By the end of 2008, global Sukuk issuance had declined by more than 50 per cent compared to 2007, a marked reversal of the strong growth trend witnessed in recent years since this market came into being. Globally, credit markets underwent a significant decline in debt issuance, mainly driven by the lack of global economic visibility, pricing issues and a shortage of committed investors. The Gulf Cooperation Council (GCC) and Malaysia have been the hardest hit, experiencing declines in Sukuk issuance of 55 per cent and 59 per cent, respectively.
Over the past year, Ijarah Sukuk has become the dominant Sukuk structure in terms of issuance volume, replacing Mudarabah, which had been the dominant structure in2007. Early in 2008, AAOIFI made a recommendation to Islamic finance market participants to refrain from issuing Sukuk structures that have a purchase undertaking or guarantee from the Sukuk issuer to repurchase at a future date at a specific price. In AAOIFI’s view, this structural mechanism is not compliant with a fundamental principle of Shari’ah, namely profit and risk sharing. However, although AAOIFI standards are widely followed (without obligation) across many countries, they are only adopted by Bahrain, the Dubai International Financial Centre (DIFC) in the UAE, Jordan, Lebanon, Qatar, Sudan and Syria.
Moody’s has followed the Sukuk market closely over the past few years and even more closely since the start of the ongoing global crisis. This Special Report presents an overview of key recent developments in the market as it strives to favourably balance the market turmoil and ideological principles
Market developments in challenging times
Sovereign and local currency Sukuk issuances have recently increased in popularity across the GCC and Asia-Pacific. Speculation has been rising as to whether GCC currencies will de-peg from the US dollar, which was weakened for most of 2008 and which has historically been the most favoured currency for debt issuance in the GCC. As a result, issuers in the region have resorted to issuing Sukuk denominated in Saudi riyals or UAE dirhams. This trend has also been seen in Asia, where the Malaysian ringgit, Pakistani rupee and Indonesian rupiah have been the most common currencies used.
A growing number of institutional and retail investors have been seeking local-currency-denominated Sukuk in a bid to reserve profit yields under the difficult credit market conditions and declining US dollar. The HSBC/DIFX Sukuk index (SKBI), representing the weighted-average credit spread over LIBOR of the individual constituents underlying the relevant index, has increased by over three times since the global credit crisis started in August 2007, trading at just over 400 bps. As the crisis deepened further in October 2008, the weighted spread increased to 900 bps.
In 2007/2008, issuers in the GCC and Asia-Pacific announced5 over $30 billion in Sukuk that were due to close in 2008, accounting for over 88 per cent of globally announced deals. Given the unfavourable credit conditions, the rising cost of borrowing and widening spreads, most of these deals failed to materialise in 2008. Had it not been for the closure of the debt markets and a decreasing investor appetite for debt securities, we estimate that 2008 issuance would have reached $45 billion, compared to actual issuance of $15.1 billion.
However, market conditions were not the only difficulty issuers faced in 2008. In February, AAOIFI issued a statement of six guidelines containing advice relating to Sukuk tradability, the corporate responsibility of the Sukuk manager, the purchase of certain Sukuk structures at their net rather than nominal value, and the duty of the Shari’ah Supervisory Board (SSB) to oversee the implementation of funds and investments in a Shari’ah-compliant manner and not to limit their involvement to issuing fatwas at the time of the Sukuk issuance.
Ijarah Sukuk emerged as the lead structure in 2008 in terms of Sukuk issued; in 2007 Mudarabah had been the most frequently form of issued Sukuk. The increased popularity of Ijarah Sukuk reflects its simple structure and the abundance of tangible assets with which it can be structured.
Against this backdrop, we have also seen Sukuk issued through securitisation becoming a more mainstream financial vehicle. One of the key fundamental objectives of Shari’ah is the sharing of profit and losses. This can be practised through many Sukuk structures including Mudarabah, Musharaka and Investment Partnership. These structures have been proven to be successful and favourably accepted by SSBs when structured around a true sale securitisation. Sukuk holders can and will be able to trade them in accordance with Shari’ah principles if they have ownership rights and obligations for assets, including usufruct or title rights.
In July 2008, the Abu Dhabi-based Sorouh Real Estate launched the first Islamic securitisation of land and associated rights to payment from a pool of GCC obligors. These were primarily GCC real estate developers which pay scheduled instalments to purchase land plots, concentrated within two real estate developments --Shams and Saraya within Abu Dhabi, the capital city of the United Arab Emirates. The purchase contracts were originated by Sorouh, one of the three key real estate master developers in Abu Dhabi that has been granted land on preferential terms by the government.
Sukuk issuance analysis
Global Issuance: 2008 Decline Reverses Recent Trend
In 2008, global Sukuk issuance decreased by over 50 per cent compared with 2007, reversing the trend seen in recent years. Of the most common Sukuk structures, Murabaha issuance increased by nearly 60 per cent, whilst Ijarah witnessed a moderate decline of eight per cent, largely due to the global credit environment. However, Musharaka and Mudarabah Sukuk declined by 83 per cent and 68 per cent, respectively. This sizeable decrease was witnessed across many of the key issuance markets, including the GCC and Malaysia.
Ijarah and Murabaha have clearly emerged as the most popular Sukuk structures for both investors and issuers. This is likely due to their simple contractual terms and the comfort of Shari’ah scholars in approving their compliance. Musharaka, Mudarabah and Wakalah for Investment Sukuk tend to be more complex and involve a form of partnership (Mudarib), joint venture (Sharik) or investment partnership (Wakil Istithmar) between Sukuk holders and the Sukuk manager.
AAOIFI has argued that Musharaka, Mudarabah and Istithmar Sukuk are profit- and loss-sharing partnerships that in economic upturns lead to profit-sharing and in downturns may lead to loss-sharing. In the statements it released in early 2008, it therefore stressed the importance of the profit- and loss-sharing aspects of Sukuk and advised that the purchase undertaking commitment by the Sukuk manager/issuer at its nominal value should be dismissed, as this commitment represents a form of guarantee that does not adhere to the principles of Shari’ah, regardless of whether the manager is a Mudarib, Sharik or Wakil for investments.
Despite this, Diminishing Musharaka has emerged as an accepted structure, incorporating both Shari’ah compliance consistency and a profit- and loss-sharing partnership.
Malaysian Sukuk issuance declined by 59 per cent
The Malaysian market, a key issuer of corporate, financial institution and sovereign Sukuk, experienced a decline in issuance of 59 per cent compared with 2007. One could argue that, as Malaysian issuers have not formally adopted AAOIFI standards, the issuance decline should have not been that severe, especially if we include local currency Sukuk, which would still be favoured and issued in the local ringgit market. This raises again the question of how much this slowdown is a function of global credit market conditions and how much is due to issues of Shari’ah compliance. Bahrain and UAE Sukuk issuances (represented by those issued out of the DIFC) also declined, by 36 per cent and 51 per cent, respectively.
Latest issuance trends: More local currency and sovereign issues
As the US dollar has historically been the most favoured currency for debt issuance in the GCC, its weakening over most of 2008 has meant that issuers in this region have resorted to issuing Sukuk denominated in local currencies, mainly in UAE dirhams (AED) and Saudi Arabian riyals (SAR). With speculation increasing throughout 2008 on the prospect of a de-pegging of GCC currencies from the US dollar, the outlook for local currency issuances has become increasingly significant.
As global US dollar issuance declined to less than $2 billion from over $14 billion in the same period of 2007, local currency issuance increased in the UAE to nearly AED19 billion in 2008, an increase of over 150 per cent from 2007.
A corporate issuer’s decision to tap the Sukuk market is usually dependent on its ability to achieve favourable pricing and on the robustness of the capital market environment. These two factors were missing for most of 2008, leading many Sukuk issuers to postpone announced issues awaiting better credit and market conditions. We estimate that over $30 billion of Sukuk value had been announced in 2007/2008 for issuances in 2008 that did not materialise in 2008. If we incorporate both announced and closed Sukuk issuances, the total volume would have risen to $45 billion, healthy growth of 35 per cent over 2007.
By contrast, sovereigns and supranational institutions are less likely to slow down their issuance. On the contrary, in periods of slower growth and uncertain credit and capital market conditions, governments will need to increase their borrowings to compensate for revenue shortfalls from taxes and other sources of income, including lower oil and natural resource prices. Indonesia, Bahrain and Gambia have all seen an increase in their sovereign Sukuk issued.
In 2008, the number of sovereign Sukuk deals issued increased to 72, representing over 44 per cent of total deals issued and an increase from 23 in 2007. In addition, previously planned and announced Sukuk issues by Kuwait, Turkey, Japan and Thailand are likely to tap the market once there is some stability on the credit and capital markets.
Sukuk issue rating
Sun Finance / Sorouh
In the second half of 2008, Moody's assigned several investment-grade ratings to three classes of Sukuk certificates issued by Sun Finance. This transaction is not only the largest public ‘Islamic’ securitisation, but also the first EMEA securitisation of land and associated rights to purchase payments from a pool of local real estate developers.
The deal was originated by Sorouh Real Estate, one of the three real estate developers in Abu Dhabi that have been granted land by the government to deliver its2030 urban plan. The total value of the rated Sukuk certificates was over AED4 billion ($1.1 billion). Ratings assigned were Aa3/A3/Baa3/NR at 55/5/20/20 per cent of the capital structure, respectively.
The 61 obligors will pay in scheduled instalments over the next four years to purchase undeveloped land which is concentrated within two real estate developments –Shams and Saraya – in Abu Dhabi.
Local real estate markets in the Middle East are still faring relatively well –albeit with a notable decline – and regional demand for residential and commercial property has allowed the local phenomenon of pre-selling of land and property often years in advance of actual delivery date. While this model shifts the immediate speculative construction risk from Sorouh (originator/master developer) to the underlying sub-developers, it does not eliminate the ultimate exposure to price volatility or decline in the local property markets.
Sun Finance Limited, a special purpose vehicle (SPV) incorporated under the laws of Jersey (UK), will issue the three classes of Moody’s-rated AED-denominated notes to fund the purchase of the assets.
Because of the Islamic nature of the transaction, and unlike typical ABS transactions, there will be a transfer and registration of the freehold title of the land. This registered transfer, as well as the assignment of the purchase payment rights, is governed by local Abu Dhabi and Federal UAE law, while the remaining security documents are governed by English law.
The notes are priced at AED200/250/350 respectively in an environment that has also started to see a thinning of local currency liquidity. All the notes were placed in the region.
Faisal Hijazi is Business Development Manager for Rating Services and Islamic Finance at Moody’s in Dubai.