Complex Made Simple

Are sukuks going to crash as inflation soars?

In the middle of June UK gilts had their biggest sell-off for years as markets digested the thought of what higher interest rates to tackle inflation might mean for bond prices. Inflation is bad news for bonds. Inflation tends to push up interest rates so fixed interest rate instruments decline in value. In the Gulf that means sukuks.

Sukuks have become very popular in the region, combining the ethical appeal of Islamic banking with exposure to local currencies which are thought likely to revalue upwards.

And international banks have rushed to join the sukuk issuance bandwagon over the past couple of years, sometimes displacing the local banks, even the Islamic ones.

Investors have, from time to time, wondered about the return on offer from sukuks. Earning 2.5% above Eibor on sukuk from the Dubai Electricity and Water Authority does not look like a great return: 4.5% ‘profit’ as interest on sukuk is termed, despite the geopolitical risk of the Gulf, is not a great deal.

Indeed, with UAE inflation above 10% – some say as high as 20% this year – this is a negative real rate of return on this investment. A few years of inflation roaring at this kind of level and your sukuk is going to be worth a lot less in real terms than you paid for it.

Likely Eibor rise

It gets worse when you think Eibor is likely to rise eventually to combat inflation. Admittedly because of the dollar peg this will be dictated by the policy decisions of the Federal Reserve in the US and not the local Central Bank.

But eventually the US economy will recover sufficiently from recession to allow the authorities to tackle inflation by raising interest rates from their present very low 2% level.

Then Eibor will go up and the price of sukuks, with their fixed margins above Eibor will fall in value. All the local sukuk are listed, so the price falls will be clearly visible on the big board of the Dubai Financial Market or Dubai International Financial Exchange.

Really sukuks are no more or less than US treasury-related corporate bonds tailored to an Islamic format. So if inflation and high interest rates make life tough for T-bonds then it is also going to be equally tough for the sukuk market.

Disastrous bond investment

The celebrated analyst Dr Marc Faber has written many times that he thinks 30-year treasury bonds may turn out to be a historically bad buy and, for what is supposed to be an ultra-safe investment class, prove to be a disastrous investment.

Of course nobody can be quite sure what the Fed has planned. Probably even chairman Ben Bernanke is not working to a fixed plan. It could be that the US recession proves to be longer and more intractable than anybody thinks and he is forced to keep interest rates very low despite problems of imported inflation from commodities.

Then sukuk may retain investor appeal as a defensive alternative to cash paying low deposit rates. But if interest rates go up, then sukuk values will go down.

See also:
High oil prices impact on Dubai’s real estate market
June trading hits Dow Jones Islamic Market Indexes