Interpreting Middle East Economic News and Analyzing Market Trends

Forget about Sukuk, it’s time to talk about Salaf Bonds!

HM Treasury Sukuk

This article is re-posted from Islamic Finance News, volume 12 issue 10, published on March 11, 2015.

It would have been unimaginable a few years ago to talk about negative bond yields much less witness this phenomenon happening right before our eyes.  The reality is that today we are seeing an increasing number of bonds in Europe and Japan falling into negative yield territory.  The Wall Street Journal estimates that there are currently $1.7 trillion in bonds trading with negative yields and the number is growing daily.

For this we can thank central banks for their QE and other money-printing programs as they continue with their failed attempts at stimulating global growth.  This, by the way, has gone on for six years and shows no sign of changing in the near future.  What does this mean for the bond market?  It means that yields are going lower and more will fall deeper into negative territory.


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What does it mean to have a negative yield and who would buy such an instrument?

Bonds that have a negative yield simply mean that investors have to pay for the right to own them.  If they hold the bond to maturity they will get back less than they invested.

Investors are lining up to buy these bonds.  Recent government issues in Europe have been oversubscribed.  Some corporate issues, such as Nestle, have also seen their yields go negative. There are three main reasons investors are piling into these bonds:

First, the world is headed for deflation on a global scale, despite all the central banks’ efforts.  This can be witnessed by falling commodity prices and the fact that many countries in the EU are already in deflationary territory or barely showing positive inflation as is the case in the U.K.  A recent article on stated that inflation in the U.K. has reached its lowest level since records began.  Investors fearing deflationary pressures will grow are piling into these bonds because they will profit from holding on to them as deflation takes hold.  It is also important to note that in a deflationary environment the weakest issuers tend to default first and then go up the ratings chain.  Therefore, negative-yielding bonds tend to be from the highest-quality issuers and will only exacerbate the trend to negative territory as investors flee to safety.

The second reason for buying these bonds is to hedge against other currencies.  Investors buying into negative-yielding Euro bonds might hope to gain if the Euro appreciates against other currencies.

The third reason is the result of the European Central Bank’s (ECB) recent announcement to launch a QE program.  Investors believe that it will only make the current bonds rise in value giving them a return.  As the supply of bonds eligible for the ECB’s QE program (i.e. the highest quality) dwindles, the values of these bonds are expected to rise giving investors a gain after they sell.

On the flipside, these central bank actions are hurting more people and institutions than they are helping.  For example, insurance companies and pension funds stand to lose as they need fixed income to pay out to their clients.  Savers are also punished because there are no more safe havens for their hard-earned income. 


What solutions does Islamic finance have to help?

Sukuk have been a driving force over the past decade in globalizing Islamic finance and bringing much needed fixed income solutions to Islamic investors.  The phenomenal growth of the sukuk market has been well-documented and reported on in recent years.  However, falling yields and a rush of cash out of emerging markets where the sukuk market’s prime issuers are based will slow the growth in the coming years.  This trend presents an opportunity to develop a new financial instrument; Qard Hassan bonds, or simply interest-free bonds.  A Qard Hassan is a benevolent loan given usually for charity with repayment of the principal on demand by the lender.  I am told that there is a better term of an Islamic interest-free loan, which is SalafSalaf differs from Qard in that it is an interest-free loan with repayment over a specified period and not on demand.  The word Hassan means benevolent and is typically meant for charity.  Therefore, it will be more appropriate to call this new instrument Salaf Bonds.

The benefit of Salaf bonds from an Islamic perspective is that it is a money loan and does not need to be tied to any asset.  This makes it much less complex than Sukuk.  There are also no interest payments or complex structure to monitor and collect rent/lease payments.  The Salaf can be used for any Shariah compliant purpose and be based solely on the credit quality of the issuer.  The principle must be fully repaid with no discount (no negative yield) and no premium.  From a conventional perspective, these bonds can be more attractive than negative-yielding bonds for two main reasons.  First, they will never have a negative yield and second, they will have no market volatility risk.  This can be a downside for investors hoping to gain on the fluctuation in bond prices.

However, it’s worth noting that the three main reasons investors are buying negative-yielding bonds today make holding Salaf bonds attractive as well.  First, in a deflationary environment, a return of your investment is more important than seeking a return on your investment.  As long as the issuers of Salaf bonds are of the highest quality, investors holding them stand to gain more than holding on to negative yielding bonds.  Second, Salaf bond investors can also benefit from appreciating currencies.  Euro investors can gain from holding on to U.S. dollar Salaf bonds if the dollar appreciates against the Euro.  Third, investors need not worry about supply and demand of these bonds affecting their prices. Shariah requires that money and loans such Qard Hassan and Salaf do not trade at a premium or discount.


Who can issue Salaf Bonds?

Any government or company can issue Salaf bonds provided their business is deemed to be Shariah compliant, such as companies in energy, healthcare, manufacturing and technology.  Conventional banks, insurance companies, hotels and gaming companies will not be able to issue Salaf bonds.

In a deflationary environment, Salaf bonds become attractive to OPEC members.  Falling oil prices mean OPEC members will need to tap into debt markets to fund their expected budget gaps.  Salaf bonds provide them with a Shariah compliant solution that can be attractive to conventional and Islamic investors alike.  Oil exporters such as Kuwait, Qatar, Saudi Arabia and the U.A.E have high credit ratings and can easily issue in U.S. dollars broadening the appeal for their bonds on a global scale.  Investors in the Middle East may not like these bonds as they are accustomed to earning a return on their investments.  This, however, will not matter as investors from other parts of the world will be lining up to get a guaranteed zero return by top-rated issuers, which would have been unthinkable a few years ago.