The Sustainability of Islamic Bonds
Content
The Sustainability of Islamic Bonds (Sukuk) as a Global Financing Instrument
A PhD Research Proposal Outline
Prepared by Maszuin Kamarudin MBA Universiti Tun Abdul Razak (UNIRAZAK) Malaysia Email: [email protected]
1.0. Background
Sukuk are indeed promising as a Shari’ah compliant financing instrument. Total Sukuk issuance amounts to US$ 236.75 billion as per June 2011 with Malaysia still champions the Sukuk issuance . This big number of Sukuk issuance can be supported by the fact that western countries such as the United Kingdom and United States have jumped on the bandwagon for issuing Sukuk as indicated by the UK‟s consideration of Sukuk for government financing, and the issuance of Sukuk by General Electric and East Cameron Gas in the US. Based on Islamic Finance Information Services („IIFS‟) statistic database of Sukuk, Sukuk issuance experienced an impressive growth from 2005 to 2006, increasing by 134% with the total Sukuk issuance amounting US$ 26 million. Sukuk issuance peaked at US$46 million in 2007 but substantially declined by 64% to US$17 million in 2008. The Sukuk market has grown rapidly over the last few years in terms of size, numbers and sophistication. Sukuk has become an alternative for conventional bonds and being used in financing for the last twenty years. It provides sovereign governments and corporations with access to the huge and growing Islamic liquidity pool, in addition to the conventional investor base. Malaysia has emerged as leader in Sukuk market since the first corporate Sukuk issuance in 1990 by Shell MDS Sdn. Bhd. This is due to the consistent growth in the issuance of Sukuk, increase in the level of knowledge and numbers of expertise amongst market players and progressive development of the Malaysian legal framework. This situation makes Malaysia the world‟s largest Sukuk issuer with more than 60% of outstanding global Sukuk (as at end of 2009). From total Sukuk issued globally, 66.8% with a value of USD 67,872 million were issued in Malaysian market, as illustrated in Table 1. As at end June 2010, local currency Sukuk market stood at a whopping USD76.4 billion or 35.5% of total bond market outstanding. This is attributable to various factors including well-executed policies, facilitative regulatory environment, increasing numbers and sophistication of intermediaries that continue to push the frontiers in terms of product innovation as well as the existence of a complete, matured and well established Islamic financial system. Although Sukuk were badly hit in 2008, they are indeed a promising ICM‟s instrument (IFIS, 2009). One reflection of this is the Sukuk rebound throughout 2009 brought mainly by sovereign and quasi-sovereign Sukuk issuances. These included the US$1.4 billion Sukuk issuance of Terengganu Investment Authority in Malaysia, US$487.2 million retail Sukuk issuance of government of Indonesia, plus Sukuk from the Dubai government, the Islamic Development Bank (IDB), and so forth (Zawya Sukuk Intelligence, 2010).
1
1
The data is retrieved from combination 2 databases: Islamic Finance Information Services (IIFS) and Zawya Sukuk Monitor.
Sukuk declined by 15% in 2010, which indicates that there was low confidence in Sukuk market. This can be explained that there have been 21 Sukuk defaults recently in Islamic capital market space as reported by Khnifer (2010), with Nakheel Sukuk and East Cameron Gas Sukuk are the most controversial one. These Sukuk defaults pose severe legal risks of Sukuk inherent in the Sukuk contract. Specifically, the risk emanating from Sukuk contract‟s enforceability whereby whether or not the Sukuk can be enforced in order to protect the rights of Sukuk holders in the event of Sukuk defaults. Although Sukuk is claimed to be more secured than the conventional bonds due to the requirement of physical assets to underpin deals, Sukuk is now asserted to have lost credibility as a feasible and viable Islamic long-term project financing instrument. In the Malaysian context, despite being a leader in Sukuk market, Malaysia has also recorded cases of Sukuk defaults such as of Johor Corporation, Ingress Sukuk Berhad, Tracoma Holdings Berhad and Nam Fatt Corporation Berhad. Although Sukuk defaults in Malaysia are not widely discussed, the issue raises concern on the investors‟ protection and the survival of Malaysian capital market in the future. A default occurs due to the breach of any binding obligations under the original terms of the agreement between the issuer and the Sukuk holders. Apparently, both contractual parties must fulfill their obligations under the contract or agreement. The complexity of structure and several legal issues may be significant on rating process, but from a rating perspective, assessing the risk of the issuer's inherent credit strength is fundamental to the final rating outcome. In other words, performance of the Sukuk issuer highly affects the final rating on the Sukuk itself.
The aim of this study is to investigate the sustainability of Sukuk issuance across the globe as a global financing instrument in terms of its default risk exposure and the assessment on the Sukuk ratings in terms of credit worthiness and stability. This study will also discuss the prospects and challenges in terms of regulations, governance, structures, and liquidity management faced by global Sukuk in sustaining its purpose as a financing instrument.
2.0. Literature Review
2.1. The Concept of Sukuk The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) officially defined Sukuk in the Standard for Investment Sukuk as certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services, and it identified at least fourteen possible Sukuk structures. The AAOIFI Standard distinguishes Sukuk from stocks, bonds, and from the conventional process of securitization as well, emphasizing that Sukuk are not debt certificates with a financial claim to cash flow and that they may not be issued on a pool of receivables. Rather, they are similar to a trust certificate with proportional or undivided interest in an asset or a pool of assets, and the right to a proportionate share of cash flow is derived from ownership interest that carries risks and benefits. Sukuk structures vary from Murabaha (cost-plus sales), Salam (pre-payment of an asset for future delivery), Ijara (rental/ lease agreement), Istisna (build-to-own property), Mudaraba and Musharaka (partnerships)2. However, most offerings to-date are Ijara-based, with some recent innovations taking place in the structuring and pricing of Musharaka Sukuk (Abdel-Khaleq and Richardson, 2007; Wilson, 2008). Appendix 1 and 2 present diagrams to illustrate Ijara and Musharaka Sukuk structures, respectively. In a typical Ijara Sukuk structure, the originator sells assets to the Sukuk issuer, which is a bankruptcy-remote special purpose vehicle (SPV) that is created to act as a trustee for investors acquiring the assets (Iqbal and Mirakhor, 2007)3. The assets are leased back to the Sukuk issuer for a stated period, with the agreement to sell the asset back to the lessee at the end of the lease period4. At the same time, the SPV issues certificates of participation to investors
2
Murabaha, Salam, and Istisna Sukuk certificates are not readily tradable on the secondary market due to Shari’a restrictions (Usmani, 2002). 3 Shari’a scholars agree that ownership of an asset is possible with proper documentation even if the title is not registered under the buyer's name. The common practice is to transfer the beneficial title but not the legal title of ownership to avoid transfer taxes or other unfavorable costs. One exception is the case of Qatar global Sukuk whereby an actual transfer of the land title took place to the SPV. 4 It should be noted that there are Shari’a restrictions to executing a contract of sale of the leased assets at a future date at the time of initiating the Ijara agreement. The sale/ purchase deal is not an integral part of the Ijara agreement, and can only be executed at the time of transferring back the assets from the lessor to the lessee. Alternatively, an initial sale/ purchase undertaking can be entered into, allowing the lessee to ultimately purchase back the assets. Such an undertaking is not a contract, and is only binding on the undertaker while the other party has the option not to proceed. Further, it is only signed after completing the initial sale agreement relating to the assets.
representing undivided ownership in the underlying asset. Over the term of the lease contract, the trustee receives rental payments for the use of the asset and distributes them to certificate holders in proportion to their ownership stake5. At the expiry of the lease contract, Sukuk holders‟ ownership claims cease to exist and payments flow stop. They receive the return on their principal and asset ownership reverts to the lessee. If the asset has a market value, Sukuk holders can realize a capital gain or loss. However, if the underlying is a public good for which there is no market, Sukuk holder exercise an embedded put option whereby the originator buys back the underlying assets at face value. Alternatively, in a Musharaka Sukuk structure, the two parties include an originator providing a pool of assets and an SPV which raises cash by selling Sukuk notes to investors (Abdulkader and Nathif, 2004). These parties enter into a Musharaka (partnership) arrangement for a fixed period and agree on profit- and loss sharing ratios. The issuer also undertakes to buy the Musharaka shares of the SPV on a periodic basis. The two partners then appoint a managing agent (usually the originator) to act on behalf of the Musharaka, and to develop or make efficient use of the asset(s). In return, the agent gets a fixed agency fee and a variable incentive fee payable. The cash returns generated from the Musharaka are paid as profits to the Sukuk investors. At the end of the fixed Musharaka period, the issuer would have bought back the Musharaka shares at pre-agreed prices and intervals, and the SPV no longer has any shares in the partnership. Partnership contracts through Musharaka Sukuk strengthen the paradigm of Islamic finance and are preferred from the viewpoint of jurists because they rest on profit-andloss arrangements. The returns on such participation certificates are contingent on the company fundamentals and not benchmarked to market rates. They are also attractive to investors because they are negotiable instruments that can be traded in the presence of an active secondary market. 2.2. Sukuk- the comparison to Conventional Bonds The recent controversy on the compliance of Sukuk with the precepts of Shari’ah signals that Sukuk are generally structured along Western rules of asset securitization, and raises the question of whether these innovative financial instruments are really different from conventional bonds. According to Miller, Challoner, and Atta (2007), Sukuk are structured in a way to ensure an equivalent return to a conventional bond, the difference being that the return on the Sukuk is generated from an underlying asset and not from the obligation to pay interest. Similarly, Wilson (2008) argues that financiers exercise special care to render Sukuk identical to other conventional securities because they aim at simplifying investors‟ risk assessment of these new investments. As a result, Sukuk mirror conventional securities, suggesting that product innovation coupled with distinctive and pricing risk characteristics is lagging in the Islamic finance industry. Shari’ah scholars disagree with rendering Islamic financial instruments familiar to international investors because of the danger of making them similar to conventional interest-based products,
5
Most Ijara Sukuk pay a predetermined rate of return to investors. Variable rate Sukuk linked to an agreed upon pricing benchmark, usually the LIBOR, may also issued under a Master Lease Agreement.
despite the argument that such similarity helps bridging the gap between conventional capital markets and the emerging Islamic securities market, further strengthening global financial integration. According to the President of the AAOIFI Shari’ah Council, Mohammad Taqi Usmani, current practices of issuing Sukuk replicate the structure of conventional bonds in terms of lack of ownership, right to a fixed return, and the guarantee of repayment of principal. Usmani (2007) also argues against obtaining international ratings, since Sukuk can be rated by the recently established regional ratings agency, if needed, and Islamic banks should stand ready to endorse the acceptability of Sukuk. Alternatively, Cakir and Raei (2007) take an opposing stand on the suspected comparability of Sukuk and conventional bonds, suggesting that Sukuk are different financial instruments compared to conventional bonds. 2.3. Rating performance and Sukuk defaults Bandyopadhyay (2006) reports that as the credit quality worsens i.e. decline in the rating grades, the probability of default (PD) increases. Furthermore, the PD jumps sharply as soon as the rating move from investment to non-investment grades (i.e., from BBB rating to BB) and that justifies the reason for a study on the rating performance and Sukuk defaults. He also observes that rating stability declines as the credit quality worsens. The higher risk in the bottom grades (mainly non-investment grades) calls for developing a corporate default predictor model that would better capture the firm‟s characteristics and could give an early warning signal of corporate distress. This issue is very relevant and significant not only for conventional corporate bond, but also for Sukuk. Furthermore, in the wake of a series of high profile Sukuk defaults in the GCCs, such as Investment Dar, Saad Group and Dubai World‟s Nakheel Sukuk in 2009, Sukuk are alleged to have lost credibility as feasible and viable Islamic long-term project financing instrument (Raja Teh Maimunah, 2010). 2.4. Sukuk prospects and challenges Sukuk serve as an important instrument for resource mobilization and a primary vehicle for the development of Islamic capital markets. Solé (2008) argues that expanding the range of financing opportunities for the private sector in Kuwait (and other similar emerging economies engaged in large infrastructure projects) by developing Sukuk and bond markets is likely to deepen the financial sector and diversify the economy away from oil activities. Jobst et al. (2008) summarize the economic, financial, legal, and regulatory challenges for the Sukuk market. They also suggest that, despite the global financial crisis, there is a strong demand from both Muslim countries and conventional global institutions for Shari’ah-compliant securities in the form of Sukuk. Abdel-Khaleq and Richardson (2007) evaluate the legal challenges for issuing Sukuk in nonIslamic jurisdictions and argue that Sukuk avail a new area of cooperation between various international stakeholders. The authors present the first American Sukuk offering backed by US oil and gas assets, and issued by The East Cameron Gas Company. The deal involves parties from the US, a bankruptcy-remote intermediary issuer of certificates in the Cayman Islands, investors from the Muslim and Western worlds, bankers in London and Beirut, and legal counsels from Dubai and Houston. The transaction is deemed Shari’ah-compliant because it
essentially involves the sale of property, and it ties investor returns to a profit distribution scheme which also depends on the performance of the underlying. More importantly, the Sukuk originator was able to tap liquid resources from the Muslim world to support drilling and operation wells in the Gulf of Mexico for a Texas-based company, thus providing an alternative and innovative form of corporate financing that complements traditional sources of funding. Wilson (2008) addresses the criticisms to Ijara Sukuk related to linking distributions to the LIBOR. He examines innovations in the structuring of Sukuk securities and the potential for novel structures based on Musharaka or a hybrid of different Sukuk structures. Wilson also proposes adopting alternative benchmarks to the LIBOR based on macroeconomic indicators of real activity such as GDP growth for sovereign Sukuk and of firm performance in the case of financing corporations. In Islamic finance, conventional financial derivatives are not Shari’ah permissible investments because they are regarded as being unreal instruments, or 'promises', as opposed to actual assets. Tariq and Dar (2007) assess the various risks associated with Sukuk investing. They also discuss the possibility of developing Shari’ah-compatible risk mitigating techniques such as embedding in Sukuk options and swap features to hedge against those risks. Convertible Sukuk are first issued in the Malaysian market in 2005, but they have not been widely launched in any market before until recently in Dubai6. However, these financial instruments can only achieve their benefits if they are issued and traded on a large scale. According to Moody's (2007, 2008), the major drawback is that Sukuk are usually held till maturity and an active secondary market has yet to develop. In the GCC region, there is almost no secondary trading in Sukuk because most investors treat these instruments as "buy and hold" investments. McMillen (2007) argues that widespread issuance and trading can be achieved if Sukuk obtain ratings, which are currently absent in light of the inability to secure satisfactory legal opinions with respect to Shari’ah enforceability issues in different jurisdictions. The impact of such legal impediments might be lessened under a standardization of Shari’ah-compliant transactions that reduces transactional risks through consistency, predictability, and transparency in the enforcement of Shari’ah, in addition to contributing to the integration of Islamic financial services in the global economy. Aside from legal enforceability issues, a recent debate was initiated regarding the Shari’ahcompliance nature of Sukuk7. After a series of meetings in 2007, the AAOIFI Shari’ah council issued in February 2008 proposals for amendments in contemporary Sukuk issues including
6
Examples include the $200 million International Investment Group (IIG) Sukuk exchangeable into shares of a Kuwaiti company, and the Malayan Banking Bhd subordinated Sukuk qualifying as Tier 2 capital and which includes embedded options for the originator to redeem in whole (and not in part) the Sukuk. 7 The Sukuk debate was triggered after a scholar reportedly said that most current Sukuk structures are not Shari’a-compliant and appear to violate the principle of risk and profit sharing by promising to pay back principal (Norman, 2009).
new recommendations regarding the ownership of underlying assets in a Sukuk transaction and the guarantee of the principal investment to Sukuk certificate holders. These AAOIFI efforts culminated in the publication of six core principles for structuring and issuing Sukuk in relation to asset ownership rights and obligations of Sukuk holders, the non-tradability of Sukuk with underlying revenue streams or debt, the corporate responsibility of the Sukuk manager when actual earnings fall short of expected earnings, the lessee‟s right to purchase leased assets when Sukuk are extinguished for their nominal value, the purchase of Sukuk at net value instead of nominal value, and the on- going duty of the Shari’ah Supervisory Board after initial Sukuk issuance (AAOIFI, 2008).
3.0. Research Objectives & Questions
This research has four main objectives, which are as follows: a) Appraising the default risk exposure at stake in the present Sukuk structures. b) As precautionary measures for global Sukuk issuers regarding the importance of Sukuk structuring in relation to default risk exposure c) Presenting regulatory and financial implications for the ideal Sukuk development in the ICM given the legal issues of present state of Sukuk structures, and d) Providing holistic approaches from academia and practitioners point of views to tackle unresolved legal and financial challenges of Sukuk.
In order to achieve the stated research objectives, there are three important questions that need to be answered in this research, which are as follows: a) What is the present state of Sukuk structures? b) What are the significant default incidences that occur in the present Sukuk structures? c) What are the regulatory and financial implications (governance, structures, and liquidity management) for a sustainable Sukuk structure development in the global Islamic capital market?
4.0. Methodology
4.1. Quantitative research methodology: This mainly involves data collection on various Sukuk issuances from January 2001 to December 2010 across the globe with an intended sample of 50-100 Sukuk issuances. The main focus in this methodology is to collate data from writing materials relating to the topic of the research. This includes prospectuses, publications, articles, magazines, online research, and information service providers. Data collected was then filtered with respect to different criteria such as chronology, geographic distribution, issuer status, country of origin, etc., and depicted in the form of tables and/or charts for better understanding.
4.2.
Qualitative research methodology: The main focus in this methodology is to collect and analyze materials or data in respect of Sukuk issuance sustainability. This includes the types of structures used, legal features, default incidence, innovation and Shari‟ah issues. There are numerous books and other materials that provide in-depth analysis of Sukuk structures and related issues. This paper will follow qualitative or descriptive research method, related to the growing issues of Sukuk defaults by focusing on the development of theory through a case study approach (Eisenhardt, 1989; Yin, 1994). In order to maximize the benefit of this report, some case studies and articles on specific Sukuk structures and issues will be included. The ultimate objective of the study is to provide an understanding on the default cases and its implication on the sustainability of Sukuk as a global financing instrument.
4.3. Theoretical Framework What is Default Risk and How it is Measured Default risk is the main risk that faced by Islamic bond holders. They are very focus on this problem because the default case in Dubai world. That is accepted that default is the important treatment that must be found the solving in the Islamic bond. There are literally hundreds of ratios and interactions that are potentially interesting, but seven factors seem crucial8. The following are the most powerful inputs for predicting default: a) Volatility, higher equity volatility implies higher probability of firm‟s asset value falling below its level of debt, which implies insolvency. This is only measurable for public companies. b) Size: for non-traded companies, size proxies for much of equity volatility. Bigger companies are generally more diversified in their exposure to geographies, products, and peoples, and this lowers their prospective volatility. One could argue that size is truly different factor, and there‟s some truth there, though this can easily get into hair-splitting. c) Profitability: higher profits lower default probabilities. Combining profitability with interest expense makes it combination of leverage and profitability. d) Leverage/Gearing: higher leverage implies higher default probabilities. Higher market valuation implies a greater distance between a firm‟s asset values its level of debt. e) Liquidity: lower liquidity (current assets/current liabilities) implies higher default probabilities in all-countries, though this effect it reversed for those 3,000 or so investment-grade companies. f) Growth: both high and low growth rates are associated with higher default probabilities. g) Inventories: higher inventory levels imply higher default probabilities.
8
Chen and Sumindra, in the credit rating, 1981.
The above are the general concepts of bond and default problems. There are several factors in financial ratios that imply the default problem of a bond/obligation. However in Islamic bond case, there are no significant differences with conventional bonds in the default risk perspectives. Nevertheless this must be examined by empirical research to find the best theory about default risk and exposure in Islamic bonds (Sukuk). Rating on Sukuk reflects the (credit) worthiness and stability of Sukuk. By having the annual rating reviews conducted by the respective rating agencies, Sukuk investors are adequately informed of the issuer‟s status and progress. In addition, the rating changes on Sukuk may be significant to the possibility of Sukuk default to a certain extent. Generally, Sukuk with higher rating is unlikely to default and vice versa.
5.0. Significance of the Study
The research could be useful for Islamic financial institutions, investors and governments. It could also be helpful in decision making and policy formulation; and for those who need to gain some basic knowledge and background on the level of research in the Sukuk field.
6.0. Proposed Timeline
Activity Full Proposal Literature Review Methodology Data Gathering Data Analysis Conclusions and Implications Introduction Amendments and Revisions Total (excluding proposal) Words 8,000 20,000 15,000 Duration 3 months 6 months 6 months 12 months (overlapping) 8 months 4 months 2 months 2 months 36 months (3 years)
20,000 15,000 5,000 75,000
References
AAOIFI (2008). Shari‟ah Board resolutions http://www.aaoifi.com/aaoifi_sb_sukuk_Feb2008_Eng.pdf on Sukuk, available at
Abdel-Khaleq, A., Richardson, C. (2007). “New horizons for Islamic securities: Emerging trends in Sukuk offerings”, Chicago Journal of International Law, 7(2), 409-425. Abdulkader, T., Nathif, A., (2004). “Islamic Bonds: Your Guide to Structuring, Issuing and Investing in Sukuk.” Economy Institutional Investor. Bandyopadhyay, A. 2006. “Predicting probability of default of Indian corporate bonds: logistic and Z-score model approaches”, The Journal of Risk Finance, vol. 7, no. 3, pp. 255-272. Cakir, S., Raei, F. (2007). “Sukuk vs. Eurobonds: Is there a difference in value-at-risk?” International Monetary Fund Working Paper WP/07/237. Eisenhardt, K. M. 1989. “ Building Theories from Case Study Research”, Academy of Management Review, vol. 14, no.4, pp 532 – 550. Iqbal, Z., Mirakhor, A. (2007). An Introduction to Islamic Finance- Theory and Practice. Wiley Finance Editions, John Wiley and Sons, Inc., Hoboken, New Jersey. Jobst, A. (2007). “The Economics of Islamic Finance and Securitization”. IMF Working Paper n°07/117, Washington. Khnifer, M, (2010). When Sukuk Default- Certificate Holders Can Take Default Worries Off Their Shoulders with Proper Asset-Backed Sukuk. Business Islamica Magazine, pp 20-25 McMillen, M. J. T. (2007). Contractual Enforceability Issues: Sukuk and Capital Markets Development. Chicago Journal of International Law. , 7(2). Miller, N.D., Challoner, J., Atta, A. (2007). “UK Welcomes the Sukuk”. International Financial Law Review, 26(5), 24-25. Moody‟s (2007). “Focus on the Middle East”. Inside Moody‟s, (Winter). Moody‟s (2008). “Focus on the Middle East”. Inside Moody‟s, (Spring). Raja Teh Maimunah Raja Abd Aziz, 2010. “Sukuk Have Lost A Lot of Credibility of Late. Is This Justified? Did We Get It Wrong? How Do We Fix It? What Are The Alternatives to Sukuk?”, So Far Journal, vol. 1, no. 1, pp. 7-9. Solé, J. (2008). “Prospects and challenges for developing corporate sukuk and bond markets”. International Journal of Middle Eastern Finance and Management, 1(1), 20-30. Tariq, A.A, Dar, H. (2007) “Risks of Sukuk structures: Implications for resource mobilization”. Thunderbird International Business Review, 49(2), 201-223. Usmani, M.T (2007). “Sukuk and their contemporary applications”. Translated from the original Arabic by Sheikh Yusuf Talal DeLorenzo, AAOIFI Shari‟ah Council meeting, Saudi Arabia. Wilson, R. (2008). “Innovation in structuring of sukuk securities”, Humanomics, 24(3), 170-181. Zawya Sukuk Intelligence 2011
A PhD Research Proposal Outline
Prepared by Maszuin Kamarudin MBA Universiti Tun Abdul Razak (UNIRAZAK) Malaysia Email: [email protected]
1.0. Background
Sukuk are indeed promising as a Shari’ah compliant financing instrument. Total Sukuk issuance amounts to US$ 236.75 billion as per June 2011 with Malaysia still champions the Sukuk issuance . This big number of Sukuk issuance can be supported by the fact that western countries such as the United Kingdom and United States have jumped on the bandwagon for issuing Sukuk as indicated by the UK‟s consideration of Sukuk for government financing, and the issuance of Sukuk by General Electric and East Cameron Gas in the US. Based on Islamic Finance Information Services („IIFS‟) statistic database of Sukuk, Sukuk issuance experienced an impressive growth from 2005 to 2006, increasing by 134% with the total Sukuk issuance amounting US$ 26 million. Sukuk issuance peaked at US$46 million in 2007 but substantially declined by 64% to US$17 million in 2008. The Sukuk market has grown rapidly over the last few years in terms of size, numbers and sophistication. Sukuk has become an alternative for conventional bonds and being used in financing for the last twenty years. It provides sovereign governments and corporations with access to the huge and growing Islamic liquidity pool, in addition to the conventional investor base. Malaysia has emerged as leader in Sukuk market since the first corporate Sukuk issuance in 1990 by Shell MDS Sdn. Bhd. This is due to the consistent growth in the issuance of Sukuk, increase in the level of knowledge and numbers of expertise amongst market players and progressive development of the Malaysian legal framework. This situation makes Malaysia the world‟s largest Sukuk issuer with more than 60% of outstanding global Sukuk (as at end of 2009). From total Sukuk issued globally, 66.8% with a value of USD 67,872 million were issued in Malaysian market, as illustrated in Table 1. As at end June 2010, local currency Sukuk market stood at a whopping USD76.4 billion or 35.5% of total bond market outstanding. This is attributable to various factors including well-executed policies, facilitative regulatory environment, increasing numbers and sophistication of intermediaries that continue to push the frontiers in terms of product innovation as well as the existence of a complete, matured and well established Islamic financial system. Although Sukuk were badly hit in 2008, they are indeed a promising ICM‟s instrument (IFIS, 2009). One reflection of this is the Sukuk rebound throughout 2009 brought mainly by sovereign and quasi-sovereign Sukuk issuances. These included the US$1.4 billion Sukuk issuance of Terengganu Investment Authority in Malaysia, US$487.2 million retail Sukuk issuance of government of Indonesia, plus Sukuk from the Dubai government, the Islamic Development Bank (IDB), and so forth (Zawya Sukuk Intelligence, 2010).
1
1
The data is retrieved from combination 2 databases: Islamic Finance Information Services (IIFS) and Zawya Sukuk Monitor.
Sukuk declined by 15% in 2010, which indicates that there was low confidence in Sukuk market. This can be explained that there have been 21 Sukuk defaults recently in Islamic capital market space as reported by Khnifer (2010), with Nakheel Sukuk and East Cameron Gas Sukuk are the most controversial one. These Sukuk defaults pose severe legal risks of Sukuk inherent in the Sukuk contract. Specifically, the risk emanating from Sukuk contract‟s enforceability whereby whether or not the Sukuk can be enforced in order to protect the rights of Sukuk holders in the event of Sukuk defaults. Although Sukuk is claimed to be more secured than the conventional bonds due to the requirement of physical assets to underpin deals, Sukuk is now asserted to have lost credibility as a feasible and viable Islamic long-term project financing instrument. In the Malaysian context, despite being a leader in Sukuk market, Malaysia has also recorded cases of Sukuk defaults such as of Johor Corporation, Ingress Sukuk Berhad, Tracoma Holdings Berhad and Nam Fatt Corporation Berhad. Although Sukuk defaults in Malaysia are not widely discussed, the issue raises concern on the investors‟ protection and the survival of Malaysian capital market in the future. A default occurs due to the breach of any binding obligations under the original terms of the agreement between the issuer and the Sukuk holders. Apparently, both contractual parties must fulfill their obligations under the contract or agreement. The complexity of structure and several legal issues may be significant on rating process, but from a rating perspective, assessing the risk of the issuer's inherent credit strength is fundamental to the final rating outcome. In other words, performance of the Sukuk issuer highly affects the final rating on the Sukuk itself.
The aim of this study is to investigate the sustainability of Sukuk issuance across the globe as a global financing instrument in terms of its default risk exposure and the assessment on the Sukuk ratings in terms of credit worthiness and stability. This study will also discuss the prospects and challenges in terms of regulations, governance, structures, and liquidity management faced by global Sukuk in sustaining its purpose as a financing instrument.
2.0. Literature Review
2.1. The Concept of Sukuk The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) officially defined Sukuk in the Standard for Investment Sukuk as certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services, and it identified at least fourteen possible Sukuk structures. The AAOIFI Standard distinguishes Sukuk from stocks, bonds, and from the conventional process of securitization as well, emphasizing that Sukuk are not debt certificates with a financial claim to cash flow and that they may not be issued on a pool of receivables. Rather, they are similar to a trust certificate with proportional or undivided interest in an asset or a pool of assets, and the right to a proportionate share of cash flow is derived from ownership interest that carries risks and benefits. Sukuk structures vary from Murabaha (cost-plus sales), Salam (pre-payment of an asset for future delivery), Ijara (rental/ lease agreement), Istisna (build-to-own property), Mudaraba and Musharaka (partnerships)2. However, most offerings to-date are Ijara-based, with some recent innovations taking place in the structuring and pricing of Musharaka Sukuk (Abdel-Khaleq and Richardson, 2007; Wilson, 2008). Appendix 1 and 2 present diagrams to illustrate Ijara and Musharaka Sukuk structures, respectively. In a typical Ijara Sukuk structure, the originator sells assets to the Sukuk issuer, which is a bankruptcy-remote special purpose vehicle (SPV) that is created to act as a trustee for investors acquiring the assets (Iqbal and Mirakhor, 2007)3. The assets are leased back to the Sukuk issuer for a stated period, with the agreement to sell the asset back to the lessee at the end of the lease period4. At the same time, the SPV issues certificates of participation to investors
2
Murabaha, Salam, and Istisna Sukuk certificates are not readily tradable on the secondary market due to Shari’a restrictions (Usmani, 2002). 3 Shari’a scholars agree that ownership of an asset is possible with proper documentation even if the title is not registered under the buyer's name. The common practice is to transfer the beneficial title but not the legal title of ownership to avoid transfer taxes or other unfavorable costs. One exception is the case of Qatar global Sukuk whereby an actual transfer of the land title took place to the SPV. 4 It should be noted that there are Shari’a restrictions to executing a contract of sale of the leased assets at a future date at the time of initiating the Ijara agreement. The sale/ purchase deal is not an integral part of the Ijara agreement, and can only be executed at the time of transferring back the assets from the lessor to the lessee. Alternatively, an initial sale/ purchase undertaking can be entered into, allowing the lessee to ultimately purchase back the assets. Such an undertaking is not a contract, and is only binding on the undertaker while the other party has the option not to proceed. Further, it is only signed after completing the initial sale agreement relating to the assets.
representing undivided ownership in the underlying asset. Over the term of the lease contract, the trustee receives rental payments for the use of the asset and distributes them to certificate holders in proportion to their ownership stake5. At the expiry of the lease contract, Sukuk holders‟ ownership claims cease to exist and payments flow stop. They receive the return on their principal and asset ownership reverts to the lessee. If the asset has a market value, Sukuk holders can realize a capital gain or loss. However, if the underlying is a public good for which there is no market, Sukuk holder exercise an embedded put option whereby the originator buys back the underlying assets at face value. Alternatively, in a Musharaka Sukuk structure, the two parties include an originator providing a pool of assets and an SPV which raises cash by selling Sukuk notes to investors (Abdulkader and Nathif, 2004). These parties enter into a Musharaka (partnership) arrangement for a fixed period and agree on profit- and loss sharing ratios. The issuer also undertakes to buy the Musharaka shares of the SPV on a periodic basis. The two partners then appoint a managing agent (usually the originator) to act on behalf of the Musharaka, and to develop or make efficient use of the asset(s). In return, the agent gets a fixed agency fee and a variable incentive fee payable. The cash returns generated from the Musharaka are paid as profits to the Sukuk investors. At the end of the fixed Musharaka period, the issuer would have bought back the Musharaka shares at pre-agreed prices and intervals, and the SPV no longer has any shares in the partnership. Partnership contracts through Musharaka Sukuk strengthen the paradigm of Islamic finance and are preferred from the viewpoint of jurists because they rest on profit-andloss arrangements. The returns on such participation certificates are contingent on the company fundamentals and not benchmarked to market rates. They are also attractive to investors because they are negotiable instruments that can be traded in the presence of an active secondary market. 2.2. Sukuk- the comparison to Conventional Bonds The recent controversy on the compliance of Sukuk with the precepts of Shari’ah signals that Sukuk are generally structured along Western rules of asset securitization, and raises the question of whether these innovative financial instruments are really different from conventional bonds. According to Miller, Challoner, and Atta (2007), Sukuk are structured in a way to ensure an equivalent return to a conventional bond, the difference being that the return on the Sukuk is generated from an underlying asset and not from the obligation to pay interest. Similarly, Wilson (2008) argues that financiers exercise special care to render Sukuk identical to other conventional securities because they aim at simplifying investors‟ risk assessment of these new investments. As a result, Sukuk mirror conventional securities, suggesting that product innovation coupled with distinctive and pricing risk characteristics is lagging in the Islamic finance industry. Shari’ah scholars disagree with rendering Islamic financial instruments familiar to international investors because of the danger of making them similar to conventional interest-based products,
5
Most Ijara Sukuk pay a predetermined rate of return to investors. Variable rate Sukuk linked to an agreed upon pricing benchmark, usually the LIBOR, may also issued under a Master Lease Agreement.
despite the argument that such similarity helps bridging the gap between conventional capital markets and the emerging Islamic securities market, further strengthening global financial integration. According to the President of the AAOIFI Shari’ah Council, Mohammad Taqi Usmani, current practices of issuing Sukuk replicate the structure of conventional bonds in terms of lack of ownership, right to a fixed return, and the guarantee of repayment of principal. Usmani (2007) also argues against obtaining international ratings, since Sukuk can be rated by the recently established regional ratings agency, if needed, and Islamic banks should stand ready to endorse the acceptability of Sukuk. Alternatively, Cakir and Raei (2007) take an opposing stand on the suspected comparability of Sukuk and conventional bonds, suggesting that Sukuk are different financial instruments compared to conventional bonds. 2.3. Rating performance and Sukuk defaults Bandyopadhyay (2006) reports that as the credit quality worsens i.e. decline in the rating grades, the probability of default (PD) increases. Furthermore, the PD jumps sharply as soon as the rating move from investment to non-investment grades (i.e., from BBB rating to BB) and that justifies the reason for a study on the rating performance and Sukuk defaults. He also observes that rating stability declines as the credit quality worsens. The higher risk in the bottom grades (mainly non-investment grades) calls for developing a corporate default predictor model that would better capture the firm‟s characteristics and could give an early warning signal of corporate distress. This issue is very relevant and significant not only for conventional corporate bond, but also for Sukuk. Furthermore, in the wake of a series of high profile Sukuk defaults in the GCCs, such as Investment Dar, Saad Group and Dubai World‟s Nakheel Sukuk in 2009, Sukuk are alleged to have lost credibility as feasible and viable Islamic long-term project financing instrument (Raja Teh Maimunah, 2010). 2.4. Sukuk prospects and challenges Sukuk serve as an important instrument for resource mobilization and a primary vehicle for the development of Islamic capital markets. Solé (2008) argues that expanding the range of financing opportunities for the private sector in Kuwait (and other similar emerging economies engaged in large infrastructure projects) by developing Sukuk and bond markets is likely to deepen the financial sector and diversify the economy away from oil activities. Jobst et al. (2008) summarize the economic, financial, legal, and regulatory challenges for the Sukuk market. They also suggest that, despite the global financial crisis, there is a strong demand from both Muslim countries and conventional global institutions for Shari’ah-compliant securities in the form of Sukuk. Abdel-Khaleq and Richardson (2007) evaluate the legal challenges for issuing Sukuk in nonIslamic jurisdictions and argue that Sukuk avail a new area of cooperation between various international stakeholders. The authors present the first American Sukuk offering backed by US oil and gas assets, and issued by The East Cameron Gas Company. The deal involves parties from the US, a bankruptcy-remote intermediary issuer of certificates in the Cayman Islands, investors from the Muslim and Western worlds, bankers in London and Beirut, and legal counsels from Dubai and Houston. The transaction is deemed Shari’ah-compliant because it
essentially involves the sale of property, and it ties investor returns to a profit distribution scheme which also depends on the performance of the underlying. More importantly, the Sukuk originator was able to tap liquid resources from the Muslim world to support drilling and operation wells in the Gulf of Mexico for a Texas-based company, thus providing an alternative and innovative form of corporate financing that complements traditional sources of funding. Wilson (2008) addresses the criticisms to Ijara Sukuk related to linking distributions to the LIBOR. He examines innovations in the structuring of Sukuk securities and the potential for novel structures based on Musharaka or a hybrid of different Sukuk structures. Wilson also proposes adopting alternative benchmarks to the LIBOR based on macroeconomic indicators of real activity such as GDP growth for sovereign Sukuk and of firm performance in the case of financing corporations. In Islamic finance, conventional financial derivatives are not Shari’ah permissible investments because they are regarded as being unreal instruments, or 'promises', as opposed to actual assets. Tariq and Dar (2007) assess the various risks associated with Sukuk investing. They also discuss the possibility of developing Shari’ah-compatible risk mitigating techniques such as embedding in Sukuk options and swap features to hedge against those risks. Convertible Sukuk are first issued in the Malaysian market in 2005, but they have not been widely launched in any market before until recently in Dubai6. However, these financial instruments can only achieve their benefits if they are issued and traded on a large scale. According to Moody's (2007, 2008), the major drawback is that Sukuk are usually held till maturity and an active secondary market has yet to develop. In the GCC region, there is almost no secondary trading in Sukuk because most investors treat these instruments as "buy and hold" investments. McMillen (2007) argues that widespread issuance and trading can be achieved if Sukuk obtain ratings, which are currently absent in light of the inability to secure satisfactory legal opinions with respect to Shari’ah enforceability issues in different jurisdictions. The impact of such legal impediments might be lessened under a standardization of Shari’ah-compliant transactions that reduces transactional risks through consistency, predictability, and transparency in the enforcement of Shari’ah, in addition to contributing to the integration of Islamic financial services in the global economy. Aside from legal enforceability issues, a recent debate was initiated regarding the Shari’ahcompliance nature of Sukuk7. After a series of meetings in 2007, the AAOIFI Shari’ah council issued in February 2008 proposals for amendments in contemporary Sukuk issues including
6
Examples include the $200 million International Investment Group (IIG) Sukuk exchangeable into shares of a Kuwaiti company, and the Malayan Banking Bhd subordinated Sukuk qualifying as Tier 2 capital and which includes embedded options for the originator to redeem in whole (and not in part) the Sukuk. 7 The Sukuk debate was triggered after a scholar reportedly said that most current Sukuk structures are not Shari’a-compliant and appear to violate the principle of risk and profit sharing by promising to pay back principal (Norman, 2009).
new recommendations regarding the ownership of underlying assets in a Sukuk transaction and the guarantee of the principal investment to Sukuk certificate holders. These AAOIFI efforts culminated in the publication of six core principles for structuring and issuing Sukuk in relation to asset ownership rights and obligations of Sukuk holders, the non-tradability of Sukuk with underlying revenue streams or debt, the corporate responsibility of the Sukuk manager when actual earnings fall short of expected earnings, the lessee‟s right to purchase leased assets when Sukuk are extinguished for their nominal value, the purchase of Sukuk at net value instead of nominal value, and the on- going duty of the Shari’ah Supervisory Board after initial Sukuk issuance (AAOIFI, 2008).
3.0. Research Objectives & Questions
This research has four main objectives, which are as follows: a) Appraising the default risk exposure at stake in the present Sukuk structures. b) As precautionary measures for global Sukuk issuers regarding the importance of Sukuk structuring in relation to default risk exposure c) Presenting regulatory and financial implications for the ideal Sukuk development in the ICM given the legal issues of present state of Sukuk structures, and d) Providing holistic approaches from academia and practitioners point of views to tackle unresolved legal and financial challenges of Sukuk.
In order to achieve the stated research objectives, there are three important questions that need to be answered in this research, which are as follows: a) What is the present state of Sukuk structures? b) What are the significant default incidences that occur in the present Sukuk structures? c) What are the regulatory and financial implications (governance, structures, and liquidity management) for a sustainable Sukuk structure development in the global Islamic capital market?
4.0. Methodology
4.1. Quantitative research methodology: This mainly involves data collection on various Sukuk issuances from January 2001 to December 2010 across the globe with an intended sample of 50-100 Sukuk issuances. The main focus in this methodology is to collate data from writing materials relating to the topic of the research. This includes prospectuses, publications, articles, magazines, online research, and information service providers. Data collected was then filtered with respect to different criteria such as chronology, geographic distribution, issuer status, country of origin, etc., and depicted in the form of tables and/or charts for better understanding.
4.2.
Qualitative research methodology: The main focus in this methodology is to collect and analyze materials or data in respect of Sukuk issuance sustainability. This includes the types of structures used, legal features, default incidence, innovation and Shari‟ah issues. There are numerous books and other materials that provide in-depth analysis of Sukuk structures and related issues. This paper will follow qualitative or descriptive research method, related to the growing issues of Sukuk defaults by focusing on the development of theory through a case study approach (Eisenhardt, 1989; Yin, 1994). In order to maximize the benefit of this report, some case studies and articles on specific Sukuk structures and issues will be included. The ultimate objective of the study is to provide an understanding on the default cases and its implication on the sustainability of Sukuk as a global financing instrument.
4.3. Theoretical Framework What is Default Risk and How it is Measured Default risk is the main risk that faced by Islamic bond holders. They are very focus on this problem because the default case in Dubai world. That is accepted that default is the important treatment that must be found the solving in the Islamic bond. There are literally hundreds of ratios and interactions that are potentially interesting, but seven factors seem crucial8. The following are the most powerful inputs for predicting default: a) Volatility, higher equity volatility implies higher probability of firm‟s asset value falling below its level of debt, which implies insolvency. This is only measurable for public companies. b) Size: for non-traded companies, size proxies for much of equity volatility. Bigger companies are generally more diversified in their exposure to geographies, products, and peoples, and this lowers their prospective volatility. One could argue that size is truly different factor, and there‟s some truth there, though this can easily get into hair-splitting. c) Profitability: higher profits lower default probabilities. Combining profitability with interest expense makes it combination of leverage and profitability. d) Leverage/Gearing: higher leverage implies higher default probabilities. Higher market valuation implies a greater distance between a firm‟s asset values its level of debt. e) Liquidity: lower liquidity (current assets/current liabilities) implies higher default probabilities in all-countries, though this effect it reversed for those 3,000 or so investment-grade companies. f) Growth: both high and low growth rates are associated with higher default probabilities. g) Inventories: higher inventory levels imply higher default probabilities.
8
Chen and Sumindra, in the credit rating, 1981.
The above are the general concepts of bond and default problems. There are several factors in financial ratios that imply the default problem of a bond/obligation. However in Islamic bond case, there are no significant differences with conventional bonds in the default risk perspectives. Nevertheless this must be examined by empirical research to find the best theory about default risk and exposure in Islamic bonds (Sukuk). Rating on Sukuk reflects the (credit) worthiness and stability of Sukuk. By having the annual rating reviews conducted by the respective rating agencies, Sukuk investors are adequately informed of the issuer‟s status and progress. In addition, the rating changes on Sukuk may be significant to the possibility of Sukuk default to a certain extent. Generally, Sukuk with higher rating is unlikely to default and vice versa.
5.0. Significance of the Study
The research could be useful for Islamic financial institutions, investors and governments. It could also be helpful in decision making and policy formulation; and for those who need to gain some basic knowledge and background on the level of research in the Sukuk field.
6.0. Proposed Timeline
Activity Full Proposal Literature Review Methodology Data Gathering Data Analysis Conclusions and Implications Introduction Amendments and Revisions Total (excluding proposal) Words 8,000 20,000 15,000 Duration 3 months 6 months 6 months 12 months (overlapping) 8 months 4 months 2 months 2 months 36 months (3 years)
20,000 15,000 5,000 75,000
References
AAOIFI (2008). Shari‟ah Board resolutions http://www.aaoifi.com/aaoifi_sb_sukuk_Feb2008_Eng.pdf on Sukuk, available at
Abdel-Khaleq, A., Richardson, C. (2007). “New horizons for Islamic securities: Emerging trends in Sukuk offerings”, Chicago Journal of International Law, 7(2), 409-425. Abdulkader, T., Nathif, A., (2004). “Islamic Bonds: Your Guide to Structuring, Issuing and Investing in Sukuk.” Economy Institutional Investor. Bandyopadhyay, A. 2006. “Predicting probability of default of Indian corporate bonds: logistic and Z-score model approaches”, The Journal of Risk Finance, vol. 7, no. 3, pp. 255-272. Cakir, S., Raei, F. (2007). “Sukuk vs. Eurobonds: Is there a difference in value-at-risk?” International Monetary Fund Working Paper WP/07/237. Eisenhardt, K. M. 1989. “ Building Theories from Case Study Research”, Academy of Management Review, vol. 14, no.4, pp 532 – 550. Iqbal, Z., Mirakhor, A. (2007). An Introduction to Islamic Finance- Theory and Practice. Wiley Finance Editions, John Wiley and Sons, Inc., Hoboken, New Jersey. Jobst, A. (2007). “The Economics of Islamic Finance and Securitization”. IMF Working Paper n°07/117, Washington. Khnifer, M, (2010). When Sukuk Default- Certificate Holders Can Take Default Worries Off Their Shoulders with Proper Asset-Backed Sukuk. Business Islamica Magazine, pp 20-25 McMillen, M. J. T. (2007). Contractual Enforceability Issues: Sukuk and Capital Markets Development. Chicago Journal of International Law. , 7(2). Miller, N.D., Challoner, J., Atta, A. (2007). “UK Welcomes the Sukuk”. International Financial Law Review, 26(5), 24-25. Moody‟s (2007). “Focus on the Middle East”. Inside Moody‟s, (Winter). Moody‟s (2008). “Focus on the Middle East”. Inside Moody‟s, (Spring). Raja Teh Maimunah Raja Abd Aziz, 2010. “Sukuk Have Lost A Lot of Credibility of Late. Is This Justified? Did We Get It Wrong? How Do We Fix It? What Are The Alternatives to Sukuk?”, So Far Journal, vol. 1, no. 1, pp. 7-9. Solé, J. (2008). “Prospects and challenges for developing corporate sukuk and bond markets”. International Journal of Middle Eastern Finance and Management, 1(1), 20-30. Tariq, A.A, Dar, H. (2007) “Risks of Sukuk structures: Implications for resource mobilization”. Thunderbird International Business Review, 49(2), 201-223. Usmani, M.T (2007). “Sukuk and their contemporary applications”. Translated from the original Arabic by Sheikh Yusuf Talal DeLorenzo, AAOIFI Shari‟ah Council meeting, Saudi Arabia. Wilson, R. (2008). “Innovation in structuring of sukuk securities”, Humanomics, 24(3), 170-181. Zawya Sukuk Intelligence 2011
