May, 2019

By Muzrifah Mohamed, Associate Professor Dr. Norli Ali, Associate Professor Dr. Mohd Nizal Haniff and  Dr. Zarinah Abdul Rasit

At present, more than 300 Islamic financial institutions are operating in 75 countries across the globe. The average annual asset’s growth rate of the world’s 100 largest Islamic banks is estimated to be 27% per annum.  Islamic finance has become a major economic driver not only in the economies of Muslim-majority countries but also non-Muslim-majority countries.  The average growth rate of the Islamic finance industry is around 20% per annum. This is considered a speedy and swift growth, which has not been experienced by the conventional finance sector previously (Ho, 2015).

In 2016, the total worth of shariah assets worldwide was expected to be around USD1.9 trillion with sukuk and Islamic equity funds sharing a big chunk of the said value (Ambrose, 2017). The growth of wealth and mounting interest in the low-risk investment activities during and post financial turmoil period have instigated this fast progress in the Islamic finance industry, especially sukuk and Islamic equity funds. Sukuk has a great potential to contribute to the economic growth of a country through real sector development initiatives (Nazar, 2015). The prospect has attracted the global banks to jump on the bandwagon by forming subsidiaries specializing in the provision of Islamic financial products and services. The United Kingdom issued sukuk in 2014, while other non-Muslim majority countries like the United States followed suit by introducing Islamic financial products and services  aggressively (Nazzar, 2015; Ho, 2015).

At present, sukuk is deemed a fast-growing financial instrument issued not only by the Islamic institutions but also by its non-Islamic counterparts. These institutions shared a similar objective namely to attract investors who are inclined to invest in shariah-compliant products. Over the past two decades, sukuk has become an alternative to conventional bond and has been widely used in financing. Sukuk is a hybrid Islamic financial instrument that has both the characteristics of shares and bonds. It is a certificate of ownership that represents stakes or shares in the ownership of tangible assets linking to specific investment activities or projects that it finances. The selling of sukuk results in the selling of the share of an asset. Sukuk prices may fluctuate with both the market value of the underlying asset and the creditworthiness of the issuer. There are various applications of Islamic finance concept for sukuk such as musharakah, mudarabah, ijarah, and salam, which allow for the creation of Islamic finance instruments. In Malaysia, ringgit-denominated sukuk are structured using shariah rulings, concepts, and principles endorsed by Shariah Advisory Council to ensure a fully shariah-compliant and high level of standardization in its structure.  Similar to bonds, sukuk have a maturity date.

However, unlike conventional bonds that correspond debt to its issuer, sukuk do not represent a liability or a debt to the issuer, but instead, it gives their investors common shares in the ownership of the assets related to the project or investment activities. Thus, unlike the issuers of bonds who need to pay coupons and principals to their bondholders on certain dates, in accordance with shariah law, sukuk holders are entitled to a regular stream of revenues generated by the sukuk assets. These features give rise to the general claim that sukuk is more secure than conventional bonds as it is based on assets that underpin the deals.

The distinctive risk characteristics of sukuk as opposed to bonds as well as the various and complex structures of sukuk, potentially demand a different rating methodology. However, the current practice of rating agencies in Malaysia such as Rating Agency of Malaysia (RAM) and Malaysian Agency Rating Corporation (MARC) is to rate sukuk in ways similar to conventional bonds. Since sukuk are characterized by fixed income, it allows MARC to rate sukuk by means of conventional corporate debt, project finance, or structured rating methodologies. Leong (2016) suggests that sukuk rating of MARC does not take into account the analysis of Shariah compliance risk and the suitability of the issues underlying the shariah concept.

Arguably, the Malaysian regulatory framework requires the engagement of shariah advisory body. The appointment of such shariah advisors is expected to ensure that the issuance of sukuk is compliant with the shariah principles, and therefore mitigating shariah compliance risk. Shariah compliance risk measures the probability that sukuk violate shariah provision and hence is vital in sukuk investment (Khabari & Walid, 2013). Any violation to shariah provision would lead to damages with varying degree of significance. The risk ranges from voiding sukuk completely to the cancellation of sukuk on certain condition. For example, one of the rulings stipulated by shariah law is that the debt should not exceed 33% of the underlying assets of sukuk throughout its lifetime. Exceeding the specified limit may cause the circulation of sukuk to be halted, and thus would result in the ownership of sukuk becomes artificial. Consequently, the risk of default among the investors will be high. Such circumstance will not be an issue to the investment of bond.

Theoretically, the issuance of sukuk affects the issuing firm’s systematic risk significantly, which is consistent with the capital structure theory. Noriza and Mohd Nizal (2013) show in their study that firms with the issuance of sukuk have a higher default risk compared to those issuing conventional bonds. However, they found that sukuk was rated higher than the bond. In another study by Noriza, Mohd Nizal, and Norli (2016), the presence of institutional ownership is found to have an inverse relationship with the default risk for long-term sukuk. On the other hand, the results do not support any relationship between institutional ownership and long-term conventional bonds defaults. It is safe to conclude that sukuk instruments should be categorized as a new class of financial instruments instead of bonds. As such, they should be rated differently from bonds.

Furthermore, sukuk has a broader range of risks compared to conventional bonds. Unlike bonds that rely heavily on the credit risk of the issuer, sukuk’s risk encompasses not only credit risk but also the market risk, operational risk, and shariah compliance risk to name a few. These risks need to be taken into account when rating sukuk. Beside the risk differences between sukuk and conventional bonds, the complexity of the sukuk structure also contributes to the need for a separate rating approach for sukuk. Among the structures of sukuk include ijarah, murabahah, istisna’, musharakah and modified types of sukuk such as hybrid or pooled certificates, variable rate redeemable certificates, or fixed-zero-coupon certificates (Nazar, 2015) as well as asset-based or asset-backed sukuk structures.

A key theme from the above discussion is that a different and more appropriate rating methodology needs to be developed for sukuk. However, the key challenge would be to create awareness among key players and regulators of the Islamic finance industry about the new rating mechanism necessity.