Should conventional investors add Islamic bonds to their portfolio?

The global growth of Islamic financial institutions and a stellar 2019 for many global sukuk funds has seen demand rise

Illustration by The National 

For investors with a Sharia-compliant investment portfolio, including sukuk is a "no-brainer", according to one fund manager. This is because sukuk play the same stabilisation role that bonds do in a conventional investor’s portfolio. But, at a time of uncertainty for the global economy and with high amounts of negative yielding debt, should conventional investors consider adding sukuk to their portfolio too?

They certainly might be tempted based on the stellar returns for several sukuk funds last year. Franklin Templeton’s Global Sukuk Fund returned 12.6 per cent over 2019, while Emirates NBD Asset Management’s Global Sukuk Fund returned 11.5 per cent over the same period and Al Hilal Global Sukuk Fund delivered 10.5 per cent over the 12 months through to the end of November 2019.

However, many of these funds also produced poor results in 2018 leaving their performance over a longer period more subdued. Franklin Templeton’s fund was down 1.5 per cent for 2018, for example.

Excellent returns in 2019 are also part of a wider uplift for fixed-income assets generally. For example, the Vanguard Global Bond Index Fund — the type of fixed income fund a conventional investor might have in their portfolio — was up 8.4 per cent (net of expenses), while its benchmark, Bloomberg Barclays Global Aggregate index, was up 8.6 per cent. Riskier emerging market bonds funds delivered even better returns with the iShares JP Morgan USD Emerging Markets Bond ETF producing a total return of 15.6 per cent last year, balanced against a 5.7 per cent drop the previous year.

While the performance of sukuk markets “has indeed been strong over the past few years,” that has to be seen in the context of how well bond markets have done in general, says Richard Carter, head of fixed interest research at Quilter Cheviot, one of the UK’s largest discretionary investment firms, which has an office in Dubai.

“Obviously it depends on which measure or index you take but arguably the returns have not been that different to conventional US dollar investment grade debt,” he adds.

Over the past six years, however, the average annualised return on the Dow Jones Sukuk Index, which tracks US dollar denominated investment grade sukuk, is around 4.3 per cent, whereas over the same period the Bloomberg Barclays Global Aggregate Bond Index has produced a return of around 4.1 per cent, a slight tilt in favour of sukuk, says Angad Rajpal, head of fixed income at Emirates NBD Asset Management.

Another key performance datum is volatility. Sukuk have very low levels of volatility, especially when compared with emerging market debt, says Mohieddine Kronfol, chief investment officer of Global Sukuk and Mena fixed income at Franklin Templeton. For someone who’s investing in global fixed income, he says it makes sense to invest in global sukuk because of the diversification benefits and defensive characteristics of the asset class.

“The global sukuk market continues to exhibit low correlations to other fixed income sectors and obviously equity markets and even commodities like oil,” while also exhibiting low levels of volatility, which will typically have a positive impact in the context of an overall portfolio, says Mr Kronfol. “Adding global sukuk to a conventional investor’s portfolio reduces that portfolio’s risk."

Global sukuk have experienced less downside risk compared to major global fixed income benchmarks over the past 10 years, according to Franklin Templeton, with lower drawdowns during times of market stress, apart from the global financial crisis of 2008-2009, providing downside protection for investors.

The growth of Islamic financial institutions, such as banks and takaful institutions, which continue to capture market share from conventional counterparts, is boosting demand for sukuk and contributing to market strength, says Mr Kronfol.

Strong demand creates a “scarcity premium” which helps protect the market against drawdown in times of market stress, says Samin Abedi, the global head of portfolio management at Wahed Invest, a US robo-advisory, which also has a presence in the UAE.

Emirates NBD’s Mr Rajpal agrees. “Historically sukuk instruments have benefited from very strong scarcity value," he says. "Some of that has faded, especially in relation to sovereigns, but I would say that still pretty much exists for corporates. So there’s still a lot of scarcity value for sukuk."

However Mr Carter suggests the lower volatility may be partly due to less active trading in sukuk where investors tend to "have a buy and hold approach".

With most sukuk issued in Muslim-majority countries, it means interested investors will be adding exposure to a specific geography, typically the Middle East or countries in South-east Asia including Malaysia and Indonesia.

From a conventional investor perspective, sukuk are similar to emerging market (EM) debt, says Mr Carter, though most EM fixed income funds will have a broader exposure across Asia, Latin America and Eastern Europe.

“That [broad exposure of EM fixed income funds] has not necessarily always been a good thing because Middle Eastern bonds have performed quite well of late despite political tensions, while countries like Argentina have done poorly,” he says. “Emerging market funds may also have more exposure to currency risk whereas sukuk funds are generally dollar-based, while yields in EM funds tend to be higher due to additional sovereign and credit risk."

Downsides conventional investors may see when considering sukuk funds is that they typically have to go invest through actively managed funds, which can come with higher costs than passive index funds.

“The choice of sukuk funds in reality is fairly limited and the number of issuers in those funds is quite small,” says Mr Carter. “Conventional investors have a massive choice of funds even if they are only looking at US dollar investment-grade credit. The ETF market [for conventional fixed income] is also highly-developed and attractively priced."

The Sharia-compliant robo-adviser Wahed Invest offers a relatively low-cost option, with sukuk funds included in its investor portfolios. Its fees range from 0.5 per cent to 0.1 per cent per year depending on how much you invest.

Steve Cronin, founder of the online financial community DeadSimpleSaving.com, an independent community for financial education in the UAE, says he sees no reason for a non-Muslim investor to invest in sukuk.

“They are very concentrated in emerging markets, such as the GCC and South-east Asia, and typically corporate-backed," he says. "It's much better for most investors to take their risk in equities and then have an allocation to shorter-term government bonds for downside protection during a correction or crash.”

The “narrow breadth of the market” is the main downside for conventional investors, says Mr Carter.

Total sukuk issuance in globally 2019 were worth $162bn, according to research from S&P Ratings, while the total issuance of bonds in the US market alone was around $8 trillion according to data from the Securities Industry and Financial Markets Association/SIFMA.

“The number of issuers is fairly limited and concentrated in countries like the UAE, Indonesia and Saudi Arabia," says Mr Carter. "While many of the issuers have solid credit ratings, they are not especially well-known companies in a global context.”

Even if an investor sees value in adding sukuk to their portfolio, given the recent strong returns from many funds it’s worth questioning whether now is a good time to allocate to sukuk or fixed income. After all, chasing returns is one of the most basic mistakes an investor can make.

“There is good reason to be wary of fixed income markets [generally] at the moment given the extremely strong returns that they have enjoyed [in 2019],” says Mr Carter. “This performance has been driven by concerns over Trump’s trade war with China plus interest rate cuts from the Federal Reserve.

“However, higher quality fixed income remains an important diversifier against equity risk in portfolios and should continue to perform well if the global economy slows,” he adds.