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2006 Islamic Debt Markets:

The Malaysian debt capital market has demonstrated resilience as an alternative source of financing for the economy, fundamentally due to the accommodative interest rate environment, a pick up in domestic economic activity and ample liquidity conditions. Concurrently, a rather more exciting area within the capital market that has made headway in recent times is the area of Islamic debt. In a niche mainstream financial industry, Islamic debt instruments account for a large proportion of the private debt securities (PDS) market. In the last six years, the composition of Islamic fixed rate securities grew unabated and increased in significance (see Chart 1). Chart 1: Malaysian PDS market (19902006f)
45000 40000 35000 30000 25000 20000 15000 10000 5000 0

Chart 2: Total No. of Islamic Corporate Bonds Issued and Rated by Sector as at December 2005

T r ans por t at i on Heal t hc ar e 0. 1% Supr a 0. 1% T r dg/ s er v 3. 9% I nf r a & ut i 52. 8% 1. 4% P r op/ R eal E s t 20. 6%

Cons t r uc t i on 2. 4%

I ndus t r i al pr od 7. 5% Cons umer pr od 0. 8% P l ant / A gr i 2. 0% M i ni ng 2. 9% Fi nanc i al s er v ABS 3. 3% 0. 1% I nv es t ment hl dg 2. 1%

Source: BNM/FAST, RAM, MARC, Aseambankers Statistics include total of IPDS rated and issued to date (matured and outstanding)

Islamic

Convent ional

Tot al

Source: BNM/FAST, RAM, MARC, Aseambankers

Demand for domestic Islamic debt instruments, which accounted for only 7% of total bonds raised in 1999, grew to 25% in 2000 and subsequently to 76% in 2005, primarily due to investor awareness of alternative funding sources, i.e. Islamic instruments and the increased number of Islamic funds launched over the years. No fewer than 45% of all Malaysian domestic bonds are now Shariah compliant, especially the larger issues, and this proportion continues to grow. The result is that Malaysias Islamic financial landscape has advanced in terms of diversity of instruments and its modernity, and boasts a dual banking model whereby a developing Islamic financial system exists in parallel to the conventional banking system. To chart the growth of Islamic fixed income securities, total Islamic PDS (IPDS) issued since 1991 (matured and outstanding) amounts to US$39.46 billion at 333 issues. In terms of total number of IPDS issued, the infrastructure/utilities and property/real estate sectors dominate at 53% and 21% respectively, given the large-scale nature of these projects (see Chart 2).

Notable new Islamic fixed income securities issued in 2005 include Maybanks US$266.61 million (RM1 billion) worlds first Islamic subordinated debt issued by a Malaysian financial institution; Cagamas Islamic RMBSs US$546.56 million (RM2.05 billion) Islamic asset-backed securities; Musharakah One Capitals US$148.5 million (RM557 million) Islamic assetbacked securities; PG Municipal Assets US$21.33 million (RM80 million) first municipal bond issued in Malaysia; Jimah Energy Ventures US$1.52 billion (RM5.7 billion) infrastructure and utilities; Senai Desarus US$389.33 million (RM1.46 billion) infrastructure and utilities; and Ranhill Powertrons US$143.99 million (RM540 million) infrastructure and utilities. In 2006, the Malaysian bond market is expected to continue its aggressive stance with an estimated US$9.33 billion (RM35 billion) worth of new debt to be issued. A large proportion of these new bonds will be channelled to finance infrastructure projects, given that 2006 is the first year of the 9th Malaysian Plan. Of the total US$9.33 billion (RM35 billion) worth of new issues, 80% of the bonds are expected to be Shariah compliant, given the market momentum and demand for Islamic papers. This again denotes the pace of development and depth of the Malaysian Islamic debt market. The Al Bai Bithaman Ajil (ABBA) structure has been the preferred choice to finance such projects with long gestation

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2006 Islamic Debt Markets: New Challenges, New Frontiers

periods (see Chart 3). Under this principle, the financier purchases an asset from the issuer and sells it back to the same party at a premium. Besides ABBA, another popular Islamic PDS tool is the Murabahah concept, which caters for short to medium-term requirements. These two financing structures have dominated the local scene largely because they closely mirror conventional bonds in terms of cashflows and are easily understood by issuers and investors. Nevertheless, the Malaysian Islamic bond market has of late ventured into new innovative structures, taking into account growing interest in Islamic papers from the Middle East as well as other countries. Chart 3: Total Value of Islamic Corporate Bonds Issued and Rated by Financing Concept as at December 2005

Further prospects also exist for Islamic products in the areas of asset origination and asset management. Following on from the theme of innovation, structures that can be explored include the gradual shift to Istisnah, Ijarah and Salam based products, short-term oil and commodity linked products, equity/debt hybrids, as well as internationalizing distribution lines. Continuous research and development in the areas of product development can also enhance growth in Islamic equity funds, cultivate liquidity management of assets, as well as creating Shariah based equity benchmarks.

Bai Inah 0.7% Qar d Hassan 0.7% Bai Bi Al -Taqsit 1.3% Bai Al-Dayn 3.9% Ij ar ah 1.9% Istisnah 9.7% Bai Bi thaman Aji l 52.9% Mushar akah 2.7% Mur abahah 26.1% Mudhar abah 0.1%

The Malaysian Islamic bond market has of late ventured into new innovative structures, taking into account growing interest in Islamic papers from the Middle East
2006 will be characterized as a year that will see an average of 5.5% GDP growth for Malaysia with key sectoral drivers being the oil and gas industry, commodities and plantations. As such, the fundraising activities will also boast Shariah compliant structures that support activities in these key areas. The Malaysian bond market has thus far displayed exemplary growth with the onset of Islamic debt, which has further enhanced competitiveness and sophistication in the increasingly robust and competitive world of banking; thus contributing towards the resilience of the overall international financial architecture.

Source: BNM/FAST, RAM, MARC, Aseambankers Statistics include total of IPDS issued to date (matured and outstanding) So why are Islamic bonds becoming increasingly popular? The advantages fundamentally lie in the structure of Islamic finance itself. Islamic bonds provide an avenue for Islamic investors to invest in Shariah compliant investments, thus guaranteeing access to a larger investor base, as well as providing potential lower pricing to issuers via the wider investor pool from the participation of large Islamic investors. In the international foray, it is anticipated that global Islamic capital markets will be responsible for managing at least 50% of the total saving of Muslims worldwide in 810 years time. Nevertheless, like all financial mechanisms in the emerging stages of development, the Islamic industry poses some overreaching challenges. The main hurdle is in accessing long-term investors and ensuring sustainability of the Islamic industry. Further to this, creating a deep and liquid secondary market for Islamic instruments through the enhancing of risk management tools and innovation of new products will ensure that standards remain adaptive and effective in riding the evolutionary waves of financial innovation. Establishing sizeable and organized institutions, ongoing research and development, as well as consensus amongst Islamic jurists and scholars on Shariah issues also remains an integral core of Islamic finance.

The author is Chief Economist and Head of Research at Aseambankers Malaysia, the investment banking arm of Maybank. The information herein has been obtained from sources believed to be reliable but cannot be guaranteed. The views or opinions expressed are subject to change at any time. Neither the information nor any opinion expressed is to be construed as a solicitation for the purchase or sale of any securities. Aseambankers Malaysia does not assume any responsibility whatsoever in this respect.

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