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Sukuk structures

December 2006
Sukuk volumes just keep on growing, as Michael Saleh Gassner from IslamicFinance.de writes.
Islamic finance has, for some time, missed investment opportunities for Muslims that offer predictable returns with low risk. The majority of investment opportunities are based either on stock markets with high volatility or on real estate transactions. The investment galaxy for the Islamic investor is lacking the variety of instruments to create an efficient portfolio in line with portfolio theory and financial planning. Sukuk certificates meet the pressing need for a medium term investment and reached in 2006 a market volume of nearly $15 billion. This volume will only increase in coming years to an annual volume of tens of billions of dollars. Already a number of world-class borrowers have used the new Islamic Sukuk market: Germany; the IMF Group; and Sovereign states like Qatar, Malaysia and Pakistan.

Sukuk are securitised assets and therefore belong to the category of Asset Backed Securities. Unlike conventional ABS structures, Sukuk need to have an underlying tangible asset transaction either in ownership or in usufruct. The securitisation of pure cash flow streams from credit portfolios as undertaken in the mortgage market, for instance, cannot be structured in the same way. A properly made Sukuk limits the debt to the value of the underlying assets. A solid investment policy of the borrower results and the vicious circle of raising debts and running after them in hard times is handled in an ethical and socially more convenient way. This allows the borrowers time sort the situation out. This is important for modern states as many of them borrow money to be repaid by future generations without regard whether any assets cover the debt or not.

Different types of Sukuk

The Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI) issued standards for 14 different Sukuk types. The most common in 2004 were Sukuk Al Ijarah based on a leasing transaction. In Malaysia the Sukuk Bithaman Al Ajil (Murabaha based) is very popular but not so for Middle Eastern investors. Furthermore Sukuk Al Istisna'a had been used to raise financing facilities for real estate development.

A case study for the Sukuk Al Ijarah is the German $100 million Sukuk issued by the federal state of Saxony-Anhalt. The federal state is among the new states of Germany after reunification and their debts are guaranteed by the whole federation of Germany. Consequently the Sukuk received an excellent rating of AAA by Fitch and AA- by Standard & Poor's. The bond was priced plus 1 basis point six-month EURIBOR (European Interbank Offered Rate), which was chosen as benchmark. Citigroup was appointed as Lead Manager and Kuwait Finance House as Co-Lead Manager. The Shari'ah Board of Citi Islamic Investment Bank certified the Sukuk from the Shari'ah point of view.

The underlying transactions are a certain number of specified buildings owned by the Ministry of Finance. The usufruct was sold for 100 years to a Special Purpose Vehicle (SPV) which in turn rented it back for five years to the Ministry. The SPV was registered in the Netherlands as German law is not yet fully developed regarding securitisation, especially from a tax perspective. Choosing the Dutch foundation Stichting the Sukuk remains competitive in regard to municipality tax which would not apply for a conventional bond. The certificate holders receive a variable rent benchmarked to the EURIBOR over the period of five years. After repayment the Ministry could decide to use the SPV a second time for a new issue. The paper is listed at the Luxembourg Stock Exchange.

Benchmarking

How do you benchmark to an interest rate reference such as LIBOR or EURIBOR? Scholars, such as Sheikh Nizam Yaquby from Bahrain or Sheikh Taqi Usmani from Pakistan, explain it by using the example of two brothers working in drinks, one in alcoholic drinks and the other in soft drinks. The brother dealing in soft drinks take over the pricing of his brother dealing in alcohol. Although it is not ideal, it is regarded as acceptable. Nonetheless Sheikh Nizam Yaquby suggested that economists, students and bankers should find an alternative.

The reasoning of the federal state of Saxony-Anhalt in issuing an Islamic certificate was to broaden the investor basis to gain access to different sources of funding with a long-term view. Furthermore the state is also looking for investors and entrepreneurs interested in going into Germany and choose Saxony-Anhalt as their new location. The German Sukuk demonstrates their open-mindedness and interest in Muslim investors worldwide. A message which was widely heard.

Another structure was applied by the private sector arm of the International Monetary Fund, the International Finance Corporation (IFC). The IFC issued the Wawasan RM 500 million ($132 million) Bond on the Islamic principle of Bay Bithaman Al Ajil, which means a deferred payment. The basic feature of the underlying transaction is a sales contract resulting in debt and not a lease. The Joint Lead Managers first purchased the assets from the issuer at RM 500 million and then sold the assets back at the deferred sales price plus profit. The exceptional rating of a supranational entity will clearly strengthen the local Malaysian bond market and complement the yield curve.

The Malaysian Sukuk Bithaman Al Ajil structure is controversial in the Islamic finance industry. It results in a debt and could not therefore be traded other than at face value as debt and money cannot change value with passage of time. The majority of Middle Eastern Islamic scholars declare such an action as belonging to the definition of the forbidden Riba. Consequently the IFC did not list their Sukuk on any stock exchange in the world and there is no intended secondary market. It is likely that future issues in Malaysia will consider applying the tradable Ijarah type of Sukuk to enable secondary market trading worldwide and foster the acceptance in the Middle East markets for Malaysian Sukuk. Otherwise the Malaysian issuers will face higher pricing expectations as non-tradable Sukuk will carry an increasing premium.

The Wawasan Ringgit Sukuk by IFC was rated at AAA by S&P and Aaa by Fitch. The profit rate of the issue was fixed at 2.88 per cent for a three-year maturity. The Joint Lead Managers were HSBC Bank (Malaysia) and Commerce International Merchant Bankers Berhad (CIMB), Malaysia. Shari'ah certification was undertaken by the CIMB Fiqh Council and Dr. Mohd Daud Bakar.

Sukuk can be used for project finance as the $120 million Durrat Sukuk of Bahrain demonstrated. The Durrat Al Bahrain is a major real estate development project. The current Sukuk partly finances the $ 1.2 billion project of world class leisure and tourist destination. The project company Durrat Khaleej Al Bharain BSC is jointly owned by the Government of Bahrain and Kuwait Finance House (Bahrain).

The issue was oversubscribed by $32.5 million. The Sukuk matures in five years and pays a return quarterly. The issue was priced at 125 basis points above three-months LIBOR. Arranger and Placement Agent for the fundraising was the Bahrain based Liquidity Management Centre (LMC) , an institution holding an Islamic Investment Banking License which was established in 2002 to manage secondary market and short term investment needs of Islamic financial institutions. Among the underwriters are Dubai Islamic Bank , LMC, Bahrain Islamic Bank , Islamic Development Bank , Emirates Islamic Bank , Bank of Bahrain and Kuwait , General Organisation for Social Insurance Bahrain , National Bank of Sharjah and Arab Islamic Bank (Palestine). The Shari'ah endorsement was managed by the International Islamic Financial Market also based in Bahrain.

The Sukuk was listed on the Bahrain Stock Exchange to enable trade and secondary market for its investors. Since a Sukuk Istisnaa is not a tradable security by Shari'ah as the underlying asset does not yet exists, the goal to be tradable set by the issuer needs to be met in a pool securitisation. Contemporary Islamic scholars accept a security as tradable as long as the underlying tangible assets are of 51 per cent of market value:

The proceeds of the issue will be used by the Issuer to finance the reclamation of the land and the development of Base Infrastructure through multiple project finance (Istisna'a) agreements. As the works carried out under each Istisna'a are completed by the Contractor and delivered to the Issuer, the Issuer will give notice to the Project Company under the Master Ijarah Agreement and will lease such base infrastructure on the basis of a lease to own transaction. If the Sukuk is listed during the Istisna'a period, the Istisna'a receivable (amounts held as cash) shall be traded only at par value. Any appreciation or depreciation in the value of the Sukuk will represent a relative change in the value of the Base Infrastructure.

© Banker Middle East 2006

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