A new asset class joins the ETF world: sukuk

A little more yield, a little more risk?

A large Egyptian venture recently issued sukuk to fund the purchase of new aircraft.


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What’s an income investor to do?

Bond yields are at all-time lows, dividends are getting cut left and right, and no-one knows how businesses will weather the post-coronavirus pandemic landscape.

Here’s a new option: consider an exchange-traded fund that tracks the market in sukuk, financial instruments that take an interest in underlying assets, usually those with some sort of lease structure, giving end investors a share of the returns.

Sukuk are structured to allow compliance with Islamic principles that prohibit the payment of interest, but in many ways they behave like Western fixed-income financial instruments.

A new fund, the SP Funds Dow Jones Global Sukuk ETF
SPSK,
-0.16%

, is the first to offer access to sukuk investments in an ETF, making them accessible and tradable for broad audiences, not just those who require compliance with Sharia customs.

Naushad Virji, CEO of SP Funds, calls the fund “a really good way to pick up fixed income without debt.”

Read:ETFs behaving badly: ‘exactly what they are supposed to do’ or ‘just what we feared’?

Investors face a world of uncertainty about which sectors, industries, and companies will survive the pandemic and traditional credit analysis may be daunting.

The sukuk structure offers the chance to own a piece of the agreements — often lease-to-own deals — between high-margin companies and the pricey assets they need, like airplanes, infrastructure, or real estate.

For end investors, that means the fund itself has done the analysis of the value of the assets, rather than the credit quality of the bond issuer. For anyone more familiar with stocks, Virji said, the equivalent is a company’s tangible book value. And it’s worth noting that the ETF tracks an index that’s made up of sukuk that are investment grade, as determined by major global ratings agencies S&P Global Ratings, Moody’s Investors Service, or Fitch Ratings.

“We feel that the sukuk business will hopefully offer those same type of impressive margins within the sukuk itself which will translate into something that will beat bonds and CDs,” Virji said.

Companies with low or no debt outperformed in the wake of the 2008 financial crisis, Virji argues, so SPSK, launched in the final days of 2019, may have had impeccable timing. “Last year, with markets at all-time highs, we thought there were some catalysts for a drop or a pullback,” he told MarketWatch. “We thought, we should have an ETF that gives exposure to assets that avoid debt that we believed would hold up better in a market decline.”

Investors should consider the fund as an “intermediate-term duration fixed-income, emerging-market” instrument, said Mohannad Aama, portfolio manager at Beam Capital Management.

Most issuers in the sukuk space are located in Asia and the Middle East, Aama noted, though Virji told Marketwatch, “I’d love to have more in North America”. While diversifying across geographies can be a bonus, it can also bring additional risks.

For most investors, certainly those in the west, SPSK won’t be a “core fixed income holding,” Aama said. It does offer a little yield, currently 2.23% after the 65-basis point management fee is backed out, “but you have to put that in perspective.”

Aama thinks the biggest question mark about the fund has to do with one that looms over sukuk in general. Since they haven’t been truly tested in bankruptcy court, it’s not clear whether investors would be treated as holders of equity, or bondholders.

In response to a MarketWatch request for comment on that issue, an SP Funds spokesperson said in an email, “Bankruptcy protection to the holders and seniority to equity holder is almost universal in the space. This is buttressed by legal claims to underlying assets.”

For an investor willing to take that risk, Aama noted, the ETF offers one clear advantage: sukuk are usually long-term buy-and-hold investments, but investors in the fund can trade it whenever they want.

The investor “distribution,” akin to a dividend or interest payment, is currently 2.23% after fees, and will be paid monthly. SP Funds was unable to confirm whether that amount would stay the same in the future, however. For some context, one of the largest broad bond market ETFs, Vanguard’s Total Bond Market
BND,
-0.10%

currently yields 1.62%.

SPSK had $17.1 million in assets as of March 31, the most recent information available on its web site.

See:Will mutual funds get a second wind… as ETFs?

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