Islamic finance has been one of the fastest-growing sectors in global finance but the industry has yet to shake off perceptions about high costs and complexity that are holding back some issuers.
Sukuk, or Islamic bonds that follow religious principles such as a ban on interest and speculation, are now a major funding tool for companies in the Middle East and southeast Asia, and are becoming increasingly attractive to sovereign issuers.
Britain, Luxembourg, Hong Kong and South Africa all are keen to make maiden sukuk issues, to diversify their funding sources and tap liquidity provided by increasingly wealthy Islamic investors.
Those plans are not new: the Luxembourg government first mooted a sukuk issue in 2010, followed by South Africa in 2011, while Britain has been considering an Islamic bond since 2007.
These and other plans have been delayed by factors including double-taxation on some sukuk structures and a difficulty in identifying assets to underpin the transactions, although Islamic finance experts say such drawbacks have largely been overcome.
Jurisdictions such as Hong Kong and Luxembourg have enacted legislation in the past few years to remove double or even triple tax duties that sukuk can attract due to multiple title transfers required. Rising demand for sukuk has also depressed costs.
"These recent developments strongly signal growing international acceptance and will facilitate future issuance," said Badlisyah Abdul Ghani, chief executive of CIMB Islamic , one of the industry's top sukuk arrangers.
As a result, first-time issuers that would have expected to pay a premium on their sukuk in previous years can now achieve levels comparable to conventional bonds, he said.
"Issuers that have existing conventional bonds will have a benchmark curve to refer to and the sukuk should be priced flat, if not potentially lower, than the conventional points of reference. They should not pay a premium when raising sukuk."
Issuance of sukuk globally hit an all-time high of $134.3 billion in 2012, but fell to $114.3 billion in 2013 as jitters about U.S. monetary policy constrained emerging market assets.
Growth of the market is expected to pick up again this year as the pool of Islamic funds in the Gulf and southeast Asia continues to expand. A Thomson Reuters study predicts sukuk issuance of as much as $130 billion in 2014.
Increased clarity on sukuk structures has helped: the design and approval process has become generic as more sharia advisory firms have entered the market, pushing down costs, said Noel Lourdes, Dublin-based executive director at Amanie Advisors, a Malaysia-based Islamic finance consultancy.
"It is a lot cheaper now. For corporates, it is broadly in line with Eurobond or private dollar-denominated placement transactions," he said.
Still, the British government's plans for a 200 million pound ($338 million) issue are a downsized version of the original, partly to pass the UK Treasury's value-for-money test. And there is still a perception in financial markets that sukuk are generally more expensive or more complex than conventional bonds, or both.
When Hong Kong passed a bill in March to allow its AAA-rated government to issue a sukuk, potentially worth around $500 million, local traders said it would have to offer a yield of almost double that on its five-year Hong Kong-dollar bond, which was yielding 1.26 percent.
Islamic bankers dispute that, saying sukuk is highly sought after and pricing would be comparable with conventional bonds.
"The suggestion (Hong Kong would pay double) is absolutely out of whack. Sukuk pricing, like bond pricing, is a function of credit and the market," said Abdul Ghani at CIMB Islamic, citing the experience of the AAA-rated Islamic Development Bank .
The Saudi-based IDB has issued sukuk since 2003, pricing them with gradually lower yields, some as low as 12 basis points over Libor for five-year paper, said Abdul Ghani, whose bank helped arrange the latest IDB sukuk in February.
Other multilateral bodies that could issue sukuk, such as the Asian Development Bank (ADB) and the African Development Bank (AfDB), should expect pricing similar to their outstanding conventional debt, he said.
AfDB, which issued a three-year conventional bond at mid-swap +1 in March, is still concerned about the cost of a sukuk issue.
"For some years now, we have been in touch with banks to keep abreast of the market. However, so far it has not been cost effective for us as compared to other sources. Thus, we continue monitoring," an AfDB treasury official said.
While bankers say a sukuk premium has broadly disappeared for top-rated issuers and Gulf-based companies, some Muslim-majority countries do still face higher issuance costs as investors demand bigger yields due to limited trading activity in secondary markets for sukuk.
In Indonesia, profit rates for government sukuk - the equivalent to a coupon on conventional bonds - are on average 86 basis points higher than comparable conventional government bonds, a March report by the ADB found.
Other potential issuers also claim costs are high, including the Canadian government which last week ruled out a sukuk.
"A new unconventional product would likely lead to higher issuance costs," a Canadian finance ministry spokesperson told Reuters. "The increased costs would be inconsistent with our objective of raising stable, low cost funding to meet the government's financial needs."
Companies that have not tapped the fixed income market at all or those with sub-investment grade ratings could also have to pay a premium on sukuk, although Amanie's Lourdes said this can be mitigated with shorter tenors or plain vanilla Islamic debt facilities of between $50 million and $100 million.
"A tenor of more than five years is more challenging, especially if it is a first-time credit. We focus on BBB- or above, anything below that is difficult to take to Islamic finance investors unless the name is known," he said.
Many chief financial officers remain sceptical or just unaware of sukuk as an alternative funding option, so some level of education is needed to increase familiarity with sukuk and with the Islamic finance community.
"The pipeline will probably be a little bit more colourful if those issues are addressed," said Lourdes.