Opportunities in Islamic High Yield Sukuk – transcript

Speakers: Abradat Kamalpour and Tamer Bahgat

Hello everyone.  I'm Abradat Kamalpour, Partner here at Ashurst London in the Finance Practice and Global head of Islamic Finance Practice.

Hi everyone.  I'm Tamer Bahgat.  I am a Partner in the Banking Practice in London and driving our European and Middle East High Yield Practice.

Tamer, ever since you joined us here at Ashurst, you and I have been discussing how sukuk and high yield may marry together more than they have so far.  We obviously know what sukuk are.  Sukuk are Islamic compliant instruments that have the economic qualities that are very similar to bonds and, you know, the question that comes up is why not High Yield sukuk?  So, first, I think before we get into the Shari'ah compliant component of it, what are the key differences between an Investment Grade Bond and a High Yield Bond and then we can start looking at it from an Islamic perspective.

Sure.  I mean, the rule of thumb really comes down to the rating.  Anything that's really Investment Grade has a rating above a BB being rated by obviously, you know, your S&P, Moody's & Fitch is the general three standard ratings that we would use and anything below, kind of, you know, that line so your BB and lower ratings would really fall within that sub-investment grade world in which case, when looking to tap the capital markets in the forms of bonds, we would look at High Yield Bonds.

Okay.  And as we both know, most of the Sub-Investments Grade sukuk have really been done in local markets, mostly.  There's been very little sub-investment grade sukuk that's been done internationally on a major exchange like Ireland or Luxembourg or London that is sub-investment grade.  So, what's the, sort of, key differences around High Yield Bonds and, sort of, an Investment Grade Bond?  What's the structure for it?  Is it around the covenants, I think?  Right?

It's primarily around the covenants.  I mean, you know, when you look at an Investment Grade Bond, you're basically looking at a negative pledge and maybe a change of control.

Yes.  Which is very common in sukuk as well.

Correct.  Whereas what you have within the high yield space is a full suite of covenants.  I mean, we're basically, you know, anything from seven to 15 different types of covenants.  I mean, when you think of high yield, that really takes it from its name, the idea is that because it's a Sub-Investment Grade Asset Class Pool, what you have is, you know, covenants that protect the investors, but the investors are willing to, you know … or get comfortable by investing in this asset class.  One, from the covenants that are, kind of, the belts and suspenders but in return, they're getting higher yield.

Correct.  So higher return and risk managed with the covenants, basically

Correct. But what you also find, as well, is within the high yield spaces, even though the covenants are there, the question then is usually asked, well, "Why not a loan instead of a bond, or a High Yield Bond especially?"

And a fair question because a lot of the covenants that we're probably going to discuss, you see in bilateral Murabaha Financings.

One of the things, and we can discuss this perhaps later on, is the available liquidity of the lending market within the Middle East which is a challenge to the bond market and especially the high yield market.  But one of the significant and material differences within, kind of, the high yield versus other products is that when we look at the ratios and the covenants that are tied to these ratios, it's more of an incurrence based covenant package as opposed to a maintenance covenant package.  Now what does that all mean?  It basically means that when you look at, for example, you know, your loan documentations which the most … most of the loans in the Middle East have basically evolved or used the LMA Standard.  There is maintenance covenants and that basically usually … you will have three or four different covenants ratios.

Yes.

You know, interest cover charge which basically you'll have to maintain over, you know, the tenure of the loan itself.  You have, you know, leverage ratios which you also have to maintain.  And the whole idea is, you know, every three months the company needs to come back, provide the appropriate certificates to the agents, the bank saying, you know, we as a bank, here are our financial statements and we've been able to maintain our debt to cashflow or EBITDA ratios.

And we have this insured compliant form rated by financing bilateral and syndicated financing arrangements as well.

But that's really the core, you know, principal difference between a high yield and being incurrence, suddenly what you find is, you have restrictions, you have covenants …

Yes.

… but within the group, you know, what we know it as the restricted group which is basically all the entities that basically have to oblige by the covenants, they, within that group, can do anything.  Almost anything.  You know, you can move assets around.  You can have inter company loans.  There is a lot of flexibility within that core group.  However, your dealings outside of the group is really when these tests come into play.

Right.

But then the tests, because they're incurrence means that you only test them at the point in time when you actually want to do something.

Okay.

And doing something usually falls in three different buckets.  You know, if you want to take cash or assets outside of the group, be it for the form … you know, in the form of dividends or asset sales.

Yes.

Or if you want to borrow more money.  That's when you really test these different covenants and over and above that, you know, just to show how much flexibility exists, if you don't meet these ratios and therefore you don't meet these incurrence tests, you still have baskets and carve-outs within all the covenants that will still give you additional flexibility over and above what you would get especially if you didn't have it.

So it doesn't hamper your business basically.

Correct.  I mean, the idea really, is finding that balancing act between allowing the company to grow.  Again, you know, these are Sub-Investment Grade Corporates so the idea is, you know, they want to continue to grow.  They want to be acquisitive and so the whole idea by investors is you're not looking to inhibit them from that growth.

Which would be counterproductive.  Yes.

Correct.  But you want to control, basically, know and ensure that matches with the base case of what the management want to do with the company.  And in return, because they're a higher risk to some extent, and yes, I am getting my yield, but the right balance has to be checked.

Yes.  And there's obviously a developed market already in the conventional space of actually meeting that balance and bankers that have the, sort of, required knowledge on looking at a company and figuring out what the right balance would be.  I cannot see from a Shari'ah structure and perspective why we couldn't make this work for actually sukuk structures.  In fact, I think we can make it work.  We just have to look at some of the covenants carefully to make sure they don't breach some of the fairness requirements of Shari'ah financing but I don't think they will because we've got loan-type covenants in various financing structures already.  Shari'ah Compliant Financing Structures already so I can't see why we couldn't apply it.  I also, you know, want to point out, and as everyone knows, in the sukuk market, a large percentage of the buyers of sukuk are conventional investors.  They like the rating.  They like the return,  And I can't see why we couldn't look at a Shari'ah Compliant Institution wanting to issue High Yield sukuk or a conventional institution wanting to tap both high yield investor based and Shari'ah investors that like high yield returns and can get comfortable with the protections that the covenants would potentially provide and we can build these covenants in either various, sort of, undertaking agreements in the structures between the SPV Issuer of the sukuk and the ultimate borrower

[Agrees].

Or it could be put in, you know, the Ijara arrangements or Mudaraba arrangements.  Whatever structure we actually implementing in the transaction.

No, I think that's completely correct and to some extent there has been this continued evolution …

Yes.

… between, kind of, your, you know, traditional sukuk versus the traditional high yield that we know it in the U.S and Europe and you have had certain, you know, even corporates within the Middle East, you know … One that kind of comes to mind that was done earlier the year this year was DAMAC.  For example, in April, where they basically, I believe, issued about 500 million and it was, it was sold in essence as a sukuk High Yield.  I think they … They got it at maybe 6.5 or 6.25 per cent and what was interesting when you look at those covenant packages within the DAMAC structure, you do see the Hybrid play the …

Yes.

You basically highlight it which is, you know, it's almost like what we would refer to in our world as Fallen Angels type of package which is, you know … Fallen Angels, historically, are those corporates that, you know, kind of lived and breathed within the Investment Grade space and for whatever reasons, you know, financial difficulties or challenges or expansions or moving into certain other jurisdictions, they've dropped down to the sub-investment grade.  They still function as at, you know, investment grade, you know but for their financial positions and so they don't get that full suite of covenants you would get if you were a BB, single B traditional borrower.

Yes.

And so as a result, you know, you get High Yield-Lite is kind of the space we put them in. 

I see.

And so when you look at, for example, the DAMAC Bond, you do see that there's a lot of covenants that we would traditionally have in the high yield that you just do not have in DAMAC because of that developed sukuk, you know, grandfathering that they came on to the market with.

Well, I see … You know, based on what I'm seeing in the market, I think clients are looking for fixed income type instruments that give them a high return and especially in the region, they love that kind of investment.  If they can get comfortable with the financial covenant package and, you know, get comfortable with the fact that, look, it is a lower rated instrument but you have all these other covenants like high-yield investors have done, I think this could actually go very far in the market.  Both for, you know, companies in the region.  They may be companies based in some countries that don't have the required rating so there's a rating sealing on them so they could actually use this type of issuance mechanism to help with that and for international companies that could actually structure sukuk that's high yield and that will be appealing to Islamic Investors as well as high yield investors.

Look, I completely agree with what you're saying.  I think what's interesting and what we find, and the attraction especially for the Middle East is, when we look at  the origins of the high yield, kind of as a Fixed Asset Class, and especially we look at it historically in the U.S where you know it's a product that, you know, started showing up, kind of, in the mid-70's and really kicked off in the 80's and 90's, one of the biggest sectors that really helped drive this was the oil and gas sector.

Okay.

And that's one of the biggest attractions I think that some of the corporates would have in the Middle East is there are some huge, large cap and medium to large cap corporates that could benefit from a product, you know, or a Hybrid of a sukuk High Yield and that's primarily because of this incurrence concept that we have and the idea that you really service your debt at, you know, certain periods, usually, you know, semi annual but obviously under the sukuk it will be structured slightly differently to be compliant but the idea is this incurrence concept.  The idea that, you know, your covenants don't bite or your ratios don't bite.  And they only do when you want to do something. And therefore, when you're in the oil and gas space, you know, we've seen the oil prices plummet from being north of 100 dollars down to 40.  I think now they're trading in the 60's but that type of volatility within the oil and gas sector or other commodity sectors is what makes this product extremely appealable because so long as your business is moving forward, and so long as, you know, the debt in whatever form is being serviced appropriately, you're not going to be in breach of any of your covenants.  And I think that's one of the biggest appeals and hence, those that have come and done the traditional high yield deals from the region have predominantly been the oil and gas sectors.

Well I think that is a fantastic summary for our listeners on how we could actually put high yield and sukuk together.  You and I have discussed various structural ideas around it already which we think works for Shari'ah structures in the sukuk market and high yield.  So, I think if any listeners would like to get in contact with us, feel free to contact us and we can help with structuring your high yield sukuk.  I'm Abradat Kamalpour, Partner here at Ashurst London.

I'm Tamer Bahgat, Partner here at Ashurst London, driving the High Yield Practice in the Middle East and Europe.