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The Global Sukuk Market Is Returning To Traditional Risks

S&P Global Ratings believes that market conditions will remain supportive for sukuk issuance in second-half 2021, with low interest rates and abundant liquidity. We also expect that most Islamic finance countries will continue vaccinating their populations and that oil prices will stabilize at about $65 per barrel for 2021. Taken together, these factors point to stronger sukuk market performance in 2021 compared with 2020.

We expect sukuk issuance will reach $140 billion-$155 billion in 2021, compared with $139.8 billion in 2020. In first-half 2021, sukuk issuance totaled $90.6 billion, compared with $86.4 billion at June 30, 2020, thanks to Malaysian and Saudi Arabian issuances. By contrast, we saw a 50% drop in sukuk issuance in the UAE due to the adoption of AAOIFI Sharia Standard 59. Although issuers have found ways to comply with the standard, additional challenges persist. In our view, investors are also now more exposed to residual asset risks.

More broadly, downside risks for the sukuk market remain but they are slowly shifting toward traditional factors such as geopolitical concerns and oil price fluctuations. Notably, the evolution of the pandemic also remains a relevant concern.

In first-half 2021, we saw three sustainability sukuk issuances. The post-pandemic environment, energy transition from fossil fuels, and general attractiveness of these instruments to environmental, social, and governance (ESG) investors explain their appeal. Nevertheless, we expect that sustainability sukuk will remain a small part of overall sukuk issuance volumes due to their complexity and the slow implementation of policies to manage energy transition in core Islamic finance countries.

Sukuk Issuance Will Continue To Increase

Absent an unexpected geopolitical event, a significant drop in oil prices, or a shift in liquidity conditions on global capital markets, we expect sukuk issuance will continue to rise. In first-half 2021, total issuance reached $90.6 billion compared with $86.4 billion during first-half 2020 (see chart 1). This performance was supported by an increase in issuance from Malaysia and Saudi Arabia and Oman's return to the market after issuing conventional debt in 2020 (see chart 2). It was also supported by a higher volume of primary issuances, increasing 20%. At the same time, the volume of issuance in Bahrain, Indonesia, Turkey, and the UAE declined. In Turkey, the decline was mainly for local currency denominated issuances. Meanwhile, the UAE saw the steepest decline with a 50% drop in issuance volumes due to the adoption of Sharia Standard 59. We expect some activity from UAE issuers as they implement the new requirements.

Chart 1

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Chart 2

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Despite higher oil prices and lower fiscal deficits, we expect that some sovereigns in the Gulf Cooperation Council will continue to tap the market to fund their economic diversification programs. We also expect that bank and corporate issuances will continue to support sukuk market performance in second-half 2021. Corporate activity was muted in 2020 as companies held on to cash during the heights of the pandemic and deferred capital expenditure. A portion of these investments are expected to be executed in 2021 and will necessitate access to capital markets. Furthermore, there are about $20 billion of sukuk maturing in second-half 2021, some of which are likely to be refinanced on the market.

Foreign-currency denominated sukuk issuance increased 41.6% in first-half 2021 (see chart 3). We attribute this growth to jumbo issuances but also favorable market conditions, which we expect will continue in second-half 2021.

Chart 3

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Sharia Standard 59 Creates New Risks

AAOIFI Sharia Standard 59, which covers the sale of debt, has reportedly depressed sukuk issuances in the UAE. The standard was finalized by AAOIFI in December 2018 and came into force in the UAE starting this year. It has depressed hybrid sukuk issuance in part because it altered the requirements around an important transaction feature necessary for shariah compliance, the tangibility ratio. Many hybrid sukuk are structured around a combination of tangible assets and commodities. Before the adoption of the standard, an issuer was required to have a minimum ratio of 51% tangible assets and a maximum of 49% commodities at the inception of the transaction. The maintenance of this ratio, throughout the lifetime of the transaction, was on a best-effort basis and remedial actions in case of a breach were unclear. With the adoption of Sharia Standard 59, the maintenance of a 51% tangibility ratio becomes a legal requirement throughout the transaction's lifetime and the remedies for a breach must be clarified.

As such, some of the most recent legal documents for hybrid sukuk issued in the UAE, or by issuers that would like to attract UAE investors (subject to AAOIFI standards), included an obligation to maintain the ratio throughout the sukuk's lifetime and new clauses to clarify remedial actions. Mostly, these consisted of an obligation to restore the tangibility ratio as and when suggested by the issuer's Sharia advisor, should the ratio fall below 50% but remain above 33%. If the ratio falls below 33%, we observe that issuers generally have the obligation to delist the sukuk and provide holders the option to request early dissolution. In our view, compliance with Sharia Standard 59 creates or amplifies three primary risks.

Exposure to residual asset risk:   This was already present through total loss event risks. However, for some structures, the risk is increasing as a partial loss event also becomes relevant. Indeed, in a transaction with several assets, if one or more are destroyed, the tangibility ratio could be breached, and investors may not be fully reimbursed for their investment. Partial loss is generally covered through the obligation to ensure the underlying assets for the value of the asset and a certain amount to cover the income lost if the asset is destroyed. The insurance proceeds also have to be paid within a specific time (several days after the partial loss occurs). In our view, the insurance conditions imposed on the issuer are very restrictive, which could make insurance extremely difficult to obtain. Therefore, investors may lose some of their investments if a partial loss event occurs and would have no recourse to the sponsor, which could demonstrate that it tried to insure the asset but, as defined in the legal documents, the risks were not insurable. We do not rate sukuk transactions based on their insurance coverage. We would instead assess the remoteness of total or partial loss events and rate to that assumption.

Changing investor ranking in a liquidation scenario:  Standard 59 also affects the language related to the indemnity typically offered by the sponsor of the sukuk as an independent entity, in case it fails any of its contractual obligations. These usually include the obligations to pay rent or buy back the rights, benefits, or entitlement to the underlying assets. In a liquidation scenario, these could be perceived as nonfinancial obligations and, as such, rank after the financial obligations of the sponsor, making the sukuk creditors akin to subordinated creditors. Existing indemnity language resolved this issue by creating additional financial obligations for the sponsor (as an independent entity from the transaction). However, since this would be considered debt from a sharia perspective, it is no longer acceptable under Standard 59. In some instances, lawyers have resolved this issue by requiring that the sponsor maintains the benefit, custody, or actual or constructive possession of the underlying assets the entire time, so it can execute this indemnity. We do not rate sukuk to this indemnity, but we rate to the contractual obligations of the sponsor. This means that if the sponsor fails to comply with these obligations, the rating may be lowered to the default category.

Increasing liquidity risk for issuers and investors:   Compliance with Standard 59 creates new potential scenarios for early sukuk dissolution. If the issuer has insufficient unencumbered assets on its balance sheet, if there is prepayment risk for the underlying assets, or in a partial loss event, there could be sukuk acceleration and repayment before the maturity. For some issuers, this could be problematic, since it requires liquidity planning. Ultimately, corporates may face a higher risk of default because some of their debt might suddenly become immediately repayable. Such risks would be reflected in our liquidity analysis of the corporate.

Overall, this could mean more difficulty in accessing the sukuk market and lower investor appetite for the instrument. Sukuk instruments are already more complex and time consuming for issuers and investors than conventional bonds. This makes a critical review of some of the existing standards, and the adoption of an inclusive approach considering the views of all stakeholders, a necessity. The process would ultimately lead to the standardization of the full spectrum of sukuk (from fixed-income-like instruments to equity-like ones) factoring the requirements of regulators, sukuk issuers, and investors. Some market participants believe that standardization is not achievable. However, in our view, it is not only achievable but would unlock growth opportunities for the industry.

Standardization includes both aspects of sukuk: sharia interpretation and legal documentation. When a sukuk issuance becomes comparable with a conventional issuance from a cost and effort perspective, it will become a more prominent consideration for issuers and investors. Over the next 12 months, we expect some progress on the unified global, legal, and regulatory framework for Islamic finance that Dubai and its partners are developing. Depending on the outcome and adoption, issuers may benefit from a speedier and more streamlined process to tap the Islamic finance market. Investors may also gain greater clarity on sukuk resolution in the case of default. This could make the industry more attractive to new players.

Social And Green Issuance Volumes Are Likely To Remain Limited

Over the past six months, we have observed a few sustainability sukuk issuances. The Islamic Development Bank issued a $2.5 billion sukuk and disclosed that the proceeds will be used to finance green (10%) and social development projects (90%). Malaysia also issued a $1.3 billion sukuk, including an $800 million sustainability tranche, which was 6.4x oversubscribed. The proceeds will reportedly be used to finance social and green projects aligned to the U.N.'s Sustainable Development Goals. Furthermore, Indonesia issued a $750 million green tranche as part of its $3 billion issue in first-half 2021. Although these types of instruments may appeal to investors with ESG objectives, and we expect to see more of them, we think that they will be the exception rather than the norm.

Similarly, green sukuk is another area where opportunities are reportedly high, given the energy transition in many core Islamic finance countries and ambitions of some in the electric vehicle space. However, the additional complexity of green sukuk and the slow implementation of the energy transition agenda suggest that market dynamics will not change in the next one-to-two years.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Mohamed Damak, Dubai + 97143727153;
mohamed.damak@spglobal.com
Secondary Contacts:Sapna Jagtiani, Dubai + 97143727122;
sapna.jagtiani@spglobal.com
Benjamin J Young, Dubai +971 4 372 7191;
benjamin.young@spglobal.com

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