S&P Global Ratings believes the sukuk market will see a significant reduction in issuance volumes in 2020. The drop in oil prices and restrictions related to the COVID-19 pandemic will take a toll on important sectors in core Islamic finance countries, including real estate, hospitality, and consumer-related businesses. What's more, government measures will result in lower issuance from both corporate entities and central banks. In addition, we believe most government issuers may turn to conventional bond markets rather than issue sukuk as they grapple with the impact of weaker economic environment on their budgets. Sukuk issuance is still more complex than for conventional bonds. Added to this is investors' increasing risk aversion in the uncertain environment and widening spreads, which imply that financing conditions will be extremely tight for issuers with weak credit quality.

A market recovery is likely from the third quarter, but we don't think issuance in the rest of 2020 will be sufficient to compensate for the first-half decline. Sukuk issuance volumes fell 32% in the first quarter of this year and we expect the decrease to be even steeper in the second quarter, since most core Islamic finance countries started implementing measures related to COVID-19 in March. Overall, we forecast around $100 billion of sukuk issuance this year, about 40% lower than in 2019. In the current environment, the number of defaults among sukuk issuers with low credit quality will likely increase.

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Depressed Markets Will Hit Sukuk Issuance

We now expect the economic performance of core Islamic finance markets to remain muted in 2020, with some of them recovering only in 2021 (see chart 1). Against this backdrop, we now think the volume of issuance on the sukuk market will decline again in the second quarter (see chart 2). We expect the volume of issuance to reach $100 billion at best this year compared with $162 billion in 2019, which represents a drop by almost 40%. Already, measures to combat the COVID-19 pandemic have pushed the world's largest economies into near hibernation (see "Global Credit Conditions--Triple Trouble: Virus, Oil, Volatility," published April 1, 2020, on RatingsDirect). While China is slowly reemerging from lockdowns, Europe and the U.S. aren't yet past the viral peak, and we've not yet seen the full impact on vulnerable emerging markets. Combined with the unprecedented collapse in oil prices and record market volatility, this has eroded the creditworthiness of many entities around the world.

Chart 1

Chart 2

Fresh Liquidity Has Reduced Issuance Needs

In response to low oil prices and sluggish economic activity, several countries have implemented measures to unlock banking sector liquidity and help corporations cope with the adverse impact. This means corporates will have a lower need to enter the sukuk market this year, even assuming an economic upswing from the third quarter. We think most of their financing will come from the local banking systems, which have received incentives to provide funding from their respective governments or regulators.

Most of the sukuk issuance happens locally. With higher local liquidity, people will turn to the banking system instead of sukuk issuance. The overall volume of issuance in local currency accounted for three-quarters of total issuance in 2019 (see chart 3). We observed an increase in the share of foreign currency issuance in the first quarter, however. This is primarily due to the sharp increase in sukuk issuance in foreign currency in Saudi Arabia, while in other markets it remained stable or declined (see chart 4). We understand such issuances stemmed from the proactive sourcing of funds by the Islamic Development Bank and Riyadh Bank before the market turbulence began.

Chart 3

Chart 4

Central banks have few reasons to issue this year. Since they have opened liquidity taps through the banking sector, there is limited need for local currency liquidity management via sukuk. In 2019, central banks accounted for 17.5% of total sukuk issuance.

Issuers May Wait It Out Or Go Elsewhere

Market conditions have become very volatile. Over the past few months, we have observed large outflows of capital from some emerging economies (see chart 5). We therefore think sukuk issuers will probably wait for the best window of opportunity to tap the market in 2020 if they have no other alternative. This would require the containment of COVID-19 and the restart of economic engines in core Islamic finance countries.

Chart 5

Another key factor is that sukuk issuance is still complex. This means that, potentially, governments could turn to other instruments that are easier to bring to the market. These could take the form of bilateral/multilateral lending agreements, syndicated loans, or issuance on conventional capital markets. When oil prices dropped in 2014, market observers expected a windfall of sukuk issuances the following year. In reality, the market saw a 27.5% drop in issuance in 2015. Sukuk are still complex capital market instruments and the process of issuing them is not yet equivalent to that for issuing bonds. This tends to push issuers to seek other avenues when they need to raise financing quickly. Standardizing legal documents and Sharia interpretation is a prerequisite to making sukuk a truly competitive instrument in terms of time and effort.

Issuer Default Rates Could Rise

Given the shocks to the economic environment and rapid change in market conditions, we expect credit risk to increase sharply. Among other things, we might see much higher default rates among sukuk issuers, especially those with low credit quality or business plans that depend on supportive economies and market conditions. Defaults will test the robustness of the legal documentation used for sukuk issuance and provide insight into the outcome for investors. Investors generally do not have access to the sukuk's underlying assets in the event of a default, except when those assets were sold to the special purpose vehicle issuing the sukuk, which is an exception rather than the norm. We expect defaults and the implications for investors will bring the debate on standardization of legal documents back to the forefront.

Innovation And Green Sukuk Will Take A Back Seat

The momentum in using blockchain for sukuk and issuing green sukuk will likely slow this year. We were expecting these two areas to play a significant role in opening up the sukuk market. However, the current economic shock and volatility in capital markets mean that issuers will probably no longer view them as a priority. We believe that, once the dust settles, green sukuk and issuance of sukuk using blockchain technology will be two major accelerators for the industry.

We are also of the view that the current health crisis could act as a catalyst for the issuance of social sukuk or a new breed of instruments, for example, one on which the rate of return would decline if the issuer fulfills certain social objectives, such as supporting the healthcare system or helping companies affected by COVID-19 so they don't need to lay off staff. We also see an opportunity for the reemergence of certain strong Islamic instruments, such as Zakat and Waqf, which could again play a role in reducing the impact on the most vulnerable segments of the population or poor countries. This would not only be in line with the ultimate goals of Sharia but also create a new growth channel for the industry.

Related Research

• GCC Banks Face An Earnings Shock From The Oil Price Drop And COVID-19 Pandemic, April 6, 2020
• COVID-19 Exposes Funding And Liquidity Gaps At Banks In The Middle East, Turkey, And Africa, April 6, 2020
• Global Credit Conditions--Triple Trouble: Virus, Oil, Volatility, April 1, 2020
• COVID-19 Exacerbates Africa's Social And Macroeconomic Vulnerabilities, March 18, 2020
• Prolonged COVID-19 Disruption Could Expose The GCC's Weaker Borrowers, March 11, 2020
• AAOIFI's Proposal May Result In Different Interpretations On The Treatment Of Unrestricted Investment Accounts, Jan. 29, 2020
• Sukuk Market To Continue Expanding In 2020, Barring Event Risk, Jan. 12, 2020