Thursday, August 13, 2009

Jadwa Investment report on Saudi sukuk market

Jadwa Investment recently released a short report on sukuk markets in Saudi Arabia (PDF) which contains some details about the new Tadawul sukuk market. While it is good at covering the specific topics it covers, there are two main areas where the report could have benefited from greater detail and analysis. First, the report contains a common factoid that is incorrect:
"The main difference between sukuk and bonds is that sukuk holders take direct ownership of an underlying asset or pool of assets, whereas a bond is purely the financial debt of the issuer."
As a few of the recent defaults of sukuk have demonstrated, the ability of sukuk investors to take posession of the assets they 'own' is limited by the legal structure established to make sukuk behave as much as possible like conventional debt. This is particularly true of 'asset-based' (in contrast to 'asset-backed') sukuk. In the former case, the returns are based on an asset and therefore behave as if the investor owned the asset, although in case of default the investors are merely able to compel the issuer to repurchase the sukuk at full value. Even in cases where sukuk are asset-backed, it is unclear whether the assets will end up being owned by the issuer SPV for disposition at current market prices to allow investors to recoup the principal of the sukuk. Instead, there may be a structure that 'sells' the assets to the issuer SPV but the Issuer SPV is limited to essentially exercising a re-sale provision where it can compel the issuing company to repurchase the assets at par (or perhaps following the controversy about repurchase clauses, at market prices).

One of the defaults (actually a bankruptcy proceeding by the issuer) where the ownership of the assets by the issuer SPV may be established is the East Cameron Gas Company sukuk, the only sukuk issued by a U.S.-based company. In this case, the assets were an overriding royalty interest (ORRI) in an oil and gas lease on an offshore property off the coast of Louisiana. The sukuk documents specified a backup operator and a bankup off-taker that could serve to continue the production. This could lead to changes in how sukuk are structures to give investors greater ability to take possession of the assets on which the sukuk are based.

The second area where greater analysis would have been useful is the maturity of sukuk. The report mentions this in passages that imply that sukuk provide longer-term financing:
"Unlike conventional bank loans, companies have the ability to choose the term over which they want to borrow in a sukuk issue and there is an urgent need for more long-term financing options in the Kingdom. Most bank lending in the Kingdom is short-term and little is available beyond five years"
The unexplained part of this statement is that the secondary markets, both electronic and over-the-counter, in Saudi Arabia according to the report is composed entirely of sukuk with five-year maturities and this is largely also the case in other markets, although there are some shorter-term sukuk elsewhere. The market is nearly devoid of sukuk with short- and long-term maturities as found elsewhere in the conventional debt markets. This scarcity is the real area where the sukuk markets need to develop in order for Islamic debt markets to be a substitute for conventional debt markets.

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