Sukuk as an Alternative to Financing for Local Governments

Local
governments may face higher borrowing cost on municipal bonds (munis) after a recent
tax bill that lowered the corporate rate, making munis less attractive. Institutions
such as banks, property and casualty insurance companies, and life insurance
companies that usually subscribe to munis will start earning more money off
other types of investments because their tax rate is much lower. All else being
equal, the effective net benefit of owning municipals drops and the muni rates
may have to go up to be competitive. Local governments may be able to maintain
their borrowing cost post-GOP tax bill by diversifying their sources of fund
via alternative financing such as Sukuk.

Bâton
Global has extensive experience in the Sukuk issuances across different
geographic regions. Combining our academic research and industry expertise,
we’ve advised clients by providing specific strategies on ways to successfully
navigate the challenges in Sukuk fundraising as an alternative source of funds. 

What is Sukuk?

Sukuk
is an Islamic Investment Certificate that has similar economic characteristics
to conventional bonds and has been accepted as a mainstream asset class by
global investors. However, unlike conventional bonds, which merely confer
ownership of a debt, Sukuk grants the investor a share of an asset, along with
the commensurate cash flows and risk. Hence, Sukuk requires a minimum
percentage of tangible or physical assets to structure it, which is readily
available when the local governments are planning to issue munis. Sukuk
securities adhere to Islamic laws which prohibit the charging or payment of
interest, leading to partnerships being fully explored. Prohibiting interest
payments can be a detriment of the issuing firm’s ability to secure the best
financial terms.

How Does Sukuk Work?

The
most common form of a Sukuk is a trust certificate where an Special Purpose Vehicle (SPV) is created. The underlying asset is transferred to the SPV at
a predetermined price for the Sukuk to proceed. Next, the SPV will lease back
the assets to the issuer and distribute periodic profit to the
investors. At maturity, or on a dissolution event, the SPV will sell the assets
back to the seller at a predetermined value.

The Advantages of Sukuk

Local
governments will be able to diversify their investors base by issuing a Sukuk
instead of just relying on the traditional financial institutions for their
municipal bond financing. This is largely due to strong pent-up demand from the Islamic
investors that are hungry for avenues to park their liquidity.

Dollar-based
sovereign Sukuk issuances are extremely limited and this would ensure a robust
order book, which provides the issuer with potentially tighter pricing than the
conventional equivalent. A majority of the Sukuk investors are not affected by
the tax bill, hence their effective net benefit of owning munis remain neutral.
As a result, local government should be able to maintain their cost of
borrowing while attracting investors to invest in their programs.

Gaining
Popularity

Sukuk
issuances might be foreign for the US based issuer. However, it is becoming a
norm in Asia and recently in Europe, as there is stronger demand for it from a large
investor base. Leveraging Bâton Global’s expertise in this domain ensures
issuers are maximizing their ability to leverage this alternative source of
financing.

How
can we help ensure success with your next Sukuk issuance as an alternative
source of funds?