Income from asset backed securities

Investment in sukuk securities

Conventional investors normally hold a significant proportion of their portfolios in bonds and floating rate notes, as these provide a higher return than bank deposits. The investor expects to receive regular payments and on maturity of the bond a sum equivalent to its face value. The major risk is issuer default. Islamic investors cannot hold conventional bonds or notes if they want their portfolios to be sharia compliant, as these debt instruments pay interest. What is permissible is the holding of sukuk securities.

Sukuk are the Islamic equivalent of bonds and provide investors a stake in an asset, along with corresponding share of cash flows and risk. Sukuk pay a profit rate based on income generated by an underlying asset, such as property, or (in the case of Petronas – Malaysia’s state owned oil company) oil reserves or (in the case of Emirates Airlines) aircraft assets. The table below compares Sukuk and a conventional fixed income security.

SukukConventional bond
What does it represent?•Ownership stakes in well defined assets•Pure debt obligations
What influences the price?•Sukuk prices depend on the market value of the underlying asset•Bonds depend solely on the creditworthiness of the issuer
Types of instrument•The underlying contract for a Sukuk issuance is a permissible contract i.e. lease•There are 14 categories defined by AAOIFI•In a bond, the core relationship is a loan of money, which implies a contract whose subject is purely earning money on money (Riba)
Market size• Estimated at $100bnSource: Standard and Poor’s• $82,226bnSource: Original BIS data as of March 31, 2009; Asset Allocation Advisor compilation as of November 15, 2009

Growth of Sukuk Market

The strong momentum of the sukuk market is underpinned by the increasing demand for sukuk, especially sukuk of high credit ratings, from Islamic investors. Over the years, the Gulf region has accumulated a huge amount of oil revenue. The current account surpluses in the Gulf Cooperation Council (GCC) countries last year were estimated to be more than US$300 billion, while assets under management by sovereign wealth funds in those countries amounted to as much as US$2 trillion at the end of last year. Islamic investors in the Middle East and other Islamic countries generally have a preference for investing in Sharia compliant assets. With the expanding liquidity pool in the Islamic world, naturally, there is a commensurate increase in the demand for Islamic investment instruments globally.

Sukuk compared to conventional bonds

When considering the performance of Sukuk to conventional bond investments Sukuk has a similar return profile to high yield or corporate bonds. A comparison to the performance of the UK IMA High Yield and IMA Corporate Bond sectors shows interesting similarities. All the assets fell in value in September 2008 as the financial crisis reached a critical point and any assets with a credit risk were sold down during a flight to quality. The subsequent recover to new highs shows a similar pattern. From 2004 to 2010 Sukuk has outperformed equivalent conventional bond indices in the UK (Sukuk in its base currency, US Dollars, as converting to UK Sterling will distort the clear credit relationship).

The defining characteristic of Sukuk is that they are asset backed, which implies that when they are traded the investors are buying and selling the rights to an underlying real asset, usually a piece of real estate or a movable asset such as equipment or vehicles, this gives Sukuk a credit quality rather than a loan and income feel that is common with government bonds. It is difficult to compare Sukuk directly to governments bonds as most government issuers are Emerging Market countries so corporate bond or high yield comparisons are more appropriate.

Sukuk are increasingly being used as a substitute for corporate bonds and floating rate notes as sukuk share similar characteristics with these investment options. Both sukuk and conventional bonds have a fixed-term maturity, provide a regular inflow of income, and are tradable on the open market at prevalent yield price.

The first Sukuk were issued in the Malaysian domestic market in the mid-1990s. Sukuk can be divided into two main groups: Malaysian domestic Sukuk (primarily ringgit-denominated and governed by Malaysian law) and international Sukuk (being primarily USD-denominated and governed by English or US law).The majority of international Sukuk are governed by English or New York law but are structured in a way as to be Sharia compliant, for the benefit of issuers and investors who seek to manage their affairs in accordance with Sharia principals. The cash flows and credit risk of a Sukuk are remarkably similar to those of a conventional bond.

Malaysia is still the dominant source of Sukuk issuance, although this remains primarily domestic issuance. As the chart below show, Sukuk issuance from the Middle East has dominated. All three rating agencies have stated that their current rating methodologies and rating scales can accommodate Islamic debt instruments. The fact that credit risk has tended to relate to the originator and not the underlying asset performance has meant that, in practice, long-term ratings of Sukuk do not exceed the originator’s/issuer’s rating. They could, however, have a lower rating if there are additional risk factors specific to the Sukuk. Only in a minority of cases have rating agencies treated Sukuk as asset-backed securitizations, which in those instances can lead to a higher rating than the unsecured rating of the borrower.