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Mar 02 2010

Sukuk structures

March 2010

Dr. Mohd Daud Bakar
Amanie Islamic Finance
Consultancy and Education

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It is incorrect to assume that Sukuk are always of one particular structure. As a matter of fact, Sukuk embrace a number of structures which distinguish them from conventional bonds and from other Sukuk structures in the family of approved Sukuk. Sukuk differ in product design, product offering, pay off to the investors, and rating methodology.

Conceptually Sukuk can be divided into four broad categories. These categories include debt-based Sukuk; asset-based Sukuk; project-based Sukuk; and asset-backed Sukuk. These four categories demonstrate not only various structures but also highlight the chronological developments of Sukuk instruments. As the Sukuk market begins maturing, each new issue represents a step up on the ladder of sophistication. Sukuk issues have begun moving away from the 'bricks and mortar' debt-based issues to asset-based issues such as Sukuk Ijarah to project based issues that pay specific focus to the underlying assets that are being constructed to generate income to the Sukuk investors.

Debt-based Sukuk focuses on securitising Islamic receivables which are the outcome of a few Islamic finance contracts such as Murabahah, Ijarah and Istisna'a. These Sukuk evidence the right of the holder of the Sukuk to receive the payment as stated in the primary and secondary notes of the Sukuk. This structure resembles that of conventional bonds which are simply IOUs except that the receivables in this Sukuk must originate from Islamic approved contracts that create these future receivables. Given this context, the most suitable corporate methodology to provide ratings for the Sukuk is linked to the credit quality of the obligor/issuer. The quality of assets or projects is not relevant to the rating quality of the Sukuk except when these assets are taken as collateral.

In contrast to debt-based Sukuk, asset-based Sukuk investors will have some relationship to, or claim on, assets that are used to facilitate the issuance of Sukuk. However, from a financial obligation perspective, asset-based Sukuk are not different from debt-based Sukuk because the quality of the asset in terms of its income generating capability has no link to the credit rating quality of the issuer of the Sukuk. The rating of this asset-based Sukuk still relies primarily on the quality of credit risk of the obligor/lessee. Irrespective of the actual or potential usufruct of the leased asset, the timely payment of rental to the Sukuk investors, as reflected in the coupon payments, would depend on the credit standing of the obligor/lessee.

The manner of using the leased asset by the lessee and the income arising from using the leased asset by the lessee has no link to the payment of rental to the Sukuk holders under Sukuk Ijarah. The underlying asset which is purchased and leased back under Sukuk Ijarah is present in this structure only to facilitate the sale and lease transactions rather than to serve as a source of profit payment and principal redemption to the Sukuk investors.

Project based Sukuk are a relatively new innovation in Islamic finance as they depart from a typical debt-based or asset-based structure to a kind of profit and loss sharing arrangement seeking to provide the pay-off to the Sukuk investors based on the performance of the underlying projects in which the Sukuk investors have an undivided and proportionate ownership. Under this structure, it is expected the Sukuk investors will need to consider the risk of the venture more than the credit risk of the issuer. Also, it is worth noting that there should not be any guarantee of profit payment or principal redemption in this structure. The rating methodology should be one for project finance rather than a rating method used in the case of debt based and asset based Sukuk.

The two elements that are relevant in project finance rating methodology are the quality of cash flows and the quality of the asset of the project. While the periodic cash flow stream is relied on as the sole source of profit to be distributed to the Sukuk investors, the project assets are usually secured as collateral for the Sukuk investors. Sabic Sukuk Istisna'a could reflect this kind of project based Sukuk which is centred on the marketing services to be provided by the holding company to other subsidiaries companies. The Emirates Airline Sukuk Musharakah is another good example of this project based Sukuk.

Prior to 2008 the rating of this kind of Sukuk still used the credit risk rating simply because the quality of the Sukuk in terms of ability of payment and timely payment of the issuer are essentially based on the credit standing of the issuer pursuant to the Purchase Undertaking by the issuer. This has been the subject of scrutiny by the AAOIFI Shariah Board which led to the prohibition of such practices in February 2008.

Finally, asset-backed securities represent the real form of securitisation as they expose the Sukuk investors to real value and risk of the underlying asset. Under this structure, investors can only expect the returns from the cash flows of the underlying assets and there is no right of recourse to the owner of the assets. This is because asset-backed Sukuk would require the owner of the asset to sell his asset on a 'True-Sale' concept to the Sukuk investors without having any purchase undertaking in the case the asset fails to generate the expected income to the Sukuk investors. In short, asset-backed Sukuk are characteristically non-recourse Sukuk with the underlying assets forming the sole source of profit and principal payments.

Although Sukuk Ijarah look like the most solid form of Islamic fixed income instrument, they do not make other forms of Sukuk redundant. Indeed the introduction of project based Sukuk and asset-backed Sukuk is a normal progression in developing the Sukuk market. This is because more disclosure is needed to inform the Sukuk investors of the inherent risks associated with project based Sukuk and asset-backed Sukuk which are typically not present or relevant in debt based Sukuk such as Murabahah or Istisna'a or asset-based Sukuk in the form of Sukuk Ijarah. The challenge does not lie in the new structure of Sukuk but rather in providing a comprehensive guideline for the various Sukuk instruments to protect investors and to regulate the issuers in a more transparent and 'disclosure-based' environment. © Dr. Mohd Daud Bakar

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