Yaldaz Sadakova
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Sharia-compliant pension funds remain untapped in Canada | Canadian Insurance
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Sharia-compliant pension funds remain untapped in Canada

Despite forays by Canadian pension funds into emerging market debt, one segment of this market remains largely untapped

 

Emerging market debt is no longer exotic for Canadian pension funds. But one segment of this market—sharia-compliant bonds—remains largely new to them. Few if any Canadian defined benefit pension funds appear to hold sukuk, which have a complex structure but offer access to markets such as the oilrich Persian Gulf.

Rehan Saeed, who teaches Islamic finance at Toronto’s Centennial College, says the biggest Canadian pension funds “are in the exploratory phase” when it comes to bonds issued in a sharia-compliant manner. “The big ones have certainly looked at [sukuk]. I’ve had conversations with some representatives from these entities, looking at Islamic finance to diversify their assets.”

We couldn’t verify whether any major pension funds have looked into or invested in sukuk; several declined to comment, as did entities investing public pension assets. The New Brunswick Investment Management Corp. doesn’t hold Islamic bonds because it has no foreign fixed income allocations, says president and CEO John Sinclair. The Toronto Transit Commission pension fund doesn’t invest in sukuk either. Vincent Rodo, chief financial and administrative officer at the TTC, says asset managers decide what bonds to buy on behalf of the fund, which sets requirements about geography, management type (passive or active) and bond quality (usually investment grade). “Within those parameters, if our managers thought Islamic bonds were a good fit, they’d be purchasing them.”

It makes you wonder why pension funds are so tight-lipped about whether they own Islamic bonds. “There is such a bad perception as soon as you talk about Islam” in developed economies, says Suhail Ahmad, CEO of Hikmah Capital, a Calgary-based financial research and tech company focusing on Islamic finance.

Max Wolman, a Britain-based senior investment manager on the emerging markets debt desk with Aberdeen Asset Management, has also witnessed some unease. “You get the impression that some institutional investors are like, ‘Oh, Islamic bonds, Islamic law—I don’t want to touch it.’ But these [debt] structures have been created by lawyers, so they should be fairly robust.”

How it works

Sukuk resemble conventional bonds in that investors get a fixed return, but that return isn’t in the form of interest, which Islam forbids. Each sukuk unit represents a share of an underlying entity, such as a physical asset, business or project. In lieu of monthly interest, investors receive a share of the profits (or losses) delivered by the underlying entity.

Partial ownership in an asset is the most common sukuk structure, called ijara. With ijara, the return is the asset’s monthly rental income—usually linked to LIBOR, the widely used global benchmark for short-term interest rates.

Sukuk can be asset-based or asset-backed. With asset-based sukuk, you only own the underlying asset if the issuer defaults. With asset-backed sukuk, you own the asset from the beginning. And all this represents just a tiny share of the debt market. A report by the International Islamic Financial Market, a non-profit entity in Bahrain, says global outstanding sukuk stood at $668 billion U.S. as of July 2014—only three percent of the total global debt outstanding.

“It’s a nascent market, but it’s been tested,” says Rehan Saeed. And it’s growing. Major rating agencies such as Standard & Poor’s rate sukuk, and these bonds are listed on exchanges.

More reason then perhaps for pension funds to buy. Max Wolman says they should, because sukuk returns often resemble those of traditional bonds. Their main advantage is they provide access to countries that may not issue conventional sovereign or corporate debt, such as Malaysia, the world’s top sukuk issuer and Saudi Arabia, another major issuer.

“Say you want to get exposure to the Middle East,” says Wolman. “A particular company [there] might only have sukuk outstanding. So you have to buy the sukuk, because if you don’t, you can’t get exposure to that credit.”

But Ibrahim Warde, adjunct professor of international business at Tufts University in Boston, says sukuk require more due diligence than traditional bonds because investors need to research the underlying assets and ensure they can own them in practice, not just on paper.

He points out that Dubai’s debt relief request in 2009 shows what can go wrong when investors don’t do their homework. “There were some questions about whether the land that served as securities for those sukuk could actually be owned by foreigners.” Ironically, default fears motivated some Western hedge funds to buy Dubai’s debt. “Their reasoning was that in case there was an actual default, they will go after the government of the United Arab Emirates, given it has deep pockets.” The debt has since been restructured.

Sukuk also tend to be illiquid: most investors hold them to maturity, since demand outstrips supply. That’s why the secondary sukuk market isn’t robust.

The IIFM report notes that this could be a problem for pension funds, which try to match bond maturities to the durations of their liabilities, but the trend is changing and longer-dated sukuk are coming to market.

Sukuk also pose an ethical paradox. Islamic law forbids things such as pornography, alcohol and gambling, making sukuk ethical products. But some sukuk issuers, such as Saudi Arabia, are considered oppressive regimes by potential investors, who must decide whether to do business with such governments.

“I can understand their feelings,” says Ahmad. “Even I have issues with Saudi Arabia. I have issues with Iran.” Still, Ahmad says, investors can choose other governments that issue sukuk, some even non-Islamic.

Last year, Luxembourg and the UK became the first western nations to issue sukuk. The UK, for example, made a small issue of £200 million, which was more than 10 times oversubscribed. The sukuk provide rental income from UK government property. Other non-Muslim entities that have issued them include South Africa, Singapore and Hong Kong.

“The reason for [those issues] is clearly to tap Islamic wealth, especially in the Gulf region,” says Warde.

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Canada certainly doesn’t follow sharia law, but that doesn’t mean it can’t issue sukuk. It’s just a matter of ensuring legislation and tax rules make it possible to issue debt in a way that meets Islamic standards. “In most cases,” says Warde, “the governments issuing sukuk have needed to change their legislation to provide for sukuk as a specific asset class in terms of the tax treatment…”

Ontario dipped a toe into Islamic bonds back in 2009, right after the province’s then finance minister, Dwight Duncan, returned from Saudi Arabia and the UAE in a bid to drum up support for Ontario bonds. Duncan, now a senior strategic advisor at McMillan LLP, says his ministry wanted to learn more about sukuk to see if it could potentially issue them some day, but it didn’t have serious intentions. “We discussed them very informally. There was no formal study. There was no directive.”

Duncan’s team met several times with Islamic finance experts to learn how sukuk work. And representatives from Kuwait Finance House visited Toronto to explain how it could potentially offer a listing. At the end of all the meetings, a major challenge stood out.

“We couldn’t get clarity on what constitutes sharia-compliant bonds,” recalls Duncan. There’s no universal standard about the exact criteria a bond issuer must meet to be deemed shariacompliant: interpretations vary across Islamic countries.

Rehan Saeed says if Canada did issue sukuk, it would make the asset class less exotic for Canadian pension funds.

And Ahmad says there are other compelling reasons to do it. “We’ve got a lot of infrastructure that [will be] coming up for renewal. And that’s going to require massive investment that we can’t necessarily get from the domestic market.” He insists investors in Muslim countries would definitely be interested in Canadian sukuk. “They’re looking for high-quality assets. They’re looking for relatively stable political regions.”

This article was originally published in Benefits Canada, April 2015.

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Copyright 2014 Rogers Publishing Ltd. This article first appeared in the May 2015 edition of Corporate Risk Canada magazine