The sukuk market has been growing over the past few years, as Muslim investors seek fixed income like returns. Sukuk is an Islamic-compliant bond with cash flows similar to traditional bonds, but is prohibited from the collection or payment of interest. In order to become permissible in the eyes of sharia religious laws, sukuk issuers sell investors certificates, and the proceeds are used to buy an asset, and the investor receives periodic payments derived from the revenues generated by the asset.
Sukuk issuance is split into two types, “asset-backed” and “asset-based.” With asset-backed issuance, the investor becomes the owner of the underlying asset up until the sukuk certificate matures, and will receive a guaranteed minimum return. In contrast, with an asset-based issuance the issuer uses the funds raised to buy an asset, then leases it, using the payments received (rental/lease income) to distribute income to sukuk holders. In other words, asset-based sukuk is issued without the actual sale of an underlying asset and closely mimics a traditional bond as its pricing is based on the creditworthiness of the issuer, not the asset.
The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), provides guidance on Islamic-compliant financial instruments such as sukuk. Recently, however, AAOIFI proposed a change that requires an actual transfer of asset ownership instead of a lease agreement structure. The proposal defines rental income or revenue generated from a lease structure as not a sufficient asset for sukuk compliance. These changes will likely impact asset-based sukuk and cause a pullback in the number of new issuances.
Issuers would see their processes change around the formalities of asset transfers, increased fees and time spent structuring transactions, while directing risk taken from sukuk investors to the underlying asset. In reality, sukuk investors generally avoid taking such direct risks, and sukuk issuers prefer to maintain control of their assets. Therefore, this change in rules may make sukuk issuance under this structure less attractive.
The TAM portfolios have exposure to both asset-based and asset-backed sukuk issuance through our investment in sukuk funds. Given the shift in AAOIFI 62 standards, we have engaged with our sukuk managers to understand what this means for the management of sukuk funds. Despite structural changes and an expected drop in asset-based issuers, sukuk managers and TAM remain confident in the overall sukuk market. This is because the potential change in standards only impacts countries and jurisdictions that comply with AAOIFI. For instance, Malaysia and Saudi Arabia, which have the highest share of sukuk issuance, do not follow AAOIFI standards.
TAM is actively consulting with sukuk experts and are prepared to respond quickly should dynamics in the overall sukuk market change. If these changes have a material effect, we will shift our exposure to sukuk managers that have larger positions in markets outside of AAOIFI jurisdictions.
If you would like to speak with me about this update or discuss our TAM Sharia portfolio range, please do not hesitate to get in touch.