Saturday, May 02, 2009

Sukuk pricing: valuation or illiquidity (Part 2)

I am going to put this also on my blog at, but there are some technical difficulties preventing me from doing it right away, so I wanted to share it here.

In the last few days, Standard and Poor's placed several Dubai government related entities and sukuk on CreditWatch negative, largely caused by uncertainty about how the emirate will handle the maturity of a $3.52 billion Nakheel sukuk. Standard & Poor's wrote:

" The CreditWatch placements reflect our opinion of the likelihood of downgrades of the Rated GREs and The Notes if the potential for extraordinary government support to the Rated GREs and The Notes is not affirmed by the government of Dubai. The need for Dubai government support is potentially increasing in the face of deteriorating fundamentals for some of the Rated GREs."

While this announcement is not completely unexpected, it raises a few questions about the purpose of sukuk and their status as 'asset-based' or 'asset-backed'. This was one of the areas in the East Cameron Gas Sukuk, (currently in bankruptcy resulting from the issuer's Chapter 11 bankruptcy filing) that I examined in greatest detail to understand the structure with regards to possible default in a recent article in Islamic Business & Finance magazine. In the case of the East Cameron sukuk, there was an underlying asset, but the sukuk's musharaka structure provided no recourse for investors should the asset produce insufficient oil and gas to make payments to investors.

The reason I bring up the East Cameron sukuk in the discussion of the Dubai government related entity possible downgrade is because one of the sukuk in question, the Nakheel sukuk, is ijara, which should have different properties than the East Cameron sukuk in the case of default. As an ijara sukuk backed by an asset nearing its maturity date, the price in the secondary market, even if illiquid, should be heavily influenced by the final repayment of principal (asset buy-back). It provides a different example of whether pricing in secondary markets reflects valuation or illiquidity which I discussed earlier in regards to the JAFZ sukuk.

The Nakheel sukuk is an ijara sukuk on land the company is developing in Dubai. Two plots of land are sold to the SPV, which pays for it by issuing the sukuk. The SPV leases back the land to the developer to build on it and the payments are paid semi-annually. The lease payments are fixed throughout the term of the sukuk at 6.345% per annum (which was USD LIBOR+120 basis points when the sukuk was issued in December 2006). When the lease payments are made, 1/2 of the total amount is paid through to sukuk holders; the remainder is paid when the sukuk are redeemed. The holders of the sukuk receive, in addition to the periodic lease payments, the rights to participate in any public offerings by any of the Nakheel Group companies up until 1 year after the sukuk maturity date. These subscription rights allow sukuk investors to purchase shares at a 5% discount. The subscription rights are for up to 30% of the total public offering, with a limit based on the pricing of those offerings of 25% of the total value of the sukuk ($880 million). The sukuk investors through the SPV which issued the sukuk are hold mortgage rights on the properties, a share pledge of 18.89% of the shares of Nakheel (156.4 million shares), as well as an unsecured, guarantee from Dubai World.

The sukuk therefore is a secured debt backed by the land on which the developments are built that is 25% convertible into shares of Nakheel at a 5% discount. The valuation of the land (based on the developments that were planned when the sukuk was issued was AED 15.5 billion ($4.22 billion). The possible downgrade of the sukuk's rating reflects then one of a couple potential problems: Nakheel becoming insolvent, a decrease in the value of the guarantee from Dubai Ports (based on its ability to make whole the guarantee if Nakheel becomes unable to meet obligations to repurchase the sukuk assets), a decreased likelihood that Nakheel will proceed with an IPO which would trigger an additional payment of 2% per annum on the sukuk, or a fall in the value of the developments financed by the sukuk.

The sukuk comes due in December 2009, at which time, Nakheel will have to redeem the sukuk by repurchasing the assets it sold to the SPV plus 50% of the yield on the sukuk plus an additional 2% per annum if the company does not complete an IPO within 1 year following the maturity date. The redemption amount is $3.52 billion. The final distribution (of undistributed lease payments) is $335 million. The additional payment if there is no IPO is $211.2 million. The final periodic payment is $55.8 million and there is one more periodic payment due in May 2009 for the same amount. This means that Nakheel is facing payments totaling $4.18 billion. This is roughly equivalent to the valuation of the development when the sukuk was issued in 2006. SInce then, the property markets in Dubai as they have elsewhere worldwide, have fallen sharply. Nakheel saw its 2008 profit fall to AED 0.5 billion compared with AED 4.7 billion, largely due to a non-cash impairment on the valuation of its properties of AED 4.8 billion.

The exercise of looking deeper into the Nakheel sukuk was to provide more background on whether trading values reflect valuations or illiquidity in the secondary markets for sukuk. The Nakheel sukuk, which trades on the NASDAQ Dubai, last traded on April 21, 2009 at 73. The impairment taken on the property under construction represents about 4% of the company's total properties under construction. Although this impairment amounts to a small amount relative to the total value of the property, a similar impairment to the value of the assets on which the sukuk is based would fall to $4.05 billion, lower than remaining payments due to sukuk investors. A potential downgrade to the guarantor, Dubai World, provides a possible explanation for the valuation implied by the price at which the sukuk last traded. However, in an illiquid market, it is probably overstated. In an article last fall, a spokesman for Nakheel commented that "Globally the financial markets are in a period of unprecedented crisis, where pricing of financial instruments has been distorted across the board. Like the pricing of other sovereign credit, the pricing of the Nakheel Sukuk have similarly been affected, and current market pricing is not reflective of the credit quality of the Nakheel Sukuk". This example, like the JAFZ sukuk mentioned above, should provide further impetus for development of greater liquidity in the sukuk markets so that prices become better indicators of the value of the certificates and are not influenced greatly by the illiquidity of the market.

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