Defaults undermine new Islamic bond issues and Islamic finance

Investors who believed Islamic bonds would somehow be better protected against adversity have had their confidence undermined by four defaults that have returned issuance to the 2005 level of $2.5 billion so far this year.

Yields on sukuk or Islamic bonds are rising – and therefore bond prices are falling – despite a decline in traditional debt interest rates. Bloomberg reported that the average yield on GCC sukuk is 6.99 per cent by comparison with 5.35 per cent for non-Islamic GCC bonds.

Bad bonds

Clearly this higher cost of funds is undermining the attraction of Islamic bonds for borrowers and giving bondholders a bloody nose.

The latest default came this week from the International Investment Group of Kuwait which was unable to pay $152.5 million due to bondholders. Investment Dar, also from Kuwait and owner of Australasia on The World project off Dubai, was the first to default on a $100 million sukuk in April last year.

This April a $650 million Islamic bond sold by a unit of the troubled Saudi-owned Saad conglomerate was dissolved. Defaults do nothing for investor confidence in any bond market, and have an instant contagion impact on other similar bond issues.

The fear is that this asset class has become unstable because of inadequate due diligence during the boom years and a tendency to put undue trust in something new during a boom. A return to conventional finance and away from Islamic bonds looks inevitable, if only because the cost of funds from Islamic structures has become more expensive.

Costly compliance

It has always been unclear what benefit an Islamic structure offered bond holders, beyond compliance with religious tenants as interpreted by the lending institution. In the cold light of a recession the reality has become a bond that falls in value more than a conventional bond and costs the borrower higher rates of interest.

Islamic finance is thus revealed more as a marketing strategy for debt instruments than something of practical value to borrowers or lenders. And now that this marketing illusion is shattered that does not bode well for the future of Islamic finance.

Islamic banking is therefore lining up to be a casualty of the recession, just as it prospered in the boom years when borrowers only thought about obtaining money without any consideration of what the cost might be in the future. This has nothing to do with Islam, it is strictly a management issue.