BWFF 3033 FINANCIAL MARKET AND INSTITUTION A172 SECOND SEMESTER SESSION 2017/2018 GROUP C GROUP ASSIGNMENT 2 EMIRATES AIRLINE: A BILLION-DOLLAR SUKUK-BOND ISSUE PREPARED FOR:
DR. SHARMILAWATI BINTI SABKI PREPARED BY: NAME
MATRIC NO
SARANYAH NADUNELINGEN
237565
HWONG BOH SIEN
239048
NAJUWA SYAKIRA BT MOHD DZULKEFLI
245357
NURUL NABILAH BT JAMIL
246632
NORFATIN SYAFIQA AZMA BT AZMAN
246636
KOMATHI SHANMUGAVELU
248300
SUBMISSION ON:
14 MAY 2018
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Question 1
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Question 2
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Question 3
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Question 4
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Question 5
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Question 6
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References
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Question 1 What are the main issues in the given case study?
The main issue that has been discussed in the given case are on how the Emirates Airline (EA) making decision to finance its purchase on new aircrafts. There were various ways that EA has made to raise its brand and become one of the world's leading airline companies with 60,000 employees, 200 aircrafts and flights to 140 destinations involving 70 countries on six continents and has been circulating flight services to 34 million passengers and carrying 1.8 million tons cargo. EA was established on March 1985 with the starting capital of $ 10 million and two aircraft from Dubai’s royal family. After that, the EA developed a journey back and forth, which began with flight to Bangkok, Hong Kong, Manila and Singapore. After being developed and growing in Asia, the EA is stepping on a site to the European market, which began operating to London, Frankfurt and Paris. In a financial crisis incurred back in 2009, Dubai has experienced some major problems due to a mismatch between the maturities of its assets and liabilities. Government-related entities (GREs) with aggressive business strategies and fragile cash flows relied on short term debt, leads to substantive financial difficulties. In order to solve this issue, Dubai World asked for a restructuring of its debt worth of $26 billion so its developer Nakheel announced a delay in the repayment of $4 billion sukuk. First of all, sukuk is an Islamic investment certificate which is in other word called Islamic bond. It has the same function as a conventional bond but because of interest is prohibited in Islamic laws, a company or sukuk holder must be entitled to participate to the performance of the underlying asset or business activity and has right on both profit and losses resulting from the business activity. A key decision in engaging the lead managers is
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whether to underwrite the issue or act on a best-effort basis. Underwriting involves guaranteed placement of any remaining portion of the issue by any underwriting bank. Islamic bonds are appear to be a significant asset class in the international markets. In conjunction to that, Emirates Airline (EA) treasury department is struggling to determine the best way to finance a new aircraft or planes in the coming year. Analysts was unsure with the opinions whether to focus on repeating the sukuk issues, exploring other types of sukuk bonds or rely on conventional financial arrangements. Based on empirical results, EA raised $1.75 billion from issuing Islamic and conventional bonds on March 12, 2013 and February 6, 2013. EA announced to issue a 10 years amortizing sukuk bond which matures in 2023 and has an amortizing structure for 5 years of average weighted life. This means that, sukuk will reduce in value of the bond gradually over a period of time. Therefore, the full amount should be paid fully before the final maturity date. This leads the arrangers release the initial profit rate guidance at a range between 300 basis points to 350 basis points relative to five-year mid-swaps. Besides, EA repaid a $550 million sukuk bond that used to pay back for the purchase of plane in 2005. In 2013, on the other hand EA has to raise approximately $5 million to pay for its existing aircraft orders. As a result, it only raised $1.75 billion from the issuance of sukuk. In the sale of the 10-year amortizing sukuk bonds at a profit rate of 3.875 per cent accounted for $1 billion and the maturity date is on March 19, 2023. The remaining $750 million came from the 12-year amortizing regular bonds at a coupon of 4.5 per cent and due on February 6, 2025. The sukuk bonds yielded 0.486% (4.51% - 4.024%) basis point lower profit than regular bonds yield. The most concerning issues that attacked EA was the fluctuations in jet fuel and currency exchange. Its debt obligations was mostly in AED (UAE dirhams) or US$. There
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was also a small portion of debt obligation in Singapore dollars. Based on the consolidated income statement. Although the revenue was increasing year by year but the net profit and profit attributable to Emirates’ owner was fluctuating significantly. Therefore, it is difficult for the EA to issue bonds between sukuk or conventional bonds to finance for new aircrafts or planes in the coming year.
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Question 2 Why is there a yield difference between the two issuance in these two different markets? Is this due to difference in risk, investor clienteles, liquidity, seniority or something else?
In Emirates Airline’s case study, there are two types of issuance, which are Islamic bonds (Sukuk) and conventional bonds. Sukuk or Islamic bonds, is a form of financing to issuer that adhered to Islamic laws, the principles of Shari’ah. The face value of sukuk is based on the market value of an underlying asset. Interest and speculation are prohibited in Sukuk, however investors will get profit rate or share of profits from the underlying asset as well as share for any loss incurred. Sukuk also gives the investor partial of asset ownership which must be directly related to the purpose of financing with business activity on which the transaction is based. Conventional bonds are the long-term debt issuance to raise debt finance. The bond price’s face value is based on issuer’s creditworthiness or credit rating. It is compulsory for issuer to pay back the principle and interests upon the maturity date to the investors. Under conventional bonds issuance, interest is the fixed income for investors. Besides, it does not give investors share of assets ownership as it is a debt obligation from issuer to the investors. Risk sharing elements also do not applicable under conventional bonds issuance. In general way, the differences exist because of Sukuk is not being typical debt instruments and having asset directly attached to it. Conventional bonds were tradable in conventional markets, whereas not all Sukuk were tradable as it is depending on the type of Sukuk. Based on the case study, Emirates Airline raised $1 billion from issuing Islamic bonds (Sukuk) and $750 million from conventional bonds. The sale of 10-year amortizing Islamic bonds at a profit rate of 3.875 per cent and 12-year amortizing conventional bonds at a coupon of 4.5 per cent. The yield curve at issuance suggested these bonds should have similar
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rates, however Sukuk bonds yielded 48.6 basis point lower profits than yield on conventional bonds, which means Sukuk sold with a lower implied yield. In finance, the term yield refers to the owner of a security will receive returns in form of cash. The term structure of interest rates known as yield curve, is one of the common bond valuation method. It measures the market’s expectation of future interest rates given the current market conditions. Yield curve is also a plot of the yields on bonds with differing terms to maturity, yet similar in term of risk, liquidity and tax considerations. From the risk perspective, Sukuk has same risks as conventional bonds especially in term of rate of return risk. For instance, fixed return on Sukuk unable to rise although the market rate is increased, thus it can cause less earnings on Sukuk. However, rate of return risk is not specifically unique to Sukuk as it is similarly to be found in conventional bonds. Moreover, credit risk also arises in both conventional bonds and Sukuk issuance. Under Sukuk issuance, the Shari’ah principles will limit the credit risk management instruments available to investors. This is because Sukuk are issued in emerging markets where the counterparties that possess less sophisticated risk management mechanism will have tendency to default on their commitments. In fact, a risk that only face by Sukuk issuer is Shari’ah compliance as if the underlying assets of Sukuk changed, it will cause Sukuk no longer be Shari’ah compliant. In consequence, the certificate will be rendered null and void. In relation to price, bond yields have inverse relationship with bonds’ price. When current interest rates increase, the bond’s price will decrease as the bond is sold at discounted price to attract more demands. So, it will lead to increase of bond yields or vice versa. Besides, if demand for bonds rise, the price of bond increases and yield will decrease. There is an issue on whether Sukuk and conventional bonds issuance will have same yield level,
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ceteris paribus or not. Some sources stated Sukuk has higher yields or lower prices than conventional bonds. According to Reuters, the average yields for Sukuk issuance in Malaysia with the most liquid Sukuk market are 8 bps higher than conventional counterparts. Market practitioners provided that Sukuk are in greater demand than conventional bonds that lead to higher price commanded by former, ceteris paribus. Moreover, as compared to 10-year Sukuk bonds, 12-year conventional bonds are issued with longer maturity period that lead to high risk, interest rate increase and increase the yields. In contrast, Sukuk issued by Emirates Airline was at lower price of 99.331% and lower yield of 4.024% as compared to conventional bonds price of 99.941% and yield of 4.51%. Thus, it makes the Sukuk a cheaper source of financing for Emirates for purchasing its 30 new A380 aircrafts. In overall, the yields between conventional bonds and Sukuk major affected by maturity term of 12 years and 10 years respectively. It brings different level of risk that result in low or high interest rates affect the price of bonds and yields.
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Question 3 For this question only, assume this price differential is due to differences in investor clienteles. Does this provide an opportunity that hedge fund managers could exploit? If so, how exactly would they exploit this opportunity? If not, explain the market impediment or friction that prevents hedge fund managers from acting on these price differences.
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Question 4 Why were six different banks involved in this issuance? For simplicity, assume that the banks equally split the issuance. Should the banks’ fees for their services differ between the sukuk bond and the straight bond? If so, by how much and in which direction?
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Question 5 The sukuk bond issued by EA is of the “wakala” variety (comparable to principle-agent model), even though the largest block of sukuk bonds falls into the “ijara” category (sale and lease back). Why did the company choose this structure? Is it right structure? Why or why not?
Now, issuing sukuk bond is becoming the best way in Islamic financial market and it also one of the attractive instrument to investor in term of competitive investment. The company issued sukuk bond of the ‘’wakala’’ variety even though the largest block of sukuk bonds fall into the ‘’ijara’’ category because it allowed the islamic and conventional investor to access it significant liquidity pools without compromising risk return objective and it also incurred the lower of financing cost is one of the reason why company issuing this sukuk bond. Besides, the sukuk bond issued by EA which is ‘’wakala’’ is the right structure. The interest under this structure is prohibited under Islamic law and it also useful and important for EA in term of underlying asset while sukuk entitled to proceed the performance of the underlying asset. This is because the previously EA issued the bond to raise the debt finance while the bondholder were received the interest at the end of the contract before dividend and principal but by using ‘’wakala’ it will received the profit return but it must be agreed by parties and outset. By using this,if the company have any excess profit, it will kept as incentive fees. It also comprise a broad range with the Shari’a compliant assets and the criteria of assets must be approved by relevant Sharia board.
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Question 6 How should EA finance its next batch of planes? What about the batch after that? Recommend a financing roadmap for EA for its existing orders of A380 planes. Make sure to consider the maturity choice of the firm as well.
Based on the case given, Emirate Airline should finance its next batch of planes by repeating the sukuk issue. It is because when Emirate Airline keep repeating that sukuk issue therefore the sukuk holder which is Emirate Airline itself will entitled to proceed the performance of the underlying asset or business activity and also have a right to profit resulting from their activity. Besides that, in our opinion Emirate Airline should repeating this sukuk issue because before this they had been already doing this and as a result their fund was raised in order to pay for its existing aircraft order. According to the HSBC & NASDAQ DUBAI CORPORATE US DOLLAR SUKUK INDEX (2013), average yield on global corporate sukuk have risen 46 basis points to 4.62 percent since the Fed said June 19 it might taper its asset-purchase programmes as early as this year and the yield on Emirate $1bn sukuk which carries a 3.875 percent profit rate increase 0.31 of percentage point in the period to 5 percent in Dubai . So, if Emirate Airline continue repeating this sukuk issue therefore it will be easier for them to finance the next batch of planes compared to try any different ways. The another factor why Emirate Airlines should continue repeating this sukuk issue because of their financing cost is lower compared to other. However, the best recommendation that can be use to financing roadmap to Emirate Airline for their existing order of A380 planes which is Emirate Airline itself should keep repeating the sukuk issue by issuing that sukuk bond or also known as Islamic bond that consisted of “ijara (sale and lease back concept)” or “murabaha (cost-plus financing)”.
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Emirate Airlines (EA) can proceed to continued issued sukuk bond as their announced plan to issue US$1 billion of Islamic Bonds (Sukuk) on 11 March 2013 with maturity date of 10 years and also using similar rate to finance their next batch of planes. Here we can conclude that, continue repeating sukuk issue is consider the best option that Emirate Airline can take to finance its next batch of their planes itself.
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References
1. “Five Important Differences Between Sukuk and Traditional Bonds.” Sukuk | Home of the Global Sukuk Industry, www.sukuk.com/education/important-differences-sukuk-traditional-bonds-2207/. 2. “How Sukuk (Islamic Bonds) Differ from Conventional Bonds.” Dummies, www.dummies.com/personal-finance/islamic-finance/how-sukuk-islamic-bonds-diffe r-from-conventional-bonds/. 3. Pettinger, Tejvan. “Factors That Determine Bond Yields.” Economics Help, www.economicshelp.org/blog/5354/economics/factors-that-determine-bond-yields/. 4. HSBC & NASDAQ DUBAI CORPORATE US DOLLAR SUKUK INDEX (2013), “Emirates Airlines considers $4.5bn sukuk to pay for 21 aircraft”, Article of NUAE. https://www.thenational.ae/uae/emirates-airline-considers-4-5bn-sukuk-to-pay-for-21aircraft-1.286101
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