Halal Money Matters Podcast

Episode 28 - The Rise of Sukuk in Fixed Income with Patrick Drum

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Narrator:
The thoughts and opinions expressed on Halal Money Matters do not necessarily reflect the views of Saturna Capital, Amana Mutual Funds, or their affiliates.

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Monem Salam:
Welcome to Halal Money Matters, sponsored by Saturna Capital. I'm Monem Salam.

Scott St. Clair:
I'm Scott St. Clair.

Monem Salam:
Our guest today is Patrick Drum, who is portfolio manager and senior analyst here at Saturna Capital. One of the topics that always comes up that I get a lot of questions about is Halal fixed income and so I thought we'd have Patrick on to dive a little bit deeper as to what that really means and how Muslims in America can take advantage of that.

Scott St. Clair:
Yeah, when I started working at Saturna, I was really curious what the differences between traditional fixed income and sukuks were as well.

Monem Salam:
Well, great. Let's bring in now Patrick. Welcome to the show.

Patrick Drum:
Thank you. It's a pleasure to be a part of this show and invited.

Monem Salam:
Just a little bit background about yourself. I know you worked for a larger firm before joining joined here. So can you just kind of quickly just go over your bio?

Patrick Drum:
Happy to do so. I've been with Saturna, I just crossed nine years here in mid-October, and it's an absolute joy. Prior to that, I was with the group by UBS, the Swiss financial firm, was part of an institutional and advisory group where we're providing investment consulting to institutions and high net worth families with an emphasis on sustainability. And that's where I obtained my focus in sustainability or what we more codify is environmental, social and governance ESG factors. Prior to that, done some business valuation at a group called Moss Adams, and then prior to that where I really cut my teeth in fixed income was a mortgage trader at a certainly small bank called Washington Mutual. For those who know that story, I was part of that group that created the products that took the world down.

Monem Salam:
(laughs) Well, let's not go there. (laughs)

Patrick Drum:
Right. That's a journey that led me to sustainability.

Monem Salam:
And so it seems like you had a very traditional or a conventional, I should say, conventional fixed income background. When you first joined, how did you get involved in the halal fixed income market?

Patrick Drum:
It's been serendipity. I joined Saturna with two mandates really. One was to help sort of extend the Islamic finance into sort of the modern framework of ESG and just try to help provide that that direction and insight and guidance while simultaneously helping Saturna Capital launch their Sustainable Funds. My background at that particular point is I had been running multi-currency conventional global fixed income a variety of advisors and networks throughout UBS North America. Literally the day that I walked in that day, one of our colleagues, who's now retired, a real talent, Phelps McIlvaine, said, hey, I got something for you. We got this mandate out of Malaysia. You need to figure this out. And I looked at that and I've never shared this with you guys, but I was like, oh, you got my name spelled wrong., but alright, we'll figure this out. And that started the journey of us that in fact, you Monem, had handed and helped curate that engagement in Malaysia for about a prior four year period. So it was a bit serendipitous that my timing to walk in the door, I was asked to figure out how to build a platform and start our very first institutional sukuk engagement for US dollar global sukuk with a Malaysian institutional client.

Monem Salam:
It's been a probably a really, really steep learning curve. And I what I'm hoping to do in this podcast is really kind of get our shareholders and our listeners to be able to, you know, really understand what it means, you know, when we say halal fixed income. So let's start, you know from maybe the basics, let's talk about it from the advent of this market, you know, back in wherever it was. So if you have a little bit of a history and in this market, that would be great to hear from you.

Patrick Drum:
I have been doing some faith based aligned investing because I represented a variety of clients with a variety of different mandates, some very tailored, some just reflecting a faith based. So this in itself wasn't particularly new, that particular time I walked in not knowing absolutely no knowledge of any kind with regards to A, that an Islamic fixed income market exists, B, any attributes about it or its size or anything. So was a steep learning curve. I've often joke it's akin to jumping on a NASA rocket, but I tell you, it's been a blessing. I couldn't be more fortunate to have been part of this process and serve the community. My background I grew up as a Navy brat. And why does that matter? And I studied foreign language and lived abroad and did some things. So I was very comfortable in working with different communities and integrating different value sets and having worked in the fixed income capital markets and also having played with some of the large institutional players, I knew how they thought, I knew how kind of framework wise to build this process. But learning this community of the sukuk market was in itself a learning curve, everything from default histories. I think the very first issue came out of Shell Corporation, out of Malaysia, I think it was 1986 I want to say. I think the very first and this is again off the top of my head, Bahrain was the very first sovereign issue of a US dollar sukuk and I think that was back in 1991. Really, there hadn't been a lot of issuance. At that particular time Malaysia was predominantly the issuer and it's still globally the largest issuer, about two thirds of the market size, but that is ringgit. Issuance of US dollar sukuk still was relatively small, and (canonates) of the Middle East, in particular, the Gulf Cooperative Council. Being on ground, I learn from the conversations.

Monem Salam:
You've actually introduced a term so far I've been only defining as halal fixed income. So you mentioned the word sukuk.

Patrick Drum:
It's a typical name that's deployed to characterize the Islamic fixed income instrument that obtains that religious review known as a fatwah. Similar instruments such as murabuha and so forth. But really, sukuk embodies that structure. And the whole essence of sukuk is that it's tethered to some underlying asset and that can take many forms, which is a different discussion, but it's tethered to an asset. So these are certificates and at times that are used by, say, armies because it represented a certain claim to whether a certain cachet of food, of a certain size, essentially represented an ownership interest in a variety of different assets. And hence this was a certificate known as sukuk to reflect that.

Monem Salam:
So the government would issue these, let's say, pieces of paper and they would give them out to their army on a right to, for example, let's say grain, right? Foodstuffs. And so the army officer could go in and basically get foodstuffs on a certain percentage of whatever that piece of paper was, is that how it works?

Patrick Drum:
Soldiers would use it to represent a certain amount of like grain or what have you, a certain stash of bread or what have you. It was an easy way for them to carry, or rather represent the carrying of their certain grocery items. At this point, I'm going to be kind of going into conjecture in collective details that I've read over the years. There isn't too much information. I've had to dig very far on that.

Scott St. Clair:
How do those original sukuk, how do they look now? How does the modern sukuk for our current investors look?

Patrick Drum:
Sukuk provide that tethering, so there has to be an underlying asset. So I call it the four legs of a chair that separate and create a means of distinguishing Islamic fixed income with conventional fixed income. Sukuk obtained typically a credit rating doesn't mean all the time by the major credit ratings. They typically have a maturity, you know, three, five, ten, whatever years, and they tend to have a stated coupon or a profit rate, just like a conventional fixed income. So what are the distinguishing factors? And it's these four legs of a chair. One is the first, it goes to the essence of Islamic finance and the essence is of risk sharing. There's sort of this duality of a partnership that exists. It's not in competition, but a partnership. And that is they're sharing in the potential for both profits, but also a clear, full acknowledgment of the sharing and risks and potential losses. The second one is that it has to be tethered to some assets. And just like the food that we were sort of characterizing or these kind of coupons for food, these certificates identify somewhere which the investor is generating this income because the Islamic economy is tied to an asset economy. So whether it's sell time air units or minutes or seats on an airplane in the future or hard real estate like, say, a bridge or a bridge toll, or a ship line or duty fees at a dock, or the ship itself, or a building. So it can take a lot of forms as long as it's tethered to a particular asset. And that asset generates some degree of income, whether it's from rental, rights of use, as examples. So again, the first one is risk sharing. The second one, it's tethered to an asset. The third is, is that there can be no guarantees and there was a bit of this drama or bit of a sort of episode in 2008 where Taqi Usmani, Sharia adviser of considerable standing had basically called, in a simple term, foul. He was saying that this sukuk at that time were implying a level of guarantee when they shouldn't and that undermines that risk sharing component because there has to be a true and delineated means of sharing both risks as well as potential for profits. And that almost undermined the whole sukuk market, but it recovered. And the market goes through these periods of kind of resetting and reasserting itself and it's part of that process of growth. So again, the three are far, risk sharing tethered assets, no guarantees. And the final aspect is a religious review known as a fatwa. So it goes to a Sharia advisory review where they say, and the first thing I always look for, is the fact say, yes, this is Sharia compliant. And that's what in part makes and creates the structuring of a security of a like fixed income that is in fact Sharia compliant because its assets are derived in income or profit sharing are derived from these underlying assets. And that in itself is where the connections differ. And I started differently on this risk sharing and I'll close with this. You can get this asymmetric aspect of risk where I'm a bond holder and I'm indifferent to the issuer's ability to make payment or performance. And therefore they become beholden to me to make heck or high water these payments, whether or not there's assets or whether there's financial engineering or what have you. But a sukuk is tethered to the underlying of the assets itself. So there's this component of risk sharing where a default of a bond or an inability to make performance in a bond is asymmetrical, meaning there are some protections that investors guaranteed that that bond is supposed to perform. And again, that's different and distinct from that risk sharing of the Islamic community. So that's really kind of what I call the four legs of the chair, and they have to have all four. I get asked by folks that own a municipal bond whether that's halal, because it's a well, it's a road, there's a toll. And I said, well, this has gone through a religious review and has it got, you know, it has to have all four legs of the chair. And I use that just as a simple way of trying to help think about that.

Monem Salam:
Let's talk a little bit about tethering to the asset. Right. So in a conventional bond, what's the opposite to tethering to an asset?

Patrick Drum:
Well, in a bond, there is no tethering of an asset. It's just a financial obligation. The performance of that bond is not tied to any particular asset, it is just issued.

Monem Salam:
So it's like a loan and you're just basically paying off that loan with a little bit of a payment on top of it.

Patrick Drum:
Correct.

Monem Salam:
And then so now the third one you mentioned was no guarantee. You know, that's true. I mean, the asset goes, you know, goes belly up or, you know, bridge burns down or something like that. And I guess the sukuk holder has no right to demand either the principal or the payments of that. Is that correct?

Patrick Drum:
The sukuk is placed in a trust where upon that trust is acting in their beneficial ownership interest. And there are two types and there's a bit of technicality. Usually there's a requirement for that bridge to have an insurance just for protection in the case. But there have been cases wherefrom a legal precedence, where those investors, they really are buying a claim to these assets, have that right to those assets. Now it depends on the structuring. That's getting down really deep in the weeds. But in a sense is where we're going is, it's tethered to an asset and its financial performance is tethered to the asset.

Monem Salam:
Okay. So is that an opposite case for the conventional side?

Patrick Drum:
Yeah, there's no guarantee but in the conventional world that debt obligation is an obligation of payment, which is essentially what makes it debt.

Monem Salam:
From that perspective, if a company doesn't make due on its payment either, you know, the bondholders can go after them or the company has to declare bankruptcy, whereas maybe in the sukuk it's because it's tied to a certain asset. Maybe that's the only the asset that actually the sukuk holders have a right to whatever that asset is.

Patrick Drum:
Uh huh.

Monem Salam:
And then, I mean, obviously the religious review, but it's pretty straightforward. There's a there's a Sharia advisor. And typically what I tend to say is like there's multiple layers of this religious review because usually what happens is the sukuk has its own Shariah board. Then each of the banks that's underwriting also has their own Sharia board that has to approve it if they're Islamic as well. So there's multiple reviews that are happening at the same time.

Patrick Drum:
Issuers also have the ability to do what's called as a substitution because like the bridge that you mentioned that may have caught on fire or what have you, the issuer can then substitute in one asset with another just for offering a greater flexibility. One of the most important tenets to this is like, well, is this really Islamic? And where I try to impart a bit of pragmatism is this. I call it the spirituality of imperfection. And what I mean by that is, is that from a kind of a religious or spiritual side, you aspire for the greatness that you're aiming to achieve. But then as humans, we're sort of caught in kind of the dirt and the mud of life and that is sort of the challenge is. To try to strike this balance of you creating a financial instrument that honors and adheres to the Islamic principles. But it's got to also work into the world of the financial markets. And so they construct it as much as possible to apply, but also because you need tradeability, you need liquidity, because if it doesn't occur, there's no scaling the size of this particular market, which is now exceeds outstanding 800 billion. It just crossed that mark about a month ago. So this market's really grown in size. There are some constructs they've done in the legal side to permit its adaptability and growth while offering the issuer flexibility because an asset may be a good fit at one time, but might become, for whatever reason, impaired. And it doesn't mean that that certificate doesn't offer value, but this issuer may need some flexibility from a legal standpoint to substitute a different asset for, say, a bridge to an airplane, just arbitrarily to throw you an example. There's these constructs, there's a lot of these kind of nuances in this aspect, but it still goes through a religious review. At the end of the day, anything that I own or we own, that's the first thing I look for. I'm not a sharia adviser. My goal is just to align the fund with the community's ambition, to have an investment to reflect their faith. And that's my first priority. And then second, to the investment manager. But there's a lot of these kind of nuances in there. The market has grown because of these flexibilities.

Scott St. Clair:
So, Patrick, I'm wondering if these sukuk offer any purely financial benefits over traditional fixed income securities?

Patrick Drum:
That's a great question. Financial performance is one unique aspect. One is also sometimes geographic in issue or exposure. And then the third, which is and kind of step back a bit. There's a lot of literature on sukuk outstanding, but when you read it, over 90% of it is dealing with the Malaysian ringgit sukuk market and that's a very small market per se, out of the globe. And I needed to understand what are the risk characteristics, how do I want to think about behaviors and the attributes associated with this asset class? And one of the things I found in this process of educating myself, is that I found that these securities in fact tend to demonstrate among the highest risk adjusted returns among fixed income benchmarks, both developed world and emerging market. And that's a pretty, profound soap box statement to make. And the math is all there. And the reason a part is what interesting, a large part of US dollar sukuk, they tend to be more than often issued from the Middle East, in particular the GCC. It also includes issues such as from Malaysia and Indonesia and other parts of world. But by and large the bulk is from the Middle East. And there are certain attributes that region. You have frontier markets. I call it plenty in the bank, plenty in the tank, just to sort of to help characterize, and what I mean by that, there's a resiliency and stability to these assets that really have a unique preferential treatment among emerging market investors. So the Asian community, large institutional investors, European institutional investors invest in the Middle East because of the stability of frontier economies, as I mentioned, such as Qatar, Saudi and so forth, or Abu Dhabi with stated credit rating like a Double-A plus, as well as Qatar. Double-A plus is what the United States is, or what the United Kingdom is. And in addition to it, by the way, they've got maybe decades, if not 100 years, maybe almost 200 years of variety of hydrocarbon uses, such as LNG. Qatar, for example, satiates over a third of the world's energy through LNG. So they have these vast, what I call plenty in the bank, financial resources, plenty in the tank, these hydrocarbon resources. And as such it creates these very competitive returns because that part of the world is pegged to the US dollar. So they're spread or their yield is structured off the US dollar curve, and then they have these characteristics that provide stability.

Monem Salam:
I guess what you're saying here is that because of the geography of where these are being issued that you can possibly get outperformance. But the question becomes, you know, there are a lot of companies or some governments who now issue a sukuk and then also issue a bond. Right? So if you compare both of those issued at the same time, you know, is there an answer to the question, does sukuk outperform?

Patrick Drum:
In the Middle East in particular, if there was say, a conventional bond in an Islamic security, Islamic fixed income instrument such as a sukuk, you will typically find that sukuk in the Middle East, there is greater demand for that security so they actually trade tighter, which in my term in vernacular means they trade at more of a rich or full value relative to the same security, even though the issuer is the same, the exact same issuer with the same maturity. And the reason is, is because in this parts of the world, there's a higher demand at times by Islamic based institutions, whether it's insurance companies, sovereign wealth funds, banks or family offices or investors that want the securities. So these securities tend to trade with a bit more stability and greater liquidity than you would find in conventional notes. And then the third thing is, is that because you're investing in different parts of the world, in particular the Islamic communities, this might be the only instrument they might issue. The sukuk offers access to different exposures, different expressions, certain stability from geographic and issuer aspects, and they tend to have a higher demand because you have Islamic investors that need and want to align their institutional requirements with the investments.

Monem Salam:
So thank you for that explanation. I think earlier you mentioned the idea of the fact that they are very similar to conventional bonds, but they have these four characteristics that are different. And I appreciate you expounding upon that. But at the same time, I've heard a lot of people talk about the fact that hey, you know that they act exactly like a bond does. Right? And I mean, if interest rates go up, then the price is going to come down. They also have a rate of return. Is that pretty fair to say that they have these characteristics are very similar to a bond or conventional bond?

Patrick Drum:
The underlying fundamental is that it's a fixed income instrument, whether it's being expressed Islamic or conventional, and it's priced and structured, trades just like a conventional bond. And the reason is, is because they need it to gain scale, size and liquidity and acceptance. And so because of its duration and credit quality, credit attributes, and the coupon or the profit rate that it offers are similar to a coupon, it's going to be subject to the all the same attributes that fixed income securities are, such as duration risk, such as volatility risk such as liquidity risk, such as spread risk or credit rating risk or default risk. It has all the expressions that you observe in conventional securities. And because of that, it's structured like that, it needs to operate in that world. So it's subject to all those risks that one would see under conventional bonds.

Monem Salam:
One thing to keep in mind is that you like you, I'm not a scholar either, but it's not the fixed income part which makes something halal or haram. Like, for example, I can have an apartment and I can sign a two year lease on it. I can own the apartment, sign it with somebody And I fix the payment of it to $1,000 a month. Well, that's fixed income for two years for me. That doesn't necessarily make it haram. You have to look at more underlying factors of why something would be haram from that perspective. So it's perfectly fine to have that that fixed income portion of that sukuk. The question that follows from that is, you find that, even though sukuk, they pay a profit and they don't pay an interest rate, you find that they fluctuate you know, when the Fed raises rates, for example. And you know, what does the interest rate of the Fed have to do with the profit rate of a sukuk? So why do they trade very similar?

Patrick Drum:
Great question. Interest rates change and we've all observed how interest rates recently have rose, and in fact the ten year just peeked its head above 5% on the ten year US Treasury, and that hasn't occurred since 2007. So as to why that expresses in price changes, at various points in time an issuer will issue a sukuk or a conventional issuer will issue a conventional bond and they'll offer that bond at that point in time, which is the prevailing interest rate based on the maturity and the issuer's credit rating. Over time, interest rates change. And as interest rates rise and let's say hypothetically, this issuer issued this sukuk with a 3% profit rate and now rates are now at 5%. The price of that security needs to decline to reflect that 5% if they want to its value or its market rate return to be equivalent where the market is, needs to be adjusted in price so that it yields a 5% rate.

Monem Salam:
And if it didn't, then people would be selling it to buy the 5%.

Patrick Drum:
That's exactly right, because that's where the market opportunity is, because you'd be obtaining a security and a holding of security that was not given prevailing market rates.

Monem Salam:
In Islam, you know, debt, you cannot buy and sell it. And the reason is because of premium or discount on debt is considered riba or interest. Why are you able to do it in a sukuk, which you couldn't do it in a conventional bond?

Patrick Drum:
Because it's not debt.

Monem Salam:
Okay. It's not debt because you just mentioned that you can base a sukuk off of certain assets and sometimes you can lease the asset, you can partner with the asset. Is that why it's not considered debt?

Patrick Drum:
Yes, that is correct because again, it's tethered to some underlying asset and it goes through this religious review and structuring process as well as incorporating the attributes of what I call the four legs of a chair, meaning risk sharing, tethered to an asset, no promises and guarantees, and it goes through a religious review. There was a long term need that had been resonating in the halls of Saturna Capital for many years prior my arrival and that was a way to provide investors that opportunity to allocate part of their life savings and investments in something that was going to be offering stability, not subject to as much, say, some of the market volatility that other investment classes may experience. So this was really a tool to help complement the overall diversification needs that we need. Something, you know, in the various sort of baskets we have, we put our investments in area that are a little more risky because we know over long periods of time they tend to experience higher rates of growth. We also know that we need to keep a little savings in the bank just for those rainy days. And then we also know we need something in between.

Monem Salam:
If you look at asset allocation, there will be some allocation towards cash, some allocation towards equities and different types of equities and that type of thing. But there is usually, especially for those that are older, there's a significant portion sometimes in fixed income. And so for a long time for Muslims, there was no alternative for that. And what Sukuk provide is that kind of conventional bond alternative and to have that halal fixed income as a component of traditional asset allocation.

Patrick Drum:
Correct, it was aimed to serve as a substitute that would honor the faith and the community's goal of being aligned with their faith that didn't simply exist. And that itself has been a journey ensuring that this process, both of providing that from an investment standpoint, but also from a faith standpoint, and then trying to be a steward of those dual goals. And it's been just a gift and an experience and a blessing to navigate these markets when I say I do the sidewalk talk, I'm in the Middle East on a frequent basis. I'm in Asia on a frequent basis. We know the issuers, we know the community, we know what's going on. And I didn't ever think when I'm being handed this initial opportunity back when I first joined the company, that such a journey and such a path that it's illuminated that I could never imagine.

Monem Salam:
Where do you see the future of the sukuk market? Do you think more Western countries will be issuing them for their populations and those type of things? Where do you see this going?

Patrick Drum:
I would actually argue that you might see a development and growth coming from the United States on sukuk issuance. I think you're going to see a trend develop that are non-Middle Eastern or Asian issuers coming to the market to explore what that might look like. And that's really going to enhance the liquidity and diversification. A large part of these Islamic securities are owned by conventional funds. A lot of people don't know, over 20% of Middle Eastern debt and sukuk are held by various benchmarks. And over a large exposure of these benchmarks are to the Middle East. We just don't know it because it just happens to be under the radar.

Monem Salam:
I guess you're saying that the supply side is going to be able to provide the sukuk for the market from the Western perspective and these eventually which there's nothing so far in the US but these eventually might be domiciled or based on the US so the US investors can buy them. And on the flip side of that, you know, you say what is the market? The market is well it's not only the American Muslim community, but also even conventional funds and insurance companies also do buy these sukuk.

Patrick Drum:
Correct. And so really, it's both a unique financing opportunity, but also geographic in issuer. So this really might see quite a large increase scaling in honoring of the Islamic community's faith. But Islamic finance has a lot of interesting toolsets to address our future needs.

Monem Salam:
Great. Thank you so much. I'm really excited about the future as well when it comes to the sukuk market and I really appreciate your time, Patrick, for spending with us and educating our listeners about the unique characteristics of sukuk.

Patrick Drum:
Been my pleasure and happy to do it again anytime. So thank you.

Monem Salam:
Thank you for listening to Halal Money Matters. If you like what you hear, please do rate us on the app stores. And also leave us a review. It helps other people find us a lot easier.

DISCLOSURES (read by Narrator):
This podcast is prepared based on information Saturna Capital deems reliable; however, Saturna Capital does not warrant the accuracy or completeness of the information. We do not provide tax, accounting, or legal advice to our clients, and all investors are advised to consult with their tax, accounting, or legal advisers regarding any potential investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. Investors should consult with a financial adviser prior to making an investment decision. The views and information discussed in this commentary are at a specific point in time, are subject to change, and may not reflect the views of the firm as a whole.

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