When the fast-growing sukuk market ground to a halt in 2008, the future looked grim. But as the Islamic capital markets turn, will a deluge of issues come with it? Farmida Bi reports

The sukuk market was substantially affected by the global economic downturn with sukuk issuances at the end of 2008 being less than half those at the end of 2007, according to a report issued by Standard & Poor's. The drought in sukuk issuances, which took hold in the fourth quarter of 2008 now appears to be ending. The rapid growth of the sukuk market from 2004-07 was brought to an abrupt halt at the end of 2008, and undermined the theory that the Islamic capital markets had decoupled from the conventional capital markets.

As at the end of 2007, global sukuk issuance equalled $46.65bn (£28.4m) thanks to high oil prices, easy access to financing and a sentiment in favour of Islamic products in much of the Muslim majority world. In September 2008, it was generally believed that the Islamic markets had matured and were not dependent on the price of oil. In addition, the real assets that underlay Islamic structures provided protection against the credit crunch.

The Islamic markets were therefore expected to weather the storm that followed the collapse of Lehman Brothers and to resume normal business at the beginning of 2009. By the end of November 2008, however, there was a profound change of mood caused by the fall in real estate prices, the drop in the oil price and the realisation that many Islamic institutions were heavily dependant for funding on conventional financial institutions which were experiencing a liquidity shortage that then impacted the Islamic financial institutions. There was no longer any talk of a decoupled sector.

There was hope, however, that the Islamic capital markets would be the first to recover, based on the belief that these markets are most active in the developing economies which were expected to recover more quickly than the mature markets. The oil rich investors who had supported the rise of the Islamic finance market still had access to funds, although these investors are now more cautious about how those funds are spent. The optimism may have been justified, since we are now beginning to see green shoots appearing.

New issues

The first positive sign was the inaugural $650m (£396m) sukuk issue by the Republic of Indonesia in April 2009, which is reported to have been seven-times oversubscribed and priced more tightly than its conventional bond issued two months earlier. Indonesia is not investment grade rated.

The success of Indonesia was followed at the end of June 2009 by a $750m (£457m) sukuk issued by the Central Bank of Bahrain, which is also reported to have been significantly oversubscribed and to have been increased from an initial size of $500m (£305m) in response to investor demand. This is the first international sukuk issue from the Gulf in 2009, an area which, prior to the credit crunch, had accounted for most of the large international sukuk issues.

It is expected that the Islamic Development Bank will also access the markets shortly with its own AAA-rated sukuk issue.

It is typical for sovereign and quasi-sovereign issuers to access the markets first, thus paving the way for well-rated corporate issuers before the market opens up generally. The fact that we are now seeing a pattern of sovereign issuers gives reason to hope that the many corporate issuers believed to be ready to issue sukuk when the market opens up cannot be far behind. There appears to be demand from both issuers and investors, and all that is lacking at the moment is confidence. All eyes will now turn to how the market will perform after the Eid holidays in October

Defaults

The economic crisis has also resulted in the first sukuk defaults, including by The Investment Dar, a Kuwaiti Islamic investment firm which owns 50% of Aston Martin and East Cameron Gas, a Texan oil and gas company. Some commentators believe that these defaults will impact the sukuk market generally, but they should be seen simply as the signs of a maturing market. An economic downturn is likely to see some sukuk fail just as some bonds will fail in the conventional markets. What is more important is how defaults or restructurings are managed so that investors feel they are participating in a transparent and fair process.

The East Cameron Gas sukuk has raised issues as to where sukukholders stand in the line of creditors and even whether they are creditors or owners. The company has stated before the courts in Louisiana that there was no transfer of production revenues (royalties) to the special purpose issuer of the sukuk and that the sukuk transaction constituted a loan secured on the royalties, which the sukukholders must share with other creditors. The judge in the first instance, case has dismissed this argument stating that the transfer of the revenues constituted a true sale to the special purpose issuer of the sukuk, but he has given East Cameron Gas leave to find further arguments to support its case. The decision in the first instance is therefore beneficial to sukuk investors, and the greater scrutiny that legislation or defaults will bring to sukuk instruments will help the market produce more robust structures in the future.

The East Cameron Gas litigation has highlighted one of the biggest structuring issues for sukuk: are they asset-based or asset-backed? Most sukuk in the market are asset-based, where the asset is placed in the structure to generate profits that are paid to investors but, in the event of a default, the investors have no recourse to the assets and must rely instead on their contractual rights under a purchase undertaking issued, typically by the originator of the transaction.

This is usually clearly described in the sukuk documentation, including the prospectus, but some investors, especially in distress situations, continue to believe they have rights of enforcement against the assets themselves because an interest in the sukuk grants them a share of the ownership of the asset pursuant to the definition of sukuk issued by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI).

That ownership interest, however, is usually transferred to an interest in the proceeds generated, if any, by the exercise of the purchase undertaking. There are very few asset-backed sukuk where the recourse of the sukukholders is purely to the assets.

A statement made by AAOIFI in February 2008 that fixed price purchase undertakings for certain types of sukuk (including musharaka and mudaraba based sukuk) were not permissible has sometimes been blamed for the low level of sukuk issuances in 2008, and there is a concern that the continuing impact of that statement could affect future issuances. It is probable, however, that the number of sukuk issuances in 2008 was affected more by the general state of the capital market than the impact of the AAOIFI statement. It is likely, however, that most of the sukuk issuances in the coming months will be ijara-based, since that structure was not affected by the AAOIFI statement, and this will require potential issuers to have assets equal to the value of the proposed sukuk available to be placed in the structure. The ijara structure also responds to the demand for simplicity by investors

Global interest

There is huge global interest in the sukuk market. The UK Government has expressed its willingness to issue a sovereign sukuk when it is able to obtain value for money. It has also passed a series of Finance Acts, culminating in the Finance Act 2009, to put Islamic finance on an equal footing with conventional finance and, in particular, to enable UK companies to issue real estate based sukuk without suffering adverse tax consequences. The French Finance Minister, Christine Lagarde, has announced that she would like to promote Paris as a global Islamic finance centre and has introduced both tax and trust legislation to enable the French system to accommodate Islamic structures.

The market is expecting a benchmark e1bn sukuk issue to be launched by a French financial institution in the near future. In January 2009, the Monetary Authority of Singapore announced the completion of its sukuk issuance facility to provide Sharia compliant regulatory assets to respond to investor demand in Asia. Many other countries, from Turkey to Japan, in both the Muslim majority and the non-Muslim majority worlds, are considering sukuk issues and reviewing their legislation to remove tax and regulatory barriers for their potential issuers.

The future

There is widespread expectation that many of the planned Saudi infrastructure projects will be funded through sukuk issues and it may be the Saudi market, rather than the UAE, that could lead a resurgence of the sukuk market next year. Market participants expect the first non-sovereign issues of sukuk to access the markets after the Ramadan and Eid holidays at the beginning of October.

A trickle of issues could quickly turn into a flood if the initial sukuk issues do well, strengthening both issuer and investor confidence. These new issues are likely to be more robustly structured than their predecessors with, in particular, the rights of sukukholders and the powers of the Delegate/Transaction Administrator more clearly delineated as the market learns from the issues highlighted by the sukuks which are in default or are being restructured today. There seems little doubt that sukuk are here to stay as an integral part of the global capital markets and are not simply a niche product for a faith community.

Farmida Bi is a partner at Norton Rose.