Europe's first Islamic bond is expected to be issued in the next few months and increasing numbers of Western borrowers are eyeing cash-rich Muslim investors as a source of funds.
Germany's eastern state of Saxony-Anhalt expects to issue around 100 million euros ($120 million) worth of debt in a bond adapted to meet Islamic laws, which forbid interest payments, in May or June.
Bankers say the German state is not alone in its hopes of attracting investors from among the world's 1.3 billion Muslims seeking assets compliant with Islamic laws that also bar links to industries involving alcohol, gambling, weapons or pork.
"Islamic financing is a good way to diversify your investor base and presents similar economic values to conventional transactions," Renald Sanzey, global head of Islamic finance at Deutsche Bank, told Reuters from Singapore.
"It is a win-win situation because it also allows Islamic investors to diversify their portfolios further."
Another Islamic banker based in the Middle East who asked not to be named said Saxony-Anhalt's transaction would find good demand from investors already holding Islamic bonds, called Sukuks, issued by Muslim countries such as Malaysia and Qatar.
"You will find buyers as well among conventional investors, but these fellows do need a bit of education to understand how these instruments work," the Middle-East based banker said.
Islamic bonds pay no direct interest, which Muslims consider usury. They instead make regular payments based on profits from approved investments.
The Saxony-Anhalt Sukuk is based on a sale and lease back scheme under which the German state will transfer the rights on some state properties to a Dutch foundation.
The holders of the Sukuk issued by the Dutch foundation will receive rent from the properties instead of interest. Saxony-Anhalt can buy back the rights to its properties after five years.
Islamic bonds also offer an alternative to investors looking beyond the US debt market.
The recent slide in the dollar has ignited concerns that US assets may be less attractive to foreign institutions, which are huge holders of Treasury debt.
A Europe-based Islamic banker working for a global financial institution said his bank had already begun approaching borrowers in the West to launch Sukuks.
With some potential borrowers reluctant to bind assets such as equipment or property into a leasing arrangement, this banker said there were moves to develop new types of Islamic-compliant structures that would not require such pledging assets. He did not elaborate.
A second Europe-based banker said that while there was great potential for Western institutions to use Islamic bonds to raise capital, there would be some constraint on Islamic institutions buying high investment grade paper.
"Funding costs for highly rated borrowers is generally at sub-Libor costs and many Islamic banks have to borrow at Libor plus 60 to 70 basis points and so they can't just turn around and invest it in sub-Libor paper," the second European banker said.
But with Islamic institutions saddled with large pools of deposits that they have to manage, issuers whose Sukuks develop a liquid secondary market can be useful liquidity management instruments, he said.
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