September 18, 2009 3237 VIEWS

The regulatory authorities of Islamic finance have been working to bring greater clarity to the relatively young sukuk asset class, but the market will need time to digest the implications. Writer Philip Alexander

The Saudi Electricity Company sukuk (sharia-compliant financing notes) for $1.87bn issued in July 2009 helped to reopen the international market for large corporate sukuk issuance that had been largely closed since the credit crisis began to bite in 2008. But market conditions are not the only significant change for the asset class.

The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has been working for some time to bring greater clarity to a comparatively new instrument. However, a guidance paper that it issued in February 2008 caused a mixed response.

The organisation had become concerned about some of the structures used in sukuk al-musharaka (joint venture) and al-mudarabah (partnership). These sukuk allow noteholders to share in the profit or loss of the borrower without requiring a reference pool of assets equal to 100% of the value of the issuance.

Looking for flexibility

Ijara (leasing) remains by far the dominant sukuk type, accounting for more than 70% of outstanding paper. But combined mudarabah and musharaka issuance outstripped ijara significantly in 2008, by about $12bn, according to Khalid Howladar, senior credit officer for sukuk at ratings agency Moody's.

"The market moved on from ijara because many companies wanted to issue a sukuk, but did not have suitable assets that could be freed up to sell into the special purpose vehicle," says Farmida Bi, a partner at law firm Norton Rose who began working on cross-border sukuk transactions in 2004.

However, the musharaka and mudarabah risk-sharing structures are inherently more like equity than debt investments. To appeal to investors wanting a stable rate of return, structurers began to include an agreement in which the price for repurchasing the sukuk assets was set at the start of the deal. AAOIFI warned that this was considered unfair from a sharia perspective, because it amounted to the sukuk holders receiving the returns without taking the risks. Instead, the repurchase price should be agreed at maturity, once the profits of the investment from the sukuk are clear.

The difficulty is that this approach leaves a structure with equity-type risks, in that investors must share losses as well as profits. "It is unlikely that investors would be willing to take that risk for a bond-like rate of return. The guidance may have taken away some of the ability to issue a sukuk that is not backed by assets for 100% of its value," says Ms Bi.

Alternative structures

Muddassir Siddiqui, head of Islamic finance at law firm Denton Wilde Sapte, who was a member of the AAOIFI sharia board at the time the guidance was issued, sets out two possible alternatives. "You can arrange for a third party to guarantee the transaction, instead of the mudarib [partner] who is to work the investment," he says.

Another mechanism is a reserve, where an expected return is set and the mudarib agrees to pay into a reserve any earnings over that expected return. "In this way, the risk sharing is still there, but there is more safety for the investor," says Mr Siddiqui.

A further alternative would be a diminishing sukuk, in which the principal and profit payments are made periodically throughout the life of the sukuk, reducing the overall risk profile. Kuwaiti Gulf Holding Company used this structure in its Villamar sukuk, which was issued three months after the AAOIFI guidance was released.

Ijara sukuk transaction structure

Uncertain market impact

Sukuk already issued are not affected by the guidance, as sharia requires respect for existing contracts. But liquidity for musharaka and mudarabah in the secondary market has declined, as some sharia-compliant investors are more reluctant to take exposure to them, according to Zeid Ayer, chief investment officer of Malaysia's CIMB-Principal Islamic Asset Management, which manages at least $500m in sukuk.

And even the ijara structure does not guarantee a uniform investor response. "The requirements for an ijara structure can differ between jurisdictions, and investors are now concentrating on the specific rules that satisfy that structure," says Fabianna del Canto of the emerging market syndicate team at Barclays Capital, which was a lead manager on the Indonesian sovereign sukuk in May this year.

Sharia boards at banks and investment funds are still digesting the significance of the guidance, but many participants believe that it will eventually help the market to reach greater maturity and consistency. "The sharia scholars were seeking to prevent the sukuk market being usurped or abused by structural gymnastics where the veracity of the underlying musharaka, mudaraba or investment activity was questionable," says Rahail Ali, regional managing partner of law firm Lovells, in Dubai.

"There has been a flight to tried-and-trusted ijara structures. This is not necessarily what the sharia scholars wanted but commercial marketing and distribution considerations have resulted in ijara structures being very much preferred. Moving forward, innovation in the sukuk market has to match compatibility of sharia principles - in spirit as well as form," adds Mr Rahail.



(Source:The Banker)

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