Faith and fixed income in defined benefit pension investment

“The big ones have certainly looked at [sukuk]. I’ve had conversations with some representatives from these entities, looking at Islamic finance to diversify their assets.”

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Benefits Canada couldn’t verify whether any major pension funds have looked into, or invest in, sukuk. The Canada Pension Plan Investment Board, the Ontario Teachers’ Pension Plan, the Ontario Municipal Employees Retirement System and the Colleges of Applied Arts and Technology Pension Plan all declined to comment. So did entities investing public pension assets, such as PSP Investments, British Columbia Investment Management Corp. and Alberta Investment Management Corp.

The New Brunswick Investment Management Corp., which invests the province’s public pension assets, doesn’t hold Islamic bonds because it has no foreign fixed income allocations, says president and CEO John Sinclair.

The Toronto Transit Commission pension fund doesn’t invest in sukuk, either. Vincent Rodo, chief financial and administrative officer at the TTC, says asset managers decide what bonds to buy on behalf of the fund, which sets requirements about geography, management type (passive or active) and bond quality (usually investment grade).

“Within those parameters, if our managers thought Islamic bonds were a good fit, they’d be purchasing them,” says Rodo.

Why are some pension funds tight-lipped about whether they own Islamic bonds? Part of the reluctance may be due to fear of public misperceptions. In some developed economies, “there is such a bad perception as soon as you talk about Islam” given the negative media coverage the religion often gets, says Suhail Ahmad, CEO of Hikmah Capital Corp., a Calgary-based financial research and tech company focusing on Islamic finance.

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Max Wolman, U.K.-based senior investment manager on the emerging markets debt desk with Aberdeen Asset Management, has also witnessed some unease. “You get the impression that some institutional investors are like, ‘Oh, Islamic bonds, Islamic law — I don’t want to touch it.’ But these [debt] structures have been created by lawyers, so they should be fairly robust.”

How sukuk work

Islamic debt structures resemble those of conventional bonds in that investors get a fixed return. But the return isn’t in the form of interest, which Islam forbids.

Each sukuk unit represents a share of an underlying entity, such as a physical asset, business or project. In lieu of monthly interest, investors receive a share of the profits (or losses) delivered by the underlying entity.

Partial ownership in an asset is the most common sukuk structure, called ijara. With ijara, the return is the asset’s monthly rental income — usually linked to LIBOR, the widely used global benchmark for short-term interest rates.

Sukuk can be asset-based or asset-backed. With asset-based sukuk, you only own the underlying asset if the issuer defaults. With asset-backed sukuk, you own the asset from the beginning.

Sukuk represent a tiny share of the debt market. Global outstanding sukuk stood at US$668 billion as of July 2014, says a report by International Islamic Financial Market , a non-profit entity in Bahrain. That’s 3% of the total global debt outstanding.

“It’s a nascent market, but it’s been tested,” says Saeed, adding this market is growing. Major rating agencies such as Standard & Poor’s rate sukuk, and these bonds are listed on exchanges.

A good buy?

So does it make sense for pension funds outside the Islamic world to buy sukuk?

Wolman says it does — but not so much for return reasons, because sukuk returns often resemble those of traditional bonds.

Sukuk’s main advantage, he explains, is providing access to countries that may not issue conventional sovereign or corporate debt, such as Malaysia, the top global sukuk issuer, and Saudi Arabia, also a major issuer. “Say you want to get exposure to the Middle East. A particular company [there] might only have sukuk outstanding. So you have to buy the sukuk, because if you don’t, you can’t get exposure to that credit,” says Wolman.

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But Ibrahim Warde, adjunct professor of international business at Tufts University in Boston, says sukuk require more due diligence than traditional bonds because investors need to research the underlying assets and ensure they can own them in practice, not just on paper.

Dubai’s 2009 debt relief request shows what can go wrong when investors don’t do that research. “There were questions about whether the land that served as securities for those sukuk could actually be owned by foreigners,” Warde notes.

Ironically, default fears motivated some western hedge funds to buy Dubai’s debt. “Their reasoning was that in case there was an actual default, they will go after the government of the United Arab Emirates, given that it has deep pockets,” Warde explains. The debt has since been restructured.

Sukuk also tend to be illiquid: most investors hold them to maturity, since demand outstrips supply. That’s why the secondary sukuk market isn’t robust.

Additionally, Sharia-compliant bonds have shorter maturity — usually around five years and rarely more than 10. This could be a problem for pension funds, which try to match bond maturities to the duration of their liabilities, notes IIFM’s report. But, says IIFM, longerdated sukuk are now coming to market.

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Sukuk also pose an ethical paradox. Islamic law forbids pornography, alcohol and gambling, making sukuk ethical products. But many investors consider some issuers, such as Saudi Arabia, to be oppressive governments.

“I can understand their feelings,” says Ahmad. “Even I have issues with Saudi Arabia. I have issues with Iran.” But, Ahmad adds, investors can choose other governments that issue sukuk, some of which are even non-Islamic.

Last year, Luxembourg and the U.K. became the first western nations to issue sukuk. The U.K., for example, made a small issue of £200 million, which was more than 10 times oversubscribed. The sukuk provide rental income from U.K. government property. Other non-Muslim entities that have issued sukuk include South Africa, Singapore and Hong Kong.

“The reason for [those issues] is clearly to tap Islamic wealth, especially in the Gulf region,” says Warde.

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But how does a country that doesn’t follow Sharia law issue sukuk? It’s just a matter of ensuring legislation and tax rules make it possible to issue debt in a way that meets Islamic standards.

“In most cases, the governments issuing sukuk have needed to change their legislation to provide for sukuk as a specific asset class in terms of the tax treatment of sukuk,” Warde explains.

Why not Canada?

In Canada, neither the federal government nor the provinces issue sukuk. But Ontario dipped a toe in Islamic bonds back in 2009, right after the province’s then finance minister, Dwight Duncan, returned from Saudi Arabia and the UAE in a bid to drum up support for Ontario bonds.

Duncan, now a senior strategic advisor at McMillan LLP, says his ministry wanted to learn more about sukuk to see if it could potentially issue them some day, but it didn’t have serious intentions. “We discussed them very informally. There was no formal study. There was no directive.”

Duncan’s team met several times with Islamic finance experts to learn how sukuk work. And representatives from Kuwait Finance House, an Islamic bank, visited Toronto to explain how it could potentially list the sukuk.

At the end of all the meetings, a major challenge stood out. “We couldn’t get clarity on what constitutes Sharia-compliant bonds,” Duncan recalls. There’s no universal standard about the exact criteria a bond issuer must meet to be deemed Sharia-compliant: interpretations vary across Islamic countries.

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If Canada did issue sukuk, it would make the asset class less exotic for Canadian pension funds, says Saeed.

And there are other compelling reasons for the country to do it, Ahmad adds. “We’ve got a lot of infrastructure that [will be] coming up for renewal. And that’s going to require massive investment that we can’t necessarily get from the domestic market.”

Investors in Muslim countries would definitely be interested in Canadian sukuk, Ahmad explains. “They’re looking for high-quality assets. They’re looking for relatively stable political regions.”

Yaldaz Sadakova is associate editor of Benefits Canada.

Note: This is an updated version of a story that appeared in the April 2015 issue of Benefits Canada.