Letter of the law

Islamic bonds, or sukuk, are becoming increasingly popular worldwide - the IMF estimates that the global market for sukuk was US$41 billion at the end of 2006, having grown from less than $8 bn at the end of 2003. However, the instruments are now evolving, with much of the innovation coming from the Middle East. As new products are developed or adapted to become more commercially attractive, there is a constant debate as to what is acceptable under Shariah law and what is haram, or forbidden.

Much of the interest in product innovation is due to the commercial imperatives of corporate issuers.
Darshan Bijur, director, corporate finance, KPMG, says: "The sovereign issues meant that much of the structuring was not with a view to credit enhancement but with a view to making them Shariah compliant. Clearly, as corporate issuers have started stepping into the marketplace it has become a lot more important for them to want to provide credit enhancement and to structure it in a way that makes it comparable in terms of pricing to conventional financing."

One recent innovation is to issue sukuk that can be converted to equity after a certain period.

Ehsun Zaidi, global head of capital markets, Millennium Capital, a subsidiary of Dubai Islamic Bank, says: "The equity-linked space is the next big thing in sukuk. We've seen four or five deals globally so far, the two largest being PCFC [Ports, Customs and Free Zone Corporation, a business unit of Dubai World] and Nakheel, followed by Aldar, Khazanah from Malaysia and Aabar Petroleum.

"As more and more companies become public, funding requirements will continue and you'll see people looking to tap these markets where they can potentially have some hybrid-type capital with some equity features."

This kind of funding instrument has attractive features for both borrowers and lenders in the region.

"If you look at convertibles, the conversion tends to be at a 40, 50, or 60% premium to current stock price, which makes it attractive to the company," says Bijur. "In a way you have a three- to five-year instrument which is debt for that period, and at the end of that period gives the holder an option to convert.

"That for an issuer is very attractive because you have quasi-equity being issued, while the investor being given quasi-debt on the other hand is also tempted by the financial upside as and when the stock market price goes up."

Securitisation is another option. It has not been popular in the Middle East up to now, perhaps because there is insufficient legal framework to support it, but this could change, particularly with a large amount of real estate coming online.

"There will definitely be an increasing flow of securitisation transactions out of the region and because there are advantages for Middle East issuers to go for an Islamic structure versus conventional ones, you will increasingly see securitisation deals based on an Islamic format," says Zaidi.

There is a particular move among the industry to incorporate securitisation into sukuk issues, and some claim that the lease element of sukuk ijara is equivalent to securitising future income.

"Sukuk is in many ways a securitised instrument, particularly when you think of an ijara instrument," says Bijur. "The sukuk is backed not so much by the ijara asset but by rental flows." He cites the first corporate sukuk issue in Saudi Arabia, the Caravan ijara transaction in 2004, which was issued on behalf of Hanco Rent-a-car and securitised car rentals.

"The key problem here in the Middle East is the legal system," explains Arul Kandasamy, head of Islamic financing solutions, Barclays Capital. "For securitisation to be effective, to have a true sale, and for you to have comfort in terms of enforcement and of the assets underlying the trade, you need robust legal systems underlying the trade, which unfortunately are not really there in the Middle East.

"Having said that, we are currently working on a trade which should be launched later this year, which works within these constraints and which we feel will allow for a true securitisation, in the accepted Western sense. So the tide is changing. I think borrowers here recognise the importance of securitisation and how it could be another funding tool in the arsenal."

Kandasamy believes that there is no reason why Shariah compliant securitisation should not be possible.

"Ultimately with sukuk you're taking a form of credit risk," he says.

"Whereas a sukuk securitisation it actually means you're taking asset risk, event risk and performance risk as well, which is a lot closer to the underlying precepts of Shariah."

However, the market is divided over the issue. Tom O'Grady, partner, DLA Piper Middle East, a law firm, says: "The view in the market at one level is that securitisation is not possible under Shariah law because the way that securitisation works is you're giving somebody a guaranteed return."

Oliver Agha, global head of Islamic finance and head of finance Middle East, DLA Piper, adds: "Certain aspects of this area would certainly have to be considered very seriously before you could start applying them in a Shariah context. It's a new area for consideration and I would say that the Islamic scholar/lawyer jury is still out on this one."

Agha says some of the sukuk structures he has been asked to examine are not true to the spirit of Islamic finance.

"For example, a musharaka is essentially a partnership under Islamic law and one of the fundamental concepts is that partner A cannot guarantee the capital of partner B, yet I have seen certain structures that effectively do just that, where partner B's capital is guaranteed by partner A through interesting means," he says. "How you can go about calling that a musharaka when it effectively breaks one of the fundamental precepts of musharaka is news to me."

Agha adds: "There is a real move towards innovative sukuk financings. But the challenge remains in making sure the innovation does not break the back of the construct of the sukuk so that at the end of the day you end up with a sukuk instrument which is commercially viable yet completely non-Shariah compliant."

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