July 14, 2021 / 06:30 PM / By Fitch Ratings / Header Image Credit: Fitch Ratings
Recent innovations in and revisions to sukuk documentation to comply with the Accounting and Auditing Organization for Islamic Financial Institutions' (AAOIFI) sharia standards may have implications for sukuk holders' ranking, and sukuk rateability, as well as the issuers' credit profiles, liquidity and ratings, Fitch Ratings says.
Most sukuk are still structured in a way that creates an economic effect similar to conventional bonds, limiting the impact of the changes so far. Fitch adopts a case-by-case approach when rating sukuk and will monitor and report any credit impact in its public commentaries.
A number of recent international sukuk issuances contain new clauses and revised terms in their documentation to satisfy the requirements of the UAE Central Bank's Higher Shariah Authority (HSA), which aims to increase the standardisation in the UAE sukuk market through the adoption of AAOIFI sharia standards.
Standardisation may be achieved in the medium-to-long term, but, in the near term, these changes are adding further complexity to an already complex instrument like sukuk. They are also affecting the global sukuk market, as a sizeable share of international sukuk investors, arrangers and issuers come under HSA's remit and so are subject to AAOIFI sharia standards. Non-compliance could affect sukuk demand.
The changes include stricter tangibility ratio requirements with new dissolution triggers such as tangibility and delisting events and associated put options, as well as partial-loss events, changes in indemnity and in the definition of sharia. Further changes are possible in the future.
One of the key changes is the issuer's obligation to monitor and maintain the tangibility ratio above 50% throughout the sukuk's life, rather than typically at issuance. If the tangibility ratio falls below 33%, this could result in tangibility events, delisting events or the exercise of put options by investors. Such events, in turn, could reduce issuers' liquidity and potentially affect their ratings if they have to redeem their certificates in whole or in part prior to the scheduled dissolution date at the dissolution distribution amount. Historically, a fall in the tangibility ratio below a certain threshold has not always caused a dissolution event and investors did not have an associated put option.
Indemnity clauses in some sukuk documentation have also been modified, with the exercise price payment to investors now subject to the obligor being in actual or constructive possession, custody or control of all or any part of the portfolio assets. On a standalone basis, this could result in sukuk subordination. However, so far, its impact has been neutralised by the insertion of counter-clauses obliging the issuer to maintain actual or constructive possession, custody or control of all or any part of the portfolio assets during the ownership period. Failure to do so will result in an obligor event.
We expect global sukuk supply to continue growing in the short-to-medium term, as it is largely driven by sovereigns, large corporates and financial institutions. Issuers' refinancing and funding diversification needs and strong investor appetite also support growth.
The changes have so far been seen in sukuk issued by corporates and financial institutions, and less so in sovereign sukuk, largely because the latter's international sukuk structures do not contain murabaha (deferred sale payments), which are considered intangible assets.
We also expect sovereigns as well as financial institutions to be less affected by the changes due to their access to larger asset pools, their expertise in sukuk structuring and, in the case of Islamic banks, their experience of operating within a sharia-compliant framework. For corporates, complying with tangibility ratio requirements will likely be easier for those with large tangible asset bases.