Yield, pricing comparison of Islamic Sukuk and conventional bonds: there is a discrepancy

Sukuk, also known as Islamic bonds, are financial instruments that comply with Islamic law (Shariah) and its investment principles. Unlike traditional bonds, Sukuk represents ownership in a tangible asset or pool of assets rather than debt.

This means that investors are given a share of ownership or profits generated by the underlying assets, rather than just receiving interest payments. For example, the government issues asset-backed instruments to Islamic institutions which generate income by renting out the assets to the government. Sukuk is similar to conventional bonds in terms of the investment process and the returns.

In April 2020, the Ministry of Finance (MoF) reintroduced the Sukuk issuance program, which had been on hold for more than four years, in order to offer Islamic financial institutions an investment opportunity amid high liquidity and double-digit growth in Islamic Banking assets.

Additionally, it also helped the government to lower its borrowing costs in comparison to conventional bonds. Furthermore, in December 2021, the SBP also introduced Shariah-compliant modaraba-based open market operations (OMO-Injections) and a standing ceiling financing facility (MFF) for Islamic Banking Institutions to enhance monetary policy transmission and to better manage market liquidity.

The growth of GOP Ijarah Sukuk issuance has been extensive over the past 2.5 years, as the assets and deposits of the Islamic Banking Industry have also been increasing at a faster pace. According to data on the State Bank of Pakistan (SBP) website, the share of assets and deposits of Islamic Banks in Pakistan in the overall banking industry currently stands at 20% and 21% respectively, compared to 15.2% and 16.9% in March 2020. The growth in Islamic Banking assets and deposits is as follows:

For the last year, the Government of Pakistan (GOP) regularly issued both variable and fixed rate Sukuk monthly with a maturity of five years. In CY22, the central bank borrowed a large sum of PKR1,322 billion (fixed and variable) from Islamic participants under 5-year Ijarah Sukuk at a significant discount compared to conventional yields.

On a cumulative basis, it borrowed PKR2.62 trillion from Islamic Banking Institutions. During the period under review, the minimum and maximum spread on the 5-year Variable Rental Rate (VRR) Sukuk was negative (-)125bps and (+)35bps, while the Fixed Rental Rate (FRR) Ijarah Sukuk offered yield in the range of 8.4150% to 12.9407%.

History of sukuk issuances are provided below:

On January 5, 2023, the GOP raised PKR10 billion through the issuance of the first-ever semi-annual three-year maturity Ijarah Sukuk. The Government of Pakistan received bids worth PKR60.9335 billion in the range of -25 bps to +144 bps. However, GOP accepted a single bid of PKR10 billion at a spread of negative 25 bps from the benchmark yield. In the recent successful auction, SBP announced a discounted price that resulted in a spread of +35bps for 5-Year VRR Ijarah Sukuk.

In contrast, the most recent cutoff for conventional 3-year variable Pakistan Investment Bonds (PIBs) is issued at a positive spread of 105bps. Similarly, in November 2022, SBP last issued the 5-year floating rate PIB at 140 bps. This represents a significant difference of more than 130bps & 105 bps in 3- and 5-year variable instruments compared to Shariah-Compliant Ijarah Sukuk.

Similarly, based on the last successful PIB fixed rate auction in November, the government announced the cutoff of 13.35% for 5-Year PIB, while the 5-Year Fixed Rate Ijarah Sukuk was issued at a yield of 12.49%, a difference of 86 bps.

Initially, this discrepancy may have been understandable due to the market's high demand for lower yield on account of excess liquidity caused by a large growth in deposits, a shortage of Shariah-compliant risk-free instruments, and a lack of SLR-eligible securities in the system.

However, now that Islamic Banks have ample long-term instruments, no excess liquidity and there are no shortages related to Statuary Liquidity Requirement (SLR), a lower cutoff is considered unhealthy for the growth and development of the Islamic Banking System.

Islamic banks currently face another significant challenge with the concentration of coupon resetting of Shariah-compliant sovereign instruments in April and October.

This is largely due to the government's lack of planning for auctions due to limited and irregular Sukuk offerings. Secondly, due to a shortage of assets, the Government was reopening the Sukuk instead of fresh issuance.

As a result, 71.6% of Sukuk are now reset in April and October, which limits Islamic banks' ability to take advantage of interest rate hikes until the next reset date.

For example, a recent rate hike of 100 bps in January will have an impact on Islamic Bank’s portfolio in the month of March, as shown in the table below. Additionally, this also affects their capacity to offer high-profit rates to depositors.

On the other side, liabilities are adjusted immediately (for example borrowing through OMO or Interbank lending/borrowing transactions). All these issues can be addressed by issuing short-term Sukuk, such as Treasury bills based on Bai-Salam contracts.

It would be appropriate for the SBP and the MoF to recognise that all government securities within the Islamic financial system are of a long-term nature (Ijarah Sukuk – 5 years and Pakistan Energy Sukuk – 10 years) and that the Islamic banking sector lacks short-term alternatives to Treasury Bills that offer similar opportunities and returns.

Furthermore, Sukuk auctions are expected to continue as the Government is adamant to increase the share of Islamic debt in the overall domestic debt. However, the capacity of Islamic Banks to participate in Ijarah Sukuk auctions is squeezing because of liquidity constraints as the market is already under the medium-term (up to 77 days) OMO injection of PKR554 billion.

The government can tap into mutual funds as a new funding source by issuing short-term (3 & 6 months) Ijarah Sukuk, thereby creating another opportunity for the Shariah-compliant money market and liquid income funds for investment.

As of December 2022, the untapped assets under management (AUMs) of Shariah-compliant money market funds exceeded PKR375 billion, and the fund size for the Islamic Income Fund category reached PKR168 billion.

According to industry sources, the Ministry is considering the need for such alternatives and planning to offer short- and medium-term options (1 & 3 years with different resetting options) in the future. The issuance of short and medium-term Sukuk will enable Islamic banks and mutual funds to manage their liquidity more effectively, enable the industry to offer better products to customers, and also help improve the secondary market tradability of Islamic sovereign instruments.

However, lower yields and spreads compared to conventional instruments discourage Islamic counterparts from participating in the auctions, impacting the overall growth of Islamic banking. Similarly, if the profit rates offered on shariah-compliant products are lower than those offered by conventional banks, it may discourage depositors from choosing Islamic banking.

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