter to enjoy returns on their investment. A conventional bond, on the other hand, represents a contractual debt obligation, whereby the investors provide a loan to the issuer. The repayment of a conventional bond consists of principal (capital) at the time of maturity, and interest in the form of periodic coupon payments, which violates the principle of an interest-free loan, as per the sharia requirement. This, in turn, resulted in the introduction of sukuk by Islamic scholars. Moreover, conventional bonds exist only in the form of debt, whereas sukuk may include debt (created from sale-based transactions) on the underlying assets (in Malaysia only) and non-debt assets, such as tangible assets, usufructs and rights, assets of particular objects or investment activities.
Despite rapid growth following the pioneering issue by Shell MDS Malaysia in 1990, post-2000, the sukuk market developed more modestly, with just three sukuk issuances at the corporate level, totalling $336m. After the financial crisis of 2007-08, the global market trend for sukuk was much more positive, with issuances reaching a peak in terms of size – at over $131bn – in 2012, which translated into an increase of over 54% compared to 2011.
Malaysia’s sukuk market has also seen major growth, through the issuance of innovative sukuk structures that meet the market’s needs and yet conform to sharia principles. As of December 31 2015, outstanding sukuk totalled $261bn globally, with Malaysia making up 54% of the international market share, with both ringgit- and non-ringgit-denominated sukuk, and government and corporate sukuk.
More importantly, Malaysia’s sukuk market is characterised not just by issuances by domestic companies but by global issuers too, denominated both in ringgit and non-ringgit and including multi-lateral and sovereign-related institutions. Malaysia is the first to develop strong infrastructure and a regulatory framework for conventional bonds and sukuk.
To internationalise the sukuk market, in 2007 the SC introduced a facilitative framework for the issuance of foreign-currency-denominated sukuk. The new framework allows international documentation based on UK or US laws, and accepts ratings by international credit rating agencies to reduce issuance costs for international issuers. The organic growth of the domestic Islamic assets under management – the second largest in the world – also provides ample liquidity to support a strong secondary sukuk market.
The application of sukuk as the preferred choice for corporations and governments to raise funds from the bond market can be attributed to several factors. First, it is due to strong demand from fixed-income investors who are looking for more ethically principled instruments to diversify their investment portfolios in addition to investing in liquid instruments. In addition, there is an important segment of the investment industry that comprises takaful (Islamic insurance) operators, sharia-based funds and Islamic institutional investors looking for stable “fixed-income” type investment opportunities.
The sukuk market has been a significant driver of growth for the Malaysian capital market, with many world-first issues of sizeable amounts and innovative structures originating here in past years. These include the first global sovereign sukuk released by the Malaysian government, with a value of $600m; the first sukuk musharakah (partnership) in 2005 of RM2.5bn ($618.8m) by Musharakah One Capital, a special-purpose vehicle backed by existing Malaysian government receivables as part of a national project to supply equipment to schools in Malaysia; the first Islamic residential-mortgage-backed securities by Cagamas MBS in 2005, worth RM2.05bn ($507.4m); the first exchangeable sukuk musharakah of $750m by Khazanah Nasional in 2006; and, more recently, the first social-impact sukuk by Khazanah Nasional in 2015, worth RM1bn ($247.5m).
Considering the fact that Islamic finance is based on the principles of fairness, equality and ethics that lead to social well-being, the Malaysian government – through the SC – is spearheading efforts to drive the Malaysian capital market towards socially responsible investing (SRI). SRI, in a nutshell, is an investment strategy which seeks to consider both financial return and social good by applying both positive and negative screens to include or exclude companies in a portfolio based on social, moral and ethical criteria.
Such a move is seen as a natural progression, given that Islamic finance is derived from fundamental principles of Islamic law and seeks social justice and economic prosperity for society at large while encouraging sustainable economic activity. Islamic finance, therefore, shares a similar rationale and a common objective with SRI and has led to the advent of a new generation of investors, within which the concept of sustainability takes centre stage in the 21st century.
Fundamentally, socially responsible investors are guided by an ethical or moral code for environmental, social and governance (ESG) investments. The Malaysian capital market aims to broaden its investor portfolio by connecting these overlapping core values to access the large amount of SRI funds available in the global markets. In some markets it is clear that momentum is being built towards realising the connectivity of Islamic funds with the global, socially responsible investment funds – assets in Islamic finance and SRI stands at about $3.7trn. Islamic finance remains a niche area that can benefit from tapping into socially conscious investments, as it will attract both Islamic capital and global interest since the two have been the most rapidly growing areas of finance over the last two decades. Within this period, each segment of finance has grown at rates that far exceed that of the financial markets as a whole. Therefore, understanding the scope of SRI is pivotal for Islamic-finance practitioners to match the opportunities available in the SRI space, with sustainability being the key common factor between the two.
In recent years, some significant developments have been witnessed, such as the launch of social impact bonds (SIBs), green bonds and SRI sukuk initiatives in the Malaysian capital market. In 2014 the SC issued the SRI Sukuk Framework, which funds programmes to improve access to quality education in government schools. The framework is in line with the initiative set out under the regulator’s Capital Market Masterplan 2, which aims to promote socially responsible financing and investment. This was followed swiftly by the issuance of the first SRI sukuk in the country in 2015 by Khazanah Nasional, which established a RM1bn ($247.5m) Sukuk Ihsan Programme – the first of its kind to be approved under the SRI Sukuk Framework. Furthermore, Bursa Malaysia, in collaboration with the FTSE, launched the FTSE4Good Index series in December 2014, in which constituent companies are selected based on the fulfilment of socially responsible criteria. Its introduction is seen as a step in the right direction in encouraging and supporting enhanced ESG disclosure and practices for the Malaysian capital market.
The Malaysian capital market is poised to match the central values in Islamic finance and SRI to further explore the interplay between these markets and optimise prospects for Islamic finance by tapping into the large pool of global SRI funds. Institutional investors, such as Khazanah Nasional, are leading the way. The Employees Provident Fund – Malaysia’s largest pension fund, has also committed to ESG by announcing plans to divest its stake in tobacco businesses and focus instead on investing in SRI assets, in addition to introducing its first fully sharia-compliant fund to be launched in 2017. The Malaysian civil-service pension fund also declared a mandate for investments in sharia-compliant ESG as part of its diversification strategy.
As the leader in Islamic capital market developments, and with the largest share of the world’s sukuk market, there is no better time than the present for Malaysia to further broaden its focus towards SRI.