Negative Real Yield and Sovereign Sukuk
Negative Real Rates Have Reached the Shores of Many Countries Across the Globe.
Our Islamic finance industry is not immune. The question is, how many sovereigns have issued local denominated Sukuk for which the yield has been strongly negative throughout 2021? It is interesting that not much is there about linking negative real yield to Sukuk and inflation.
First, let us point out that real yield is the annualized return that a benchmark government bond/Sukuk facility generates once inflation is taken into account. Here is what I found about the Kingdom of Saudi Arabia (KSA).
Funding Cost
In principle, we need to examine inflation as a funding cost. Naturally, inflation impacts the currency of the investment because of relative purchasing power parity. The value of the cash flows depends on the currency that they will be received.
So in our case (KSA), the investment currency and consumption currency are the same (Saudi Riyal (SAR)). Therefore, we will be focusing on SAR inflation and SAR-denominated debt.
Value-Added Tax (VAT) and Sukuk
The KSA had experienced the impact of higher inflation during the period when the VAT hike in July of 2020 took effect. At some point, Saudi Arabia’s consumer price index jumped 6.1% in July 2020. However, things have started to change during the third quarter. Saudi Arabia’s consumer price index rose 0.3% in August 2021.
Negative Yield
To put that into context, if we look at the iBoxx Tadawul SAR Government Sukuk as a proxy for the local Saudi debt market, we will note that the nominal yield is 2.93%. The real yield is 2.63%. That was the first time that the real yield turned positive.
For almost a year, Saudi sovereign debt was in the negative territories. But that did not stop investors from piling into these negative ‘real’-yielding assets.
This means Saudi sovereign debt is attractive if the country maintains the 0.3% average (for inflation). In other words, if inflation in Saudi Arabia is equal to or below the annual yield of the iBoxx Tadawul SAR Government Sukuk index (operated by IHS Markit), investors in the index/basket of Sukuk will continue to break even or generate a positive return, adjusting to their purchasing power, on their investment.
To hedge against inflation, some US fixed-income investors tend to invest in Treasury Inflation-Protected Securities, whose principal value is indexed to the rate of inflation. But such a sophisticated debt instrument may not be available within the local debt capital market of our region.
The real yield is a simplified measure of return adjusted for purchasing power. In some markets, investors were making negative returns when adjusting for inflation.
Against the backdrop of the growing pile of negative-yielding debt in the world, investors in Saudi government debt can lock in a positive real yield.
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