Debut Islamic UK RMBS widens funding options for sharia-compliant lenders

Al Rayan Bank’s first Islamic residential mortgage-backed securitisation in the country is expected to pave the way for further transactions of this type.

The first issue of an Islamic bond backed by residential mortgages in a non-Muslim country is expected to open new funding options for lenders in the growing sharia-compliant home finance market in the UK.

Birmingham-based Al Rayan Bank, the UK’s largest sharia-compliant retail bank, issued in February a £250 million (€280 million) Islamic securitisation backed by a portfolio of nearly 1,700 sharia- compliant mortgages, known as home purchase plans (HPP), originated across England and Wales.

While sharia-compliant, the debut issue replicates as far as possible a conventional UK residential mortgage backed securitisation (RMBS), making it a valid source of funding to lenders providing Islamic finance ¬– and an alternative to more expensive deposit funding.

“We looked to other alternatives to retail funding to keep growing, and the securitisation market looks very attractive in terms of pricing,” says Amir Firdaus, treasurer of Al Rayan. “In addition to being cheaper than retail funding, securitisation provides longer-term finance.”

The issuance, dubbed Tolkien Funding Sukuk No. 1, is comprised of sukuks – Islamic financial certificates – which are in line with sharia principles regarding the payment of interest. Islamic financing prohibits lenders from charging interest on loans. In a HPP, instead, the lender co-owns the house and rents the part it is not using to the customer, which would represent the bank’s profit on the arrangement. When the customer pays the full amount of the bank’s ownership interest, the legal title to the property is transferred to the customer, and they cease paying rent.

“One of the principles of sharia financing is that all investors should be treated equally, which makes tranching problematic,” says David Shearer, partner at Norton Rose Fulbright, which acted as structuring and documentation counsel in the transaction. “In this issuance, there’s one senior tranche, which pays principal on a pass-through basis and a profit rate of three-month sterling Libor plus 0.80 percent.”

A typical prime RMBS is priced at around 0.40 percent above Libor, Real Estate Capital understands. “The pricing premium [of the Tolkien issue] is probably related to the fact that this is a new product in the market, compared with the conventional RMBS market,” says Mohamed Damak, global head of Islamic finance at S&P Global Ratings.

Irina Penkina, director at S&P Global Ratings, adds the pricing premium is also related to the risk that investors need to consider. “There are some uncertainties, such as how these underlying assets are going to perform going forward,” she says. Al Rayan’s book, worth more than £660 million, has no registered losses since it entered the residential home finance market in 2008, the bank says.

The Tolkien issue was oversubscribed, with orders representing 155 percent of the certificates offered. Demand came mainly from institutional investors, most of them based in the UK. “Part of the investors in this transaction were conventional RMBS investors, who were offered the opportunity to invest in a similar product that delivered a pricing premium,” Damak says.

The transaction not only reflects strong investor appetite, it also highlights the crucial role of capital markets for sharia-compliant lenders seeking new sources of capital.

“The bank does not have access to government funding schemes […] and so we had to look to alternative ways to diversify our funding as we keep growing. Our asset book has grown fivefold since 2013 and is now worth over £2 billion,” Firdaus says.

Demand for Islamic home finance continues to grow across the UK, which is home to 1.5 million Muslim adults, representing 3.1 percent of the UK adult population. “We have just over 4,000 customers for our home finance products, that gives an idea for the growth potential,” Firdaus notes.

Al Rayan’s home purchase and buy-to-let purchase plans reached an all-time high in 2016. Demand, as measured by the volume of eligible enquiries to the bank, increased by 9 percent in 2016 and by 99 percent in the past five years, according to the lender.

“Sharia-compliant residential housing finance is growing actively. As originators gather increasing underlying assets, the scope for further securitisation will increase,” Penkina says. “It will be natural to expect further transactions of this type tapping the market, although starting from a very low base.”

Sharia-compliant home finance products are a nascent and small segment of the UK residential mortgage market, representing only 3 percent of the total outstanding amount, according to S&P.