Managing Financial Risks of Sukuk Structures (PDF)
The purpose of this research is to review the evolution of Sukuk markets, describe the Sukuk structures and analyze the various risks underlying the Islamic sovereign and corporate Sukuk structures. The paper compares the risk underlying traditional fixed income instruments and those underlying the Sukuk structures. Interest rate swaps and other derivative instruments are utilized to manage the risk of the traditional fixed income instruments. These instruments are not available to Islamic asset managers. The paper therefore, aims to analyze the securitized structures of Sukuk and suggest Shari’ah compatible frameworks which can replicate the functions of interest rate swaps and derivatives in managing the risks of Sukuk.
The research aims to bridge an important gap in these emerging markets: namely, the analysis of risk management mechanisms in Sukuk structures. Indeed, due to the very novelty of Sukuks themselves there is a relative dearth of comprehensive research studies. Investment banks, governments, corporate clients, researchers and students interested in Islamic finance and banking are hoped to benefit from such studies. There is currently an estimated $4 billion worth of Sukuks in issue, with the market rapidly growing. Sovereign issuers include Bahrain, Malaysia, Qatar, and Saxony-Anhalt Germany. There have also been significant corporate Sukuk issues. International banks have also been involved in arranging the issuance. Therefore, this research is of immediate relevance to the Sukuk market and its participants.

The central Asian nation “is not excluding the sale of as much as $1 billion of Eurobonds next year,” Deputy Finance Minister Ruslan Dalenov said in an Oct. 26 interview in the capital, Astana. “As the sukuk market is quite narrow, it’s more reasonable to sell Eurobonds first,” which will become a benchmark, and then the Islamic bonds, he said.

Kazakhstan, where about half of the population of 16.6 million people is Muslim, may sell $500 million of Eurobonds, followed by the sale of sukuk, Dalenov said. The country doesn’t have outstanding foreign-currency bonds after it redeemed its last notes in 2007, according to Bloomberg data.

Sukuk (صكوك‎, plural of Sakk, صك) is the Arabic name for financial certificates, but commonly refers to the Islamic equivalent of bonds. Since fixed income, interest bearing bonds are not permissible in Islam, Sukuk securities are structured to comply with the Islamic law and its investment principles, which prohibits the charging, or paying of interest. Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets.

Kazakhstan, which plans a budget deficit of $5.1 billion for 2012, compared with an estimated $4.9 billion this year, may turn to international markets if government revenue and domestic bond sales won’t cover the deficit, Dalenov said. Higher-than- expected revenue from the custom union that Kazakhstan has with Russia and Belarus may help keep the budget in check, he said.

Sukuk securities tend to be bought and held and, as a result, little of the securities enter the secondary market (allowing them to be traded). Furthermore, only public Sukuk are able to enter this market, as they are listed on stock exchanges.

The secondary market whilst developing remains a niche segment with virtually all of the trading done at the institution level. The size of the secondary market remains unknown, though LMC Bahrain state they traded $55.5 million of Sukuk in 2007. The European Islamic Investment Bank (EIIB) in an interview published on Sukuk.net stated:

Secondary market trading volume has contracted significantly in the first half of 2008 when compared to 2007 where Sukuk with a nominal value of approximately $0.5bn was traded.

“Sukuk bonds” are designed to get around religious laws banning the payment of interest for money lending. But one of the most volatile debts in the Dubai World standstill is a $3.5bn Islamic bond due to be repaid in December.

However, global sales of sukuk, which pay asset returns to comply with Islam’s ban on interest, have jumped to $18.9 billion this year from $13 billion in the first 10 months of 2010, according to data compiled by Bloomberg. HSBC estimates there is $822bn Islamic finance debt outstanding in the world.

Sukuk Yields

Yields have declined 113 basis points, or 1.13 percentage points, this year, according to the HSBC/NASDAQ Dubai U.S. Dollar Sukuk Index. That compares with a 6.6% increase in developing-market bond yields, according to JPMorgan Chase & Co.’s EMBI Global Composite Index.

The Kazakh finance market “signals that it would be good if Islamic bond sales would be done in the nearest time,” Dalenov said, adding that the higher costs of Islamic borrowing “restrain us from giving optimistic estimations.”

The cost of protecting Kazakh debt against non payment for five years using credit-default swaps is 260 basis points, or 151 basis points lower than for Dubai, which last month raised $1.93 billion in a sale of Islamic bonds. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a country fail to adhere to its debt agreements. A basis point equals $1,000 on a contact protecting $10 million from default for five years.

Kazakhstan’s gross foreign-currency and gold reserves rose 15% since the end of last year to $32.5 billion in September, according to central bank data. Assets held by the country’s National Oil Fund advanced 29 percent to $40 billion in the period, it said.