With the focus on a recourse to assets in the wake of several high profile Sukuk defaults. CAMILLE KLASS explores if rating the underlying assets of a Sukuk transaction may help keep defaults at bay.
Now that the dust has all but settled on the Sukuk restructurings of 2008 and 2009, some basic investment advice really does bear repeating: invest according to your risk appetite, select a rated Sukuk, read the prospectus and know your rights in the event of a default.
While the failures have been relatively few, they did reveal that on the back of oil-driven excess liquidity in the market, particularly in the Gulf region, investors in the pre-crisis heyday were investing with abandon – not expecting that anything would fail.
There seemed to be little need to assess ratings or risks – only pricing and yields mattered.
“The whole drive of the market was returns, with real estate yields being used as benchmarks – no one read prospectuses and people thought everything they touched in Dubai would go up – they failed to appreciate that the element of risk is present in any investment,” says Raja Teh Maimunah, global head of Islamic markets at Bursa Malaysia in Kuala Lumpur.
Raja Teh draws a parallel between the Gulf countries before the crisis and Asia before the Asian financial crisis of 1997.
“Then [in Asia], people weren’t looking at yields much either, only pricing,” she explains. “They generally didn’t ask what the ratings meant, and the pricing of debt securities wasn’t reflective of the ratings”.
Now, as market watchers sift through the likely reasons for the Sukuk failure and consequent re-payment restructurings of such issuers as Nakheel and Investment Dar, the lack of ratings information is being tossed up as a possible cause.
In particular, given the nervousness surrounding these issuers’ repayment abilities, they say relying on ratings pertaining solely to the issuer’s credit quality isn’t enough, and question if also assessing the underlying assets of a Sukuk transaction could help to avert future defaults.
According to rating agencies, the assessment of the underlying assets of a Sukuk transaction is part of their rating methodology.
“The idea of assessing Sukuk based on the underlying assets’ creditworthiness is one of the approaches of our sukuk rating methodology,” says Samira Mensa, a credit analyst with S&P Ratings Services.
Nasir Ali Merchant, acting chief executive officer of Bahrain-based Islamic International Rating Agency, says it is standard at his agency, too.
Indeed, rating methodology components typically include assessing the Sukuk structure based on its objective: whether the structure is an asset-backed structure or asset-based; the role and credit quality of key participants in the transaction such as the borrower, the lessee and the guarantor; the cash flow of the underlying asset; any external credit that may be provided by the borrower or a third party guarantor; as well as the legal framework and implications of Shariah on the structure.
Underlying assets are rated on their ability to generate cash flow because in the event a Sukuk fails, investors have recourse to the assets, Merchant adds.
However, what investors should realize is that even though the rating of assets may lend greater transparency, whether they actually have recourse to the assets should an issuer be unable to meet repayments depends on the structure of the Sukuk they invested in.
“Sukuk are purposefully designed [either] to give recourse to the borrower only, or to both asset and borrower,” says Hooman Sabeti-Rahmati, a Singapore-based partner with law firm Allen & Overy. “It’s not accidental”.
Referring to the two Sukuk structures [asset-based and asset-backed], Sabeti-Rahmati says these terms are too confusing and should be avoided, as they are in legal documents, because they are far too vague.
Instead of ‘asset-based Sukuk’, he prefers the term ‘company-recourse Sukuk’, where recourse is only to the ultimate borrower and not any particular asset. He also suggests ‘asset-recourse Sukuk’ over ‘asset-backed Sukuk’, where there is recourse to specific assets (as well as to the borrower).
According to Sabeti-Rahmati: “if it’s simply company-recourse [Sukuk] you can say, even though there is an underlying asset for Shariah structuring purposes: what does it matter what the underlying asset is? Considering the credit of that underlying asset would be not just pointless but also misleading.”
Misleading because under that structure, investors have no recourse to the asset at all, only to the issuer, so the rating of the asset becomes irrelevant.
Industry experts believe that confusion among investors assuming that they will have a claim on the assets in the event a Sukuk fails may have arisen because they have read into Sukuk structures with the general idea that Islamic finance favours risk-sharing and ownership.
“In Sukuk, the ownership of the underlying asset by Sukuk holders comes with restrictions,” Sabeti-Rahmati says. “In company-recourse Sukuk, they generally can’t sell the asset except back to the company. So they can ‘own’ it but not do as they wish with it”.
In legal terms ownership is a very flexible concept, which can include many rights or very few, he adds.
Ostensibly the concern over Sukuk failures and the recoverability of principal stems from a lack of understanding of what Sukuk is and what it entails.
“The problem isn’t the absence of ratings, it’s that people often misunderstand what the basic deal with Sukuk is,” Sabeti-Rahmati says. “They actually work exactly as they are intended to work.”
For instance, in Sukuk where the physical assets of an underlying transaction are present only to fulfill Shariah compliance requirements (as in a company-recourse Sukuk), ratings agencies would adopt a corporate credit rating approach because in substance the credit risk remains that of the underlying borrower, says MARC’s Razlan.
In a company-recourse Sukuk, where investors typically do not have a secured legal claim to the underlying cash-generating assets of the Sukuk, if the corporate fails the Sukuk is also likely to fail because the assets will become part of the bankruptcy estate.
However, it is still relevant to assess and monitor the underlying assets for cash-generating ability in cases where there is an explicit guarantee from the sovereign or issuer. The relationship between the guarantor and the issuer may change over time due to the changing dynamics of the guarantor’s capacity and willingness to provide support under the guarantee, points out Razlan.
This is because in instances where there is a deterioration in the guarantor’s capacity to provide the support, reliance on the asset becomes more crucial for the issuer to service its debt, he adds.
For asset-recourse Sukuk, the underlying assets are assessed for their ability to generate sufficient cash flow, meet payments on time, and repay the principal at maturity. If the assets have sustainable cash-generating ability and the underlying assets are isolated from the underlying borrower, the Sukuk can survive the failure of the corporate.
With the onset of the recent global crisis, investors have begun to perceive asset-recourse Sukuk as safer structures and favour them over company-recourse Sukuk.
However, if the quality of the assets is low, the holder of the asset-recourse Sukuk is not necessarily in a better position than the holder of a company-based Sukuk, Razlan points out; highlighting the strong performance of certain asset-recourse issuances such as the Petronas Sukuk during the crisis.
Despite the comfort and transparency that assigning ratings to Sukuk brings in terms of the credit quality of key participants and cash-generating ability of underlying assets; ensuring investors are informed about risks does nothing to reduce the actual risk of a Sukuk default.