19 Feb 2012 SUKUK
Sukuk are asset-backed, stable income, tradable and Shariah compatible trust certificates.
TYPES OF SUKUK
The proper classification of the asset classes will also determine the type of certificates to be issued.
These certificates are issued on a stand-alone assets identified on the balance sheet. The assets can be parcels of land to be leased or leased equipment such as aircrafts and ships. The rental rates of returns on these Sukuk can be both fixed and floating depending on the particular originator.
This has gained acceptance among Shariah scholars and high in demand by large investors and Islamic financial institutions. On the supply side, many governments have found it useful to raise funds for their fiscal needs and long term financing of big projects. Corporate entities are also finding it useful to generate funds for their project specific needs
There are some useful legal and economic characteristics of ijarah contract that distil into its securitization on the form of Asset Ijaraha Bonds.
The underlying pool of assets can comprise of Istisna’, Murabahah receivables as well as Ijarah. Indeed, having a portfolio of assets comprising of different classes allows for a greater mobilization of funds as previously inaccessible Murabahah and Istisna assets can comprise a portfolio. However, still at least 51 per cent of the pool must comprise of Ijarah assets. Due to the fact that Murabahah and Istisna receivables are part of the pool, the return on these certificates can only be a pre-determined fixed rate of return.
Variable Rate Redeemable Sukuk
The abovementioned two types of Sukuk would partially represent the strength of the issuer’s balance sheet. Under some conditions, implementing Sukuk by representing the full strength of an issuer’s balance sheet can prove to be beneficial. Under some conditions, implementing Sukuk by representing the full strength of an issuer’s balance sheet can prove to be beneficial. Already several corporate entities refer to these Sukuk as Musharakah Term Finance Certificates. This can be considered as an alternative to Sukuk because of its seniority to issuer’s equity, its redeeming nature and its relatively stable rate as compared to dividend payouts.
Zero-coupon non-tradable Sukuk
Another possible classification can be created where the assets to be mobilized do not exist yet. Consequently, the objective of the fund mobilization would be to create more assets on the balance sheet of the company through Istisna. However, certificates of this nature would not readily be tradable because of Shariah restrictions. The primary asset pool to be generated would be of the nature warranted by Istisna and instalment purchase/sale contracts that would create debt obligations. The certificate on these debt arrangements can be termed as fixed rate zero coupon Sukuk.
These could be Sukuk whether zero-coupon, pure Ijara or hybrid, with the embedded option to convert into other assets forms depending on specified conditions.
TYPES OF INVESTMENT SUKUK
Expanded List of Sukuk
According to the exposure draft of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) relating to Shariah standards concering Sukuk “ Investment Sukuk are certificates of equal value representing, after closing subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs, and services, or equity of a given project or equity of a special investment activity.”
The salient feature of different type of investment Sukuk are the following:
Certificates of ownership in leased assets
These are certificates that carry equal value and are issued either by the owner of a leased asset or an asset to be leased by promise, or by his financial agent, the aim of which is to sell the asset and recover its value from subscription, in which case the holders of the certificates become owners of the assets.
Certificates of ownership of usufructs of existing assets
These certificates have various types, including the following:
Certificates of ownership of usufructs of existing assets
These are documents of equal value that are issued either by the owner of usufruct of an existing asset or a financial intermediary acting on the owner’s behalf, with the aim of leasing or subleasing this asset and receive rental from the revenue of subscription. In this case, the holders of the certificates become owners of the usufruct of the assets.
Certificates of ownership of usufructs to be made available in the future as per description
These are documents of equal value issued for the sake of leasing assets that the lessor is liable to provide in the future whereby the rental is recovered from the subscription income, in which case the holders of the certificates become owners of the usufruct of these future assets.
Certificate of ownership of services of a specified supplier
These are documents of equal value issued for the sake of providing or selling services through a specified supplier (such as educational programmes in a nominated university) and obtaining the value in the form of subscription income, in which case the holders of the certificates become owners of the services.
Certificates of ownership of services to be made available in the future as per description
These are documents of equal value issued for the sake of providing or selling services through non-existing supplier with the description of the subject matter (such as educational programs of a special quality, schedule, duration, etc. without mentioning the educational institution) and obtaining value in the form of subscription income, in which case the holders of the certificates become owners of the services.
These are documents of equal value issued for the sake of mobilizing Salam capital and the items to be delivered on Salam basis are owned by the certificate holders.
These are documents that carry equal value and are issued with the aim of mobilizing the funds required for producing a certain item and the items to be produced on Istisnaa basis are owned by the certificate holders.
These are documents of equal value issued for the purpose of financing the Murabahah commodity and the certificate holders become the owners of the Murabahah commodity.
These are documents of equal value issued with the aim of using the mobilized funds for stabling new project or developing an existing one or financing a business activity on the basis of one of partnership contracts. The certificate holders become the owners of the project or the assets of the activity as per their respective shares. The participation certificates may be managed on the basis of Musharakah or Mudarabah or through an investment agent.
Participation certificates managed on the basis of Musharakah contract
These are documents representing projects or activities that are managed on the basis of Musharakah by appointing either one of the parties or any other party to manage the operation.
Participation certificates managed on the basis of Murabahah contract
These are documents that represent projects or activities that are managed on the basis of Mudarabah by appointing mudarib for management.
Participation certificates managed on the basis of investment agency
These are documents that represent projects or activities that are managed on the basis of investment agency by appointing an agent to manage the operation on behalf of the certificate holders.
Muzara’a (sharecropping) certificates
These are documents of equal value issued for the sake of using the mobilized funds in financing a Muzara’a contract. The certificate holders become entitled to a share in the crop as per agreement.
Musaqa (irrigation) certificates
These are documents of equal value issue on the basis of a Musaqa contract for the sake of using the mobilized funds for irrigating trees that produce fruits and meeting other expenses relating to the maintenance of the trees. The certificate holders become entitled to a share in the crop as per agreement.
Mugarasa (agricultural) certificates
These are documents of equal value issued on the basis of a Mugarasa contract for the sake of using the mobilized funds for planting trees and meeting expense of the work. The certificate holders become entitled to a share in the land and plantation.
These are documents of equal value that are issued for the sake of using mobilized funds to finance execution of a concession offer in which case the certificate holders become entitled to rights associated with the concession.
RISKS UNDERLYING SUKUK STRUCTURES
An important distinction is made between market risks and other types of risk factors. Market risk is defined as the risk on instruments traded in well-define markets. Two categories of market risks are identified: general (systematic) and firm specific (idiosyncratic). Systematic risks can arise due to governmental and economic policy shifts whereas idiosyncratic risk arises because different firm specific instruments as priced out of correlation with other firms’ instruments. Market risk is composed of interest rate risks, foreign exchange risks, equity price risks and commodity risks.
Interest rate risks (rate of return risk)
This can be considered as a tae of return risk as far as Sukuk are concerned. It may be mentioned again that Sukuk based on fixed rates are exposed to this risk in the same manner as fixed rate bonds are exposed to the interest rate risk. The rise in market (interest) rates leads to the fall in the fixed-income Sukuk values.
All fixed return assets either from Ijarah, Istisna, Salam or any other origin will face this risk. This also entails reinvestment risk and an opportunity cost of investing at the new rates, particularly if the asset is not liquid as in case of the zero-coupon non tradable Sukuk. Maturity plays a very important role in intensifying the impact of this risk.
Foreign exchange rate risks
Currency risk arises from unfavorable exchange rate fluctuations which will undeniably have an effect on foreign exchange positions. In the event of a divergence between the unit of currency of denomination in which the Sukuk funds are accumulated, the Sukuk investors are rendered to an exchange risk.
Credit and counterparty risk
Credit risk refers to the probability that an asset or loan becomes irrecoverable due to a fault or delay in settlements. If the relationship involves a contractual arrangement then the counterparty risk is the probability that the counter party retracts on the conditions of the contract.
Sukuk prospectuses operate, for the large part, in emerging markets where counterparties possess less sophisticated risk management mechanisms. The rescheduling of debt at a higher mark-up rate is not existent due to the prohibition of interest. Consequently, counterparties would be more inclined to default on their commitments to other parties. Also agency costs are higher in with regards to Profit-Loss sharing arrangements.
The recent major Sukuk issuances have mainly involved assets based on Ijarah, Istisna, Salam and Murabahaha contracts. There are numerous credit risk considerations associated with these modes of finance. Salam contracts are exposed to the risk that commodities will not be supplied on time or the agreed quantity. Istisna contracts involve performance risk.
Shariah compliance risks
Shariah compliance risk refers to the loss of asset value as a result of the issuer’s breach of its fiduciary responsibilities with respect to compliance with Shariah. There could be several such instances of willful or innocent breaches. Broadly speaking, Shariah compliance risk must be defined as a rate of return forgone in comparison to the market rates, as a result of complying with Shariah. The issue hence is that of competitiveness and survival in capital markets as a Shariah complaint asset class.
Islamic finance is an economic paradigm reflecting the essence of a faith that is a way of life for Muslims.
Each prospectus has provisions for the termination of the certificate in the event of a default by the obligator. In case the obligator fails to pay the rentals on the Ijarah agreements that form the coupon payments, the certificate holder can exercise the right to nullify the contract and force the obligator to buy back the assets. Furthermore, in the event that the obligator fails to reimburse the principal amount the certificate holder can exercise the right to take legal action and force the obligator to enter into debt rescheduling proceedings.
Coupon payment risk
The obligator may fail to pay the required coupons on time. Any delayed coupons will be subject to a specified payment amount that will be accumulated with the SPV. However these accumulated funds are recommended by Shariah council’s to be donated for charitable purposes.
Asset redemption risk
The originator has to buy back the underlying assets from the certificate holder. The principal amount paid may not be equal to the Sukuk issue amount and, as a result, there is the risk that the asset may not be fully redeemed.
SPV specific risks
The Special Purpose Vehicle is generally designated to be a standalone institute that is bankruptcy remote from the originator. However, there may be a notion of settlement risk involved with the SPV in that the originator will have to channel the payments through a clearinghouse. The certificate holders will then be reimbursed through the clearinghouse.
Investor specific risks
The certificate holder is rendered to specific risks pertinent Sukuk structures. These are primarily regarding liquidity issues. The Sukuk structures, as welcome as they are in dealing with liquidity management issues in Islamic finance, are exposed to a liquidity risk because there currently does not exist a well structured and sufficiently liquid secondary market. The certificates are listed on several local markets but this alone does not signify their liquidity. The Sukuk certificates are medium to long term in maturity and their continued success will largely depend on their ability to evolve into highly liquid means of fund investment with adequate risk management mechanisms. As is the currently the case, most of the certificates tend to be held until maturity.
Risks Related to the asset
The underlying assets of the Sukuk certificates are subject to numerous risks as well. Primarily, there is the risk of loss of the assets. These are minimal with regards to Ijarah assets of land parcels. However, in the case of equipment and large scale construction typifying some of the underlying IDB assets the risk of loss may not be so negligible. Nevertheless, Islamic finance has Shari’ah compliant provisions for insurance claims in the form of Takaful and these arrangements will have to be utilized to mitigate the risks of asset losses. Related to the asset risk as well is the need to maintain the structures of the assets. Proper maintenance will ensure adequate returns to the certificate holder. According to Shari’ah principles, the SPV will usually be required to bear the responsibilities on ensuring asset structure maintenance.
Sukuk originate from developing countries. The financial infrastructure in some of these countries such as Bahrain and Malaysia are well developed. But generally this infrastructure is weak in most emerging economies. In addition, Sukuk require unique Shari’ah compliant structures. This creates a state, which can be termed as one of institutional rigidity and which cannot be removed in the short run, invariably increasing the risks of Sukuks. The features of this state are:
- Lack of hedging and financial engineering processes;
- Non-existence of inter-bank money markets;
- Lack of best practice uniform regulatory standards and regimes;
- Weaknesses in litigation and legal framework support, particularly, in the treatment of default;
- Non-uniform accounting, auditing and income and loss recognition systems;
- Non-robust investment appraisal, promotion and monitoring infrastructure;
- Ineffective external credit assessment systems;
- Rudimentary state of financial markets and
- Weak inter-segmental support and linkages. For example, without life insurance coverage the credit risk of a client is bound to be high. This is one of the important risk factors faced by Islamic banks due to non-existence of comprehensive Islamic insurance coverage.
ADVATAGES AND DISADVATAGES OF SUKUK STRUCTURES
- Increase the liquidity of the originator and investor. This will reduce risk premium in the other products of the capital market and hence contribute to lower cost of funding enterprenures.
- Increase the flow of funds to securitized asset markets.
- Can tap new and diversified source of funding through the capital market. Insitutional investors and passive investors would find it more attractive.
- Can help development of capital markets by allowing thinly capitalized market players who may have specialization in securitization and issuance to participate in the capital market.
- With development of Sukuk markets specialized issuers for different kinds of sukuk in different kinds of asset/ contract pools will emerge which will again lower the cost of funding.
- At the moment sukuk have become an avenue for parking of the excess liquidity available with Islamic banks. By this the buyers directly participate in some useful economic activity generated through their finance. The facility is for relatively long term with an option to exit at any time through secondary market. It is a better economic alternative than the commodity Murabaha used by Islamic banks. In commodity mubaraha the bank purchases some metal in bullk on spot payment from a metals exchange and sell these to another trader on deferred price marked-up by a percentage over the cost. This is a very inefficient way of earning on its liquidity by indulging in a trade that is neither needed by the bank nor by its client. It therefore has gross productive and allocative inefficiency.
- The ijarah sukuk are limited use liquidity management instruments, at least until a large supply with periodic issuance becomes the norm and a secondary market in them develops. Because as opposed to commodity Murabahah that ( in vibrant metals and commodity market) can be initiated at the will of the Islamic bank the Ijarah sukuk route has to wait until an issue is offered by the issuer. A way to develop ijarah sukuk based liquidity management isntruments for Islamic banks is to offer some ijarah sukuk series specially for the Islamic bank with periodic issues spaced at regular internbal on or before maturity of each issue.
- The initial structuring and issuance cost of ijarah sukuk at the moment is quite high. It requires a large size of isolatable assets, upfront legal, rating, and investment banking fee, as well as lots of documentation. Only large, credible, and more transparent instituions are so far able to participate in ijarah sukuk deals.
The information contained herein is for informational purposes only and is not meant to serve and should not be relied upon as professional advice. Further information on the subject matter of this publication may be obtained from lecocqassociate.
lecocqassociate provides a full range of financial regulatory, corporate and commercial advice in relation to the structuring and incorporation of entities.
This newsletter is for information purposes only. It does not constitute professional advice or an opinion. Please contact Mr. Dominique Lecocq on firstname.lastname@example.org for any questions.
 Managing Financial Risks of Sukuk Strucutres, Ali Arsalan Tariq,2004.
 Hefferan, 2003