Market conditions should remain buoyant throughout 2021, with record-low interest rates and abundant liquidity. S&P Global Ratings forecasts total sukuk issuance of about $140 billion–$155 billion this year, thanks to a recovery in issuance in Malaysia, Indonesia, and the Gulf Cooperation Council (GCC) countries. This compares with a drop in issuance to $139.8 billion in 2020 from $167.3 billion a year earlier.

We expect GDP growth in the core Islamic finance countries--the GCC countries, Malaysia, Indonesia, and Turkey--to recover from a sharp recession in 2020. We also assume that the price of oil will stabilize at about $50 per barrel in 2021. Together, these factors underpin a stronger performance by the global sukuk market in 2021 than in 2020.

However, downside risks for the core Islamic finance countries remain significant. Chief of these is whether the COVID-19 pandemic can be brought under control, even if a vaccine is widely available by mid-year, which is our baseline assumption. Until then, the main risk is that further waves of COVID-19 and the requisite containment measures may harm the countries' fragile economic recovery. This could affect the countries directly, or indirectly through lower commodity prices, exports, and capital flows.

The number of defaults or restructurings among sukuk issuers with low credit quality will likely increase in 2021 as regulatory forbearance measures come to an end. This will test the robustness of the legal documents used for sukuk issuances. However, if investors are able to get clarity on their financial recourse mechanisms because of these events, this will probably outweigh the negative impact on market sentiment.

Over the next 12-18 months, we could also see progress on a unified global legal and regulatory framework for Islamic finance that the Dubai Islamic Economy Development Center (DIEDC) and its partners are developing. We believe that such a framework could help resolve the lack of standardization and harmonization that the Islamic finance industry has faced for decades.

We may also see some sukuk issuances that aim to tackle the social problems arising from the pandemic or support the energy transition. These instruments could appeal to investors committed to environmental, social, and governance (ESG) values. However, we expect such issuances' contribution to overall sukuk volumes to remain small, due to their additional complexity and the core Islamic finance countries' slow implementation of policies to manage the energy transition.

Sukuk Issuance Will Likely Rise In 2021

We believe that some sovereigns in the core Islamic finance countries will tap the sukuk market more aggressively in 2021. We also foresee an increase in issuance by corporates. Their activity was muted in 2020 as they held on to cash and deferred capital expenditure (capex) because of the pandemic. They are likely to execute some of this capex in 2021, thereby necessitating access to capital markets. Finally, $65 billion of sukuk mature in 2021, and part of this sum is likely to be refinanced on the sukuk market. Overall, we anticipate that total sukuk issuance will reach about $140 billion-$155 billion in 2021, compared with $139.8 billion in 2020 (see chart 1).

Chart 1

The core Islamic finance countries experienced a major economic shock in 2020 due to the pandemic and low oil prices (see chart 2). Their economies entered a deep recession, with an average unweighted contraction in GDP of 3.7%. Although we expect a recovery to follow, growth will be mild compared with historical figures. We forecast average unweighted growth in GDP of 4.6% for these countries in 2021.

Chart 2

Our central assumption remains that the pandemic will come under control gradually in developed countries from second-quarter 2021, through a combination of vaccines, medical treatments, and testing, and more widely in the second half of the year. This should allow for a lifting of many social-distancing measures, a resumption of international travel, and a rebound in private demand. We also expect central banks will keep interest rates exceptionally low and continue to offer liquidity support as necessary.

While governments' financing needs are likely to decline in 2021 compared with 2020 as the oil price stabilizes and their economies grow, we think that part of these needs will be satisfied with sukuk issuance. In 2020, some governments in the core Islamic finance countries issued conventional bonds rather than sukuk, since they are easier to structure, and reportedly allow them to tap a wider investor base. The exceptions were governments and issuers under pressure to use all available financing avenues, such as those in Bahrain, Oman, some issuers in Turkey, and to a lesser extent Saudi Arabia, where an unlimited local currency program helped to minimize the drop in the overall issuance volume.

Central banks also reduced their issuance volume in most of the core Islamic finance countries in 2020, as they injected liquidity into banks and encouraged banks to lend it to corporates at preferential rates in response to low oil prices and the pandemic. This meant that the banks had met most of their economies' financing needs and corporates had less need to issue sukuk. We expect some issuance by central banks in 2021, although the overall amount is likely to remain below historical figures.

In contrast, financial institutions' issuance increased in 2020 as they sought to take advantage of supportive market conditions to strengthen their capital adequacy or lengthen their debt maturity profiles while benefiting from lower interest rates (see charts 3 and 4). Issuance by financial institutions will likely drop in 2021, but corporate issuance will more than replace it.

Chart 3

Chart 4

Interestingly, although the overall volume of sukuk issuance dropped in 2020, sukuk denominated in foreign currencies increased (see chart 5). We attribute this to favorable market conditions and abundant liquidity, which we expect will continue in 2021. More issuance by banks in the form of Tier 1 and other instruments also contributed to this increase. At year-end 2020, issuance in foreign currencies by banks totaled $9.9 billion compared with $6.0 billion at year-end 2019.

Chart 5

More Restructurings And Defaults Lie Ahead

The economic shocks in 2020 have increased credit risk for banks in the core Islamic finance countries. However, this risk has not yet fully materialized on banks' balance sheets because of the regulatory forbearance and liquidity support measures implemented in many of the countries. The extension of these measures in most countries has further delayed the materialization of credit risk.

Notwithstanding this delay, we are likely to see an increase in default rates among corporates and potentially sukuk issuers in the next 12 months, especially those with low credit quality or business plans that depend on supportive economies and market conditions. We see pressure on real estate developers in particular, given the drop in real estate prices in the GCC and the building risks in the commercial real estate sector.

We have already seen some sukuk restructurings in 2020, such as by PT Garuda Indonesia, which extended the maturity of its sukuk by three years after getting the approval of more than 90% of the sukuk holders. We expect to see more requests for extensions or restructurings among sukuk issuers in 2021, along with higher default rates. These instances will test the robustness of the legal documentation used for sukuk issuance and could strengthen the case for the documentation to be standardized. Defaults will also test the robustness of the insolvency regimes that some core Islamic finance countries have strengthened recently, including countries in the GCC. If investors are able to get clarity on their financial recourse mechanisms because of these events, this will probably outweigh the negative impact on market sentiment.

Investors generally do not have access to the sukuk's underlying assets in a default, except when the assets are sold to the special-purpose vehicle issuing the sukuk, which is the exception rather than the rule. From a rating perspective, the creditworthiness of most of the sukuk that we rate is tied to creditworthiness of their sponsor. We only rate one transaction where the repayments are underpinned solely by the cash flows from the underlying assets--a portfolio of mortgages.

Standardization Could Move Closer To Reality In 2021-2022

Over the next 12-18 months, we could see progress on the unified global legal and regulatory framework for Islamic finance that the DIEDC and its partners are developing. DIEDC embarked on this project with the Islamic Development Bank and the United Arab Emirates Ministry of Finance and several other advisors in 2020. The project's stated objectives include providing a global legal benchmark for Islamic finance, reducing regional differences in product offerings and practices, providing legal protection to all parties involved, and developing an international dispute resolution framework.

Depending on the outcome of the project, issuers may benefit from a speedier and more streamlined process to tap the Islamic finance market. Investors may also gain greater clarity on sukuk resolution in the case of default. Overall, the industry could profit from greater integration of all its components, including banking, takaful, and capital market activities. All this could create new growth opportunities and reduce the risks arising from the complexity of Islamic finance contracts. Essentially, it could make the industry more attractive to new players.

Social And Green Instruments Will Likely Make A Small Contribution

Innovative instrument structures to finance the economic recovery and tackle social issues have popped up over the past 12 months. One such instrument was the $1.5 billion sustainable sukuk issued by the multilateral Islamic Development Bank (IsDB). The proceeds of this sukuk will go toward helping the IsDB's member countries cope with the impact of the pandemic, particularly on health care and small and midsize enterprises.

Another example is the "Prihatin" sukuk that the government of Malaysia has issued. According to some market sources, the closest conventional instrument to this sukuk is a war bond. This sukuk has a low periodic distribution rate payable to the investors, and the government will use the proceeds to help restart the economy. The Prihatin sukuk would not only be attractive to all investors from a financial standpoint, but also to local investors, including retail investors, keen to contribute to the economic recovery.

These types of innovative instrument targeting social needs may appeal to other local or foreign investors with ESG objectives. If anything, they show that the pandemic has presented an opportunity to put the social element of ESG back into Islamic finance and demonstrate the social aspect of the Sharia goals, Maqasid. However, while we expect to see more of these instruments in 2021, we think that they will be the exception rather than the rule.

Green sukuk is another area of opportunity, owing to the energy transition starting in many core Islamic finance countries. As with social sukuk, while we expect to see some activity around green sukuk, we don't see it as a game changer. We expect the energy transition will take a long time to materialize in the core Islamic finance countries, and as such, expect to see sporadic recourse to green sukuk. It remains to be seen if greater standardization of these instruments or their greater contribution to the economic recovery will accelerate their development.

2021 Looks Promising For Sukuk

Overall, we expect 2021 to be a relatively good year for the sukuk market. Standardization might move forward and enhance the attractiveness of the market to new issuers. Green and social sukuk are being explored slowly and will likely contribute modestly to the market over the next 12 months. Finally, while more restructurings or defaults could occur in 2021, if investors are able to gain clarity on their financial recourse mechanisms, this will probably outweigh the negative impact on market sentiment.

Related Research

• Global Credit Outlook 2021: Back On Track?, Dec. 3, 2020
• GCC Banks: Lower Profitability Is Here To Stay, Oct. 13, 2020
• Islamic Finance: Syndication Could Make Up For Sukuk's Shortcomings, Oct. 8, 2020
• Credit FAQ: GCC Government Funding Needs Increase Sharply On Low Oil Prices And COVID-19, July 20, 2020
• Global Sukuk Market: A Window Of Opportunity Is Opening, July 7, 2020
• Islamic Finance 2020-2021: COVID-19 Offers An Opportunity For Transformative Developments, June 15, 2020
• Environmental, Social, And Governance: Islamic Finance And ESG: Sharia-Compliant Instruments Can Put The S In ESG, May 27, 2020