This document summarizes a presentation on managing risks in the sukuk (Islamic bond) industry. It defines the major risks like liquidity risk, interest rate risk, credit risk, and foreign exchange risk. It then discusses how each of these risks are currently affecting the global and Malaysian sukuk markets and challenges in managing them. Specific examples are given to illustrate the impacts and some approaches to addressing the risks are outlined. The presentation aims to help sukuk market participants understand and manage the various risks involved in investing in this industry.
1. P R O F E S S I O N A L • R E S P E C T • I N T E G R I T Y • D Y N A M I C • E X C E L L E N C E
S T R I C T L Y P R I V A T E & C O N F I D E N T I A L
Managing Risks in Sukuk Industry
Presenter: Nik Ahmad Zaki Nik Abdullah
RHB Bank
18 November 2015
Risk Management Symposium
BNP Paribas – INCEIF Centre for Islamic Wealth Management
Lanai Kijang, Bank Negara Malaysia
2. 1STRICTLY PRIVATE & CONFIDENTIAL
Page | 1
Overview
• Who are the market participants in the industry and their relationships
• What are the major risks involved in investing into sukuk and how it affects sukuk
market in current local market and global market situations
• How are these risks addressed and managed respectively by practitioners
• Challenges in Sukuk Capital Market
• Liquidity Risks
• Hedging Instruments for Interest Rates , Credit and FX
• Conclusion and Q&A
4. 3STRICTLY PRIVATE & CONFIDENTIAL
Potential in Regional Sukuk Market ( e.g. Indonesia , Thailand)
•Malaysian Government and Corporate
Bond/ Sukuk markets have developed
strongly with quite large relative to GDP
today
•However, in other regional markets such
as Indonesia and Thailand, there are still
growth potential relative to Malaysia
•We expect regional Sukuk Market to be
developed going forwards in the future
5. 4STRICTLY PRIVATE & CONFIDENTIAL
What are the risks involved?
Global
Sukuk
Market
Risks
Interest
rate risk
FX Risk /
Market
Risk
Other
Related
Risk
Credit Risk
Liquidity
Risk
6. 5STRICTLY PRIVATE & CONFIDENTIAL
Liquidity Risk
A market which is liquid, when price the buyer
offers and the price the seller is willing to accept
will be fairly close to each other. Investors, then,
will not have to give up unrealised gains for a quick
sale. When the bid offer prices grows, then the
market becomes illiquid. For example, in a buyer’s
market , buyers will tend to demand steep
discounts from sellers
Large price movements may also accompanied from
any buying/selling activity especially to the
downside.
Interest Rate Risk
The risk that an investment's value will change due
to a change in the absolute level of interest rates, in
the spread between two rates, in the shape of the
yield curve or in any other interest rate relationship
Interest rate risk affects the value of sukuk and it is
a major risk to all sukuk holders. As interest rates
rise, sukuk prices fall and vice versa.
Credit Risk / Default Risk
The risk of loss of principal or loss of a financial
reward stemming from a Issuer’s failure to repay a
sukuk or meet a contractual obligation.
Credit risk arises whenever a Issuer is expecting to
use future cashflows to pay current sukuk
obligation.
Credit risk is closely tied to the potential return of
an investment, the most notable being that the
yields on sukuk correlate strongly to their perceived
credit risk.
FX Risk / Market Risk
The risk of an investment's value changing due to
changes in currency exchange rates due to an
adverse movements in exchange rates.
It can also affect investors making international
investments. For example, if money must be
converted to another currency to make a certain
investment, then any changes in the currency
exchange rate will cause that investment's value to
either decrease or increase when the investment is
sold and converted back into the original currency.
Definition of the risks involved
7. 6STRICTLY PRIVATE & CONFIDENTIAL
Risk #1 – Liquidity Risk
Diverging Monetary Policies Across the Globe driving the Technicals
8. 7STRICTLY PRIVATE & CONFIDENTIAL
Risk #1 – Liquidity Risk
Emerging Markets Suffer Funds Outflows for Three Consecutive Months
Since July 2015
Source: EPFR
9. 8STRICTLY PRIVATE & CONFIDENTIAL
Risk #1 – Liquidity Risk
Local Market Liquidity have been affected as well…
10. 9STRICTLY PRIVATE & CONFIDENTIAL
Managing Liquidity Risks, Challenges and Outlook
Managing the wide bid offer spread / prices via:-
Selecting Sukuk with benchmark Issue Size
Analyse the bid offer during high and low volatility
situation
Monitor the rotational play and flight to quality
between DM and EM, IG vs. HY
Repurchase agreement / facility for the Sukuk
Analyse the inherent technicals characteristics of the
Issuance ( Demand vs Supply, Maturities &
Redemptions)
Analyse the Bid to Cover Ratio on recent Primary
Issuances
Banks and JLA/JLMs have to be prepared with
Market Clearing levels for Primary Issuances to avoid
Execution risks
Challenges in 2015 and Outlook
The challenging market will continue until tightening
phase in the future by US Fed and other Central
Banks shows any signs of easing on its monetary
policies.
Challenges in developing standardised Liquidity
framework for Islamic Banks and Takaful Companies
Challenges in Basel III and Liquidity Coverage Ratio
from banks investment standpoint for Sukuk with
non conventional Islamic structures such as
Mudharabah and Musyarakah which may affects its
liquidity and returns payoff structures
11. 10STRICTLY PRIVATE & CONFIDENTIAL
Risk #2 – Interest Rate Risk
•Malaysian Corporate Bond/Sukuk
market serves investors and corporate
issuers well with good levels of liquidity
•Except when Interest Rates are rising or
there is fear of rates rising
•Characterized by selling of existing of
existing bond holdings, unwillingness to
buy new bonds/sukuk and mark-to-
market lossess fuelling redemptions and
liquidating in a difficult selling
environment
•In general, bid offer spreads widen
significantly and liquidity declines
markedly
•We have experienced long low interest
rates environment since 1998 and this
might change in the future
12. 11STRICTLY PRIVATE & CONFIDENTIAL
Risk #2 – Interest Rate Risk & Inflation Risk
Inflation moderated , but OPR to Stay Put this Year
11
• Inflation moderated in September on
lower fuel prices. CPI slowed down to
2.6% in Sept 15, from 3.1% in August
15 and 3.3% in July 15, driven by
decline in transportation costs
following the cut in retail prices in
Sept
• OPR likely to remain stable for the
rest of 2015 and into 2016 at 3.25%.
RHBRI
Forecast
2013 2014 2015E 2016F
OPR 3.00% 3.25% 3.25% 3.25%
CPI 2.10% 3.40% 2.30% 2.70%
GDP 4.70% 5.80% 4.80% 4.50%
Deficit 3.9% 3.5% 3.20% 3.10%
USDMYR 3.28 3.50 4.30 4.30
13. 12STRICTLY PRIVATE & CONFIDENTIAL
Risk #2 – Interest Rate Risk
FFR Expectations from US Fed Members ; providing guidance to the market
“Dot Plot” of Fed Members’ Expectation of Fed Funds Rate Over 2015-2017 and Beyond
Source: September 16-17 2015 FOMC minutes, RHBFIC
14. 13STRICTLY PRIVATE & CONFIDENTIAL
Risk #2 – Interest Rate Risk
Key Central Banks Monetary Policies Meetings in Nov – Dec 2015
Source: September 16-17 2015 FOMC minutes, RHBFIC
15. 14STRICTLY PRIVATE & CONFIDENTIAL
Managing Interest Rate Risks, Challenges and Outlook
Managing the Interest Rate Risk via:-
Selecting Duration play for investment portfolios
Hedging instruments via Islamic Profit Rate Swap
Challenges in 2015 and Outlook
Standardizations of documents across various
jurisdictions
Based on recent briefings organised by BNM and
Financial Markets Association of Malaysia (PPKM),
we expect more players to participate in Profit Rate
Swap to hedge Interest Rate Risk
16. 15STRICTLY PRIVATE & CONFIDENTIAL
Risk #3 – FX Risk
Ringgit Weakness Derived from Global and Domestic Risks
July-14 - now:
Oil price plunged
Jan-June 2015:
Rating downgrade
1MDB debts
July-15 - now:
Political uncertainties
Declining FX Reserves
Euro debt crisis
August-15 - now:
Fed hike
CNY slowdown
Foreign outflows
17. 16STRICTLY PRIVATE & CONFIDENTIAL
Risk #3 – FX Risk
Dollar Index to strengthen further as anticipation of US Fed to hike…
75
80
85
90
95
100
105
4-Jan-13
4-Apr-13
4-Jul-13
4-Oct-13
4-Jan-14
4-Apr-14
4-Jul-14
4-Oct-14
4-Jan-15
4-Apr-15
4-Jul-15
4-Oct-15
Dollar Index
18. 17STRICTLY PRIVATE & CONFIDENTIAL
Managing FX Risks, Challenges and Outlook
Managing the FX Risks via:-
Hedging instruments via Islamic FX Forwards and
Islamic Cross Currency Swaps (ICCS) – managing both
Interest Rate and FX Risks
Challenges in 2015 and Outlook
Standardizations of documents across various
jurisdictions
Islamic Collateral Support Annex (CSA) has not been
fully developed and adopted by market participants
19. 18STRICTLY PRIVATE & CONFIDENTIAL
Risk #4 – Credit Risk
Sovereign CDS may have bottomed in 2014
20. 19STRICTLY PRIVATE & CONFIDENTIAL
Risk #4 – Credit Risk
Some Sovereign CDS exhibit rising credit risk with recent downgrades
21. 20STRICTLY PRIVATE & CONFIDENTIAL
Risk #4 – Credit Risk
Appetite for DM Assets versus EM Assets driving the Asset Allocation , IG
versus HY and Moving up the Credit Curve
22. 21STRICTLY PRIVATE & CONFIDENTIAL
Risk #4 – Credit Risk
Average Credit Spreads remain stable while Upgrade/Downgrade Ratio
declines YTD 2015
23. 22STRICTLY PRIVATE & CONFIDENTIAL
Managing Credit Rate Risks, Challenges and Outlook
Managing the Credit Risk of specific Issuer via:-
Active monitoring / assessment of Issuer ability to
repay, Issuer’s collateral assets, revenue and
cashflow generating ability
Active Rating Agencies Rating reviews on Issuers and
general Sectors Calls and Upgrade/ Downgrade Ratio
and Trends
There have yet to have a Islamic Hedging instruments
for Credit Risks. Sitting ducks with no headging
instruments
Monitor Single Issuer CDS level as proxy on Credit
Risk measurement
Challenges in 2015 and Outlook
Standardizations of documents across various
jurisdictions
Based on recent briefings organised by BNM and
Financial Markets Association of Malaysia (PPKM),
we expect more players to participate in Profit Rate
Swap to hedge Interest Rate Risk
Moving forward, market players to quote corporate
bond/ sukuk based on credit spreads over prevailing
MGS/ GII instruments before embarking to Islamic
Single Issuer CDS ( if any)
May suggest Islamic Credit Hedging Agency or further
development in Re Takaful / Re Insurance
Banks can free up its capital and lend to SME
Businesses
28. 27STRICTLY PRIVATE & CONFIDENTIAL
Summary of Macro Headline Risk
Key Drivers and Risks to Malaysia Sukuk Capital Market
Declining FX
Reserves
USD94.7bn (7.3m
import, 1.0x ST debt)
Rising inflation
+3.3% in July (June:
+2.5%, May +2.1%)China slowing
growth: Stimulus
and CNY
devaluation
Political
Uncertainties
Fed Hike Delay
Attractive Carry
Relatively Sound
Fundamental
Low external debt
Decent economic
growth
Improving fiscal
Asset quality
US Fed Rate Hike
High borrowings
Govt 57% of GDP
Hsehold 87% of GDPLow commodities
prices
Oil Price Recovery
Fund outflows
Weak currency
performance