deustsche bank introduction to sukuks

GEMS: Middle East

30 August 2007

Bond Market Guide Introduction to Sukuk

The market for Sukuk - Islamic Bonds - is growing rapidly with a total amount outstanding in excess of USD 80bn. The fastest growing class of Sukuk is Sukuk issued under New York or English law, designed to mimic Global bonds. Issuance of this ‘international Sukuk’ in 2007 (USD 10.9bn so far) already exceeds the total amount issued in 2006. In this article we aim to provide a comprehensive primer on international Sukuk. We discuss the origins of the market, the various types of Sukuk and the potential future evolution of the market.

Deutsche Bank AG/London

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DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1

Primer

Table of contents

Introduction ........................................................ Page 2

Shari’ah concepts in Islamic Finance ................. Page 3

Sukuk as a vehicle for Shari’ah compliant financing and investment ................................... Page 4

A brief history of the development of the Sukuk market...................................................... Page 8

Expectations for market development ............. 0

Credit Risk – how rating agencies approach Sukuk ................................................ Page 15

Sukuk Pricing and Secondary Market Behaviour.......................................................... Page 17

Appendix A – Equity-linked Sukuk .................... Page 19

Research Team

Marc Balston Strategist (+44) 20 754-71484 [email protected]

Arend Kapteyn Chief Economist (+44) 20 754-71930 [email protected]

Sukuk Market Size

0102030405060708090

00 01 02 03 04 05 06 07

International Sukuk

Domestic Sukuk

Outstanding amountUS$ bn

Source: Bloomberg, Deutsche Bank

Geographic Distribution

0102030405060

Asia Middle East

Domestic Sukuk

International Sukuk

Amount Outstanding, US$bn


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30 August 2007 Bond Market Guide


Introduction

Sukuk are often thought of as the Islamic equivalent of bonds and while such a comparison captures many of the characteristics of Sukuk, it is important to understand to what extent this comparison is valid. In essence, Sukuk exist as a means of translating established Shari’ah compliant financing tools into a form which in many ways mimics that of traditional bonds, and by extension provides the degree of standardisation, transparency, transferability and liquidity which has made the international bond markets such a powerful and efficient vehicle for financing and investing. It is important to note that while Shari’ah is clearly central to the concept of Sukuk, it does not generally act as the legal basis for the securities. The majority of international Sukuk are governed by English or New York law but are structured in a way as to be Shari’ah compliant, for the benefit of issuers and investors who seek to manage their affairs in accordance with Shari’ah principals.

It is somewhat misleading to think of Sukuk as being designed specifically for Muslim investors (and/or issuers). Certainly an entity need not be Islamic in order to issue or to buy a Sukuk. A better way to think of a Sukuk is as a conventional bond, but one which has been constructed in a way as to be Shari’ah compliant. A useful analogy can be found in the food industry. Many mass produced foods are manufactured in a way that allows them to be certified as halal, kosher, organic etc. Such certification is clearly designed for certain groups of consumers, but it does not prohibit other groups from consuming the product. Indeed, some food lines are only produced in such certified form as it is cheaper than producing several different lines.

The first Sukuk were issued in the Malaysian domestic market in the mid-1990s and since then over USD 125bn have been issued globally. Sukuk can be divided into two main groups: Malaysian domestic Sukuk (primarily ringgit-denominated and governed by Malaysian law) and international Sukuk (being primarily USD-denominated and governed by English or US law). Although the former group is the older and larger of the two, the market for international sukuk is growing rapidly and it is this group that forms the focus of this article.

Although the international Sukuk market is a comparatively young market, the first international Sukuk having been issued in 2001, its size already exceeds USD27bn and is growing rapidly, USD10.9bn having been issued in the first six months of 2007. The main source of issuance is from corporate issuers in the GCC1 countries – in particular from the UAE – looking to finance construction projects.

The cash flows and credit risk of a Sukuk are remarkably similar to those of a conventional bond. As a result, the specific way in which a Sukuk has been constructed so as to be Shari’ah compliant is generally not of importance to an investor who is not concerned by its Shari’ah compliance. However, since Sukuk documentation differs considerably from that of a normal bond, it is valuable to understand some of the key principles, characteristic and terminology that are commonly employed. This is one of the key objectives of this article: to give the reader the background to allow them to interpret a Sukuk prospectus – even from the perspective of determining the cash flows.

In this article we will discuss the key Shari’ah principles that relate to Islamic finance and look at how the various key types of Sukuk have been developed in order to meet these principles (in order to be Shari’ah compliant). We will also look at the history of the Sukuk market, some recent developments and our expectations for the future evolution of the market. We will discuss how the rating agencies approach credit risk of Sukuk and finally we conclude by examining in more detail some of the more liquid Sukuk structures.

1 Gulf Cooperation Council – comprising Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates.



Shari’ah concepts in Islamic Finance

There are many concepts within Shari’ah which limit the degree to which conventional capital market techniques can be applied, but the most fundamental is the prohibition of Riba. Riba – often interpreted simply as interest – is considered to be any pre-determined return on money, in other words, the generation of income from money alone. While interest is prohibited, Shari’ah does allow for financing to be provided (or accepted) in the event that it is linked to certain identifiable assets (e.g. for the trading of those assets, or for their construction).

Aside from the prohibition of riba, Islamic finance also prohibits:

Investment in companies that manufacture certain forbidden – haram – products, such as tobacco, alcohol, firearms, pork products and also investment in companies in the entertainment industry, casinos, hotels, restaurants, adult entertainment etc. (which restricts the commercial assets in which the proceeds of a Sukuk issue can be invested).

Speculation, betting and gambling (maisir) including the speculative trade or exchange of money for debt without an underlying asset transfer.

Preventable uncertainty (gharar) such as that related to derivative instruments, forwards and futures.

Trading in ‘indebtedness’ at any price other than the face value.

Islamic Finance itself is not a recent phenomenon but has developed over many hundreds of years. Over that time a variety of different contractual instruments have become well established as common ways of financing, and been given the green light by Islamic scholars tasked with developing Islamic jurisprudence and interpreting the principles laid down in (most importantly) the Qu’ran. Traditionally these instruments have formed the basis for commercial banking, although as we will see later they are now being used as the basis for many Sukuk and hence are being translated into the investment banking arena.

Before delving into the anatomy of Sukuk we briefly touch on some of the most common contracts in Islamic Finance, which form the building blocks of Sukuk. Given the Shari’ah restrictions on the trading of indebtedness, we have divided the contracts into two groups: those which can tradable at a market price and those that can only be transferred at face value. Naturally the ones in the former group are the most important for Sukuk, although the ones in the latter do occur within some Sukuk – hence their inclusion here.

Contracts which can be transferred at a negotiated price

Ijara – an ijara is essentially a lease contract whereby assets (or the usufruct of an asset) is leased out with the lessor retaining all the rights and responsibilities that go with ownership. Ijara represents the typical Islamic mortgage structure. As Ijara bonds represent ownership in well defined securities they can be freely traded in the secondary market at a market price.

Mudaraba – a mudaraba can be thought of as an asset management agreement whereby one party provides finance to another party and the second party (known as the mudarib) invests the capital according to some pre-agreed business plan. The profit of the business is distributed according to a pre-determined ratio, but any financial loss is incurred only by the finance providers.

Musharaka – a musharaka agreement is somewhat similar to that of a mudaraba, but in this case both parties provide capital (or assets) and both may be involved in the management of the assets. Essentially a musharaka is a joint-venture. As with the mudaraba, the profit of the business is distributed according to a pre-determined ratio, however, in a musharaka the loss is distributed in proportion to each partners share of the capital.



Contracts only transferable at face value

Murabaha – the most common instrument in Islamic Finance, the murabaha is essentially a tool for financing the purchase of specific assets. Under the contract the counterparty providing the financing purchases the required assets and sells them to the buyer at a pre-agreed marked-up price. The payment can be settled in instalments or as a lump sum within an agreed period.

Istisna’a – a contract which exchanges an upfront payment for the future delivery of an asset. An istisna’a contract requires that the asset is made to order. Full payment need not necessarily be made in advance and can be phased. This is the most common form of financing for construction projects.

As an indication of the relative importance of these various forms of Islamic Finance instruments, Figure 1 below illustrates the composition of the assets of the Dubai Islamic Bank (the world’s third largest Islamic bank) as of the end of 2006.

Figure 1: Composition of Dubai Investment Bank’s Islamic Assets

Sukuk: 1.6bn14.3%

Mudaraba: 0.8bn7.6%

Musharaka: 0.8bn7.0%

Ijara: 1.6bn15.0%

Istisna’a: 1.2bn11.1%

Murabaha: 4.9bn44.9%

Source: Dubai Islamic Bank Consolidated Financial Statements 31 Dec 2006

Sukuk as a vehicle for Shari’ah compliant financing and investment

Sukuk2 are effectively ‘Trust Certificates’ which employ the principals of Islamic Finance in order to provide a Shari’ah compliant, tradable security, the financial characteristics of which appear to the holder to be very similar to those of a conventional bond. At the heart of the majority of Sukuk are one or more of the traditional instruments described above, particularly those that can trade at a negotiated/market price. Hence, the most common Sukuk are based on ijara, mudaraba or musharaka.

In order for a Sukuk to be considered Shari’ah compliant the issuer will apply to a Shari’ah board of Islamic scholars. If the board considers the Sukuk to be Shari’ah compliant it issues a pronouncement (a fatwa) to certify its decision. This fatwa is similar to a legal opinion in that it is (generally) not legally binding and other scholars may disagree with the decision. For this reason, many Sukuk issuers (particularly those within the GCC) will work with a small group of Shari’ah scholars who are very familiar with Sukuk and whose judgements are widely respected in the field of Islamic jurisprudence. One scholar in particular stands out in this regard – Dr Hussein Hamid Hassan. Dr Hassan chairs a number of Shari’ah boards and has been responsible for issuing fatwas for the majority of international Sukuk.

2 The most accurate English translation of the Arabic word Sukuk is ‘participation’. In Arabic, Sukuk is actually the plural form of sakk which itself is the origin of the European word cheque.



While a basic understanding of the general structures of Sukuk can help to make Sukuk documentation somewhat more intelligible, for the most part the exact nature of the underlying structure is not generally of importance to the Sukuk holder and secondary to the cash flow characteristics of the Sukuk (from the perspective of the holder) are described by:

the periodic distribution amount (often expressed as Libor-plus amount, paid on a semi-annual basis) – analogous to a bond coupon.

the scheduled dissolution/redemption date – analogous to the maturity date of a bond.

However, from a risk perspective, the exact nature of the Sukuk can have a bearing on credit risk, legal risk and liquidity risk, all of which will be discussed subsequently.

Sukuk-al-ijara

Sukuk based on ijara (sale and leaseback) agreement are formally known as Sukuk-al-ijara. Figure 2 below illustrates the typical structure of a Sukuk-al-ijara. In this structure the issuer of the Sukuk – often a SPV – uses the proceeds of the issue to purchase the specific assets from the originator. It then leases them back to the originator (or often to an affiliate of the originator). The lease payments made by the originator are then passed on to the Sukuk holders as periodic distributions. At the end of the specified term, the originator repurchases the assets from the issuer, with the repurchase proceeds being passed on by the issuer to the Sukuk holders, in effect redeeming the Sukuk.

Figure 2: Typical structure of Sukuk-al-ijara

Issue proceeds (2)

Title to assets (2)

Lease agreement (3) Issue proceeds (1)

Periodic distribution (4)

Periodic rentals (4) Repurchase proceeds (6)

Title to assets (5)

Repurchase proceeds (5)

1. The issuer - usually an SPV - issues sukuk to sukuk holders in exchange for proceeds.

2. The issuer purchases title to assets from the originator

3. The Originator enters into a lease agreement with the issuer to lease the assets

4. The originator makes periodic rental payments on the lease to the issuer which the issuer passes on to the sukuk holders.5. At maturity (or upon a dissolution event ) the issuer sells the assets back to the originator (purchase undertaking )

6. The issuer passes the proceeds on to the sukuk holders and the SPV is dissolved.

Issuer

Originator(as seller)

SukukHolders

Originator(as lessee)

Originator(as obligor)

Source: Deutsche Bank

The rental payments on the lease agreement (i.e. the periodic distribution received by the Sukuk holders) are generally structured as semi-annual payments often with a rate determined by LIBOR plus a specified margin.

The repurchase of the assets by the originator from, in effect, the Sukuk holders, is governed by a purchase undertaking which is invoked at the scheduled dissolution date (i.e. the maturity date) or on the occurrence of a dissolution event. Such dissolution events generally include many of the clauses which are analogous to events of default on a conventional bond. As a result of the purchase undertaking, such events effectively result in an acceleration of the Sukuk, much like a conventional bond and would convert the trust certificates into a debt claim on the originator.



The underlying assets which are so essential to a Sukuk-al-ijara transaction are often land parcels, but can also be specific buildings or other property, or even simply the rights to use the property (a more recent development). The size of the Sukuk is restricted to the value of the assets being transferred from the originator to the special purpose vehicle, and once the assets have been used they cannot be used for another purpose until the Sukuk has matured – this implies some loss of flexibility on the amount of paper that can be issued by an individual borrower, though in practice this has not yet posed serious constraints. It is worth noting that Sukuk involving assets in Saudi Arabia generally employ two SPVs, one incorporated in Saudi Arabia, the other offshore. This arrangement arises because Saudi law forbids the foreign ownership of assets located in Saudi Arabia.

Sukuk-al-musharaka and Sukuk-al-mudaraba Sukuk based on musharaka or mudaraba agreements are very similar in structure, both entailing an agreement with a business plan with profit-sharing terms. Figure 3 illustrates the typical structure of a Sukuk-al-mudaraba. In this structure the SPV (the issuer of the Sukuk) acts as raab al-maal and enters into a mudaraba agreement with the originator (acting as the mudareb). The specific nature of the agreement varies from Sukuk to Sukuk, but generally it will entail the mudareb investing the proceeds provided by the SPV (obtained from the issue of the Sukuk) according to some agreed business plan. The profits-sharing terms of the agreement are often heavily weighted in favour of the SPV (often 99% to 1%). However, if the resultant share of the profits exceeds the periodic distribution amount specified in the Sukuk terms, the issuer foregoes the excess. Alternatively, if the share of profits is less than the periodic distribution amount, the mudareb is committed to fund the short-fall by extending financing to the issuer.

Figure 3: Typical structure of Sukuk-al-mudaraba

Issue proceeds (2)

Mudaraba agreement

Periodic distribution (3)

Issue proceeds (1)

Issuer's interest in Periodic distribution (3)

mudaraba assets (4) Purchase proceeds (5)

Proceeds of purchase undertaking (4)

1. The issuer - usually an SPV - issues sukuk to sukuk holders in exchange for proceeds.

2. The issuer enters into a mudaraba agreement with the originator (acting as the 'mudareb')

Typical mudaraba agreement

The mudareb invests the proceeds in accordance with the agreed business plan.

The profit generated by the business plan is shared between the issuer and the mudareb according to a pre-agreed schedule

If the issuer's profit share exceeds the amount required for the periodic distribution, the mudareb retains the difference.

If the issuer's profit share falls short of the amount required for the periodic distribution, the mudareb supplements the difference.

3. The mudareb makes periodic payments to the issuer which are passed on to the sukuk holders.

4. The orginator (as obligor) purchases all of the issuer's ownership interest in the mudaraba assets

5. The issuer passes the proceeds on to the sukuk holders and the SPV is dissolved.

Issuer(as raab al-maal)

SukukHolders

Originator(as mudareb)

Originator(as obligor)


As with Sukuk-al-ijara, the redemption of the notes is achieved by means of a purchase undertaking by the obligor. However, in the case of a Sukuk-al-mudaraba, the obligor purchases the issuer’s ownership interest in the mudaraba assets (rather than purchasing assets owned by the issuer). The purchase price for the purchase undertaking is equal to the aggregate principal amount of the certificates outstanding. The issuer then passes the proceeds of this purchase on to the Sukuk holders, effectively redeeming the Sukuk.



The primary difference between Sukuk-al-mudaraba (described above) and Sukuk-al-musharaka are that the joint venture embedded in the latter entails the originator providing a share of the capital (and/or assets), in addition to the finance provided by the issuer (ultimately by the Sukuk investors), rather than simply providing the management expertise. Compared to ijara structures, both these Sukuk variants permit greater flexibility in the cash to be raised relative to the magnitude of asset transfer, as the amount of cash to be raised does not need to correspond to the assets available for transfer into the mudaraba/musharaka.

Other structures of Sukuk Although the majority of internationally traded Sukuk are based upon ijara, mudaraba or musharaka, other forms of structure exist. As discussed above, murabaha and istisna’a contracts are two of the most common forms of Islamic finance agreements; however, Shari’ah forbids such contracts to be traded at any price other than face value, Sukuk based upon them would have limited liquidity. This constraint has led to two additional forms of Sukuk which include a proportion of murabaha and/or istisna’a contracts (among other Shari’ah compliant assets).

Hybrid Sukuk. Several construction projects in the GCC have included ijara-istina’a Sukuk for a portion of their financing. These Sukuk include both ijara agreements and istina’a agreements within them. For instance, the Durrat 2010 Sukuk3 includes a series of istina’a contracts for various construction projects which when complete are leased back under the master ijara agreement. Such Sukuk are tradable if the majority of the underlying assets (which can vary over the life of the Sukuk) are ijara.

Sukuk-al-wakala. Essentially a Shari’ah compliant investment management vehicle which allows a variety of assets to be pooled together. Provided at least 51% of the assets are tradable – such as ijara contracts – the Sukuk itself can be traded at a negotiable price. In essence, any variation in the price of the Sukuk is considered to be a variation in the value of the ijara contracts, while the other contracts in the pool remain at face value.

In the Malaysian domestic market, Sukuk based on cost-plus-sales, known as Sukuk-al-murabaha or Bai Bithaman Ajil (BBA) have dominated, although such structures are rare in the international Sukuk market as few Middle Eastern Shari’ah scholars consider them to be fully Shari’ah compliant.

Convertible Sukuk

Some of the larger, more recently issued Sukuk are also convertible into equity, although the underlying structures of the securities are still based on ijara, mudaraba or musharaka. Two main types of convertible Sukuk have been issued: conventional convertibles (giving the Sukuk holder the right to exchange their Sukuk for a pre-determined amount of a pre-existing stock) and pre-QPO4 Sukuk which give the holders the right to participate – sometimes at a discount -- in an public offering of a company’s stock (if one is offered during the life of the Sukuk). Convertible Sukuk have helped to broaden the potential investor base for Sukuk and the largest Sukuk issues have all been convertible. Even though only seven convertible Sukuk have been issued, they represent USD 11.8bn of the USD 27.8bn of international Sukuk that have been issued to date.

3 For the financing of the reclamation and initial stage development of ‘Durrat Al Bahrain’ – the Kingdom of Bahrain’s largest residential development project. 4 Qualifying Public Offering.



A brief history of the development of the Sukuk market

The first Sukuk were issued in Malaysia during the 1990s, although these were denominated in Malaysian ringgit and were targeted toward domestic investors. A key catalyst behind the growth of the domestic Sukuk market in Malaysia was the establishment in 1996 of the Shari’ah Advisory Council (SAC) of the Malaysia Securities Commission. The SAC was given the mandate to ensure that the running of the Islamic capital market complies with Shari’ah principals. The SAC created explicit guidelines for the issuance of Shari’ah compliant securities and by so doing, provided a clear benchmark view on the compliance of certain structures, thus helping to generate a degree of uniformity in the Sukuk offered.

By 2002, over USD 5bn equivalent of Sukuk was being issued annually in Malaysia, via around 100 separate offerings. However, the market was of little interest to Islamic investors outside of Malaysia for two reasons. First, the fact that all the issues were denominated in ringgit and traded only on the domestic Malaysian market. Second, and perhaps more importantly, there was a widespread view among Islamic scholars that the interpretation of Shari’ah adopted by the SAC was too liberal and that the majority of the securities that had been certified as Shari’ah compliant by the SAC were not considered Shari’ah compliant by the wider community of Islamic scholars. In particular, SAC permitted Sukuk to be based upon murabaha, while Shari’ah scholars in more conservative jurisdictions explicitly prohibit the trading of murabaha debt.

In September 2001, the government of Bahrain became the first issuer of USD-denominated Sukuk with its USD100mm five-year issue. However, as with the Sukuk issued in the Malaysian market, these Sukuk were intended for domestic investors. Nevertheless, being the first Sukuk out of the GCC and also being based on an ijara structure, this Sukuk represented an important stepping-stone towards the creation of an international Sukuk market.

The first true international Sukuk issue was issued by Guthrie (a Malaysian plantation firm) in December 2001. This was also an ijara-based Sukuk but unlike the Bahrain Sukuk was issued as a global certificate under New York law. Appropriately, the SPV was named ‘First Global Sukuk Inc.’ Two tranches were issued simultaneously a USD50mm three-year and a USD100mm five-year certificate.

Figure 4: All Sukuk Issuance Figure 5: International Sukuk Issuance

455

915

713

469

142217

579352

2210

36110

5

10

15

20

25

30

1995 1997 1999 2001 2003 2005 07YTD

AsiaMiddle EastOther

Amount Issued, US$bnTotal number of deals adjacent to bars

1714

1063

0

2

4

6

8

10

12

14

1995 1997 1999 2001 2003 2005 07YTD

AsiaMiddle EastOther

Amount Issued, US$bnTotal number of deals adjacent to bars

Source: Bloomberg, Deutsche Bank Source: Bloomberg, Deutsche Bank

Following the Guthrie Sukuk, the first sovereign Sukuk – Malaysia’s 5-year global Sukuk – was issued in July 2002. Good demand for the deal saw it upsized from the originally planned USD350mm to USD600mm. With 50% placed with investors in the Middle East, 30% to Asia, 16% to Europe and 4% to the US, the deal was clearly international. Despite the success of this deal, it was another year before the first Sukuk was launched in the GCC – the



Islamic Development Bank’s USD400mm 5-year Sukuk-al-wakala 5 . This was followed in October 2003 by a seven-year sovereign Sukuk from Qatar of USD700mm.

After the sporadic issuance of the first three years of the international Sukuk market, 2004-05 witnessed a marked increase in number of deals (six in 2004 and 10 in 2005), although the size of individual deals remained small. The highlight deals of the period were a USD1bn five-year Sukuk-al-ijara from the Government of Dubai, a USD600mm five-year Sukuk-al-ijara from the Islamic Republic of Pakistan and the first musharaka-based international Sukuk, a USD200mm five-year deal from the Dubai Metals and Commodities Centre (the ‘Gold Sukuk’). Also in 2004 was the first Sukuk issue from a non-Muslim country; the German State of Saxony-Anhalt issued a EUR100mm five-year Sukuk-al-ijara.

In 2006 the Sukuk new issue market shifted gear with the first convertible Sukuk (under a Musharaka structure), a massive USD3.5bn by DP World for the acquisition of P&O. This was followed by several more jumbo convertible Sukuk and smaller non-convertible Sukuk.

During 2006, Sukuk-al-musharaka became the dominant form, with Sukuk-al-ijara issues declining in frequency. This was partly a reflection of a shift toward using Sukuk for the financing of specific development projects and away from raising general capital using assets as collateral. However, perhaps more importantly, Sukuk-al-musharaka (and Sukuk-al-mudaraba) are generally considered closer to the spirit of Shari’ah than Sukuk-al-ijara and hence are more likely to be acceptable to Shari’ah boards.

Figure 6: International Sukuk by Type

0

2

4

6

8

10

12

2001 2002 2003 2004 2005 2006 07 YTD

MurubahaHybridWakalaMusharakaMudarabahIjara

Amount Issued, US$bn

0

2

4

6

8

10

12

14

16

2001 2002 2003 2004 2005 2006 07 YTD

MurubahaHybridWakalaMusharakaMudarabahIjara

Number of deals

Source: Individual Sukuk Prospectuses, Deutsche Bank Source: Individual Sukuk Prospectuses, Deutsche Bank

Malaysia is still the dominant source of Sukuk issuance6, although this remains primarily domestic issuance. As Figure 7 shows, Sukuk issuance within Asia has been overwhelmingly on the domestic market, while in the Middle East international Sukuk have dominated. Malaysia (along with Bahrain and Qatar) was one of the pioneers of the international Sukuk market; however, the UAE has become the dominant source of issuance. Of the USD 28bn issued to-date, more than USD 17bn has come from the UAE. Indeed, the five largest international Sukuk (and eight of the top 10) have all come from UAE issuers. Within the UAE, Dubai has been the primary source, with six of the top eight Sukuk originating from this emirate.

5 The Sukuk assets comprised ijara, murabaha and istisna’a contracts. At closing, 65.8% of the assets were in the form of ijara contracts. 6 More than 75% of the USD 129bn of Sukuk issued have been from Malaysian issuers.



Figure 7: International Sukuk dominate

in the Middle East, unlike in Asia

Figure 8: International Sukuk issuance by

country of origin

0

10

20

30

40

50

60

Asia Middle East

DomesticInternational

Amount Outstanding, US$bn Malaysia11% Bahrain

7%

Germany0%

USA1%

Saudi Arabia

9%

Kuwait3%Qatar5%

Pakistan2%

UAE62%

Proportions by USD amounts

Source: Bloomberg, Deutsche Bank, as at mid-August 2007 Source: Bloomberg, Deutsche Bank, as at mid-August 2007

Expectations for market development

As is often the case with a young, rapidly growing market, forecasts of the potential size of the Sukuk market vary widely7. In order to gauge the potential growth of the market, below we discuss the potential supply and demand of Sukuk from the perspective of both issuers and investors. However, before we begin, it is important to reiterate that Sukuk need not be issued solely by Islamic entities and need not be invested in solely by investors concerned by their Shari’ah compliant nature. As a result, the potential supply of and demand for Sukuk goes well beyond the Islamic world. Indeed, large proportions of recent international Sukuk have been placed with European (and to a lesser degree) US-based investors and certainly among some institutional investors for whom the Shari’ah aspects of the instruments is not a key factor in their investment decision8. Similarly, there have been – to date – two Sukuk issued from non-Islamic countries (one by the German State of Saxony-Anhalt and the other by a Texan oil and gas exploration and production firm), but this is expected to expand considerably. Both the UK and Japanese governments have proposed issuing Sukuk. Furthermore, French renewable energy company Velcan Energy has recently announced plans to issue EUR200mm in Sukuk to finance a hydroelectric dam project in India.

Turning to our assessment of the potential supply and demand from within the Islamic world, the bottom line is that on a 5 year horizon, the potential demand for Sukuk is likely to far outstrip available supply.

Estimating potential demand for Sukuk In trying to gauge the growth potential of Sukuk as an asset class, it is useful to start from the level of financial penetration Shari’ah compliant products currently have in both Islamic and non-Islamic countries.

The first observation in this regard is that Shari’ah compliant assets (Sukuk as well as more traditional bank finance products) generally do not exceed more than a 20% penetration rate

7 A. Jobst (“The Prospects of Islamic Securitization”, forthcoming) cites market reports estimating corporate and government issuance of USD30bn over the next 3 years. I.A. Alvi (ISFM) estimates that the stock of Sukuk would double from USD25bn in 2006 to USD50bn in 2008. S&P in October 2006 estimated the stock of rated (listed) Sukuks to double from USD10bn to USD20bn by 2010. The Gulf Daily News (May 27, 2007) cites an estimate of USD100bn in Sukuk issuance in the next 5 years. 8 The motivation for such investors to purchase Sukuk lie instead in portfolio diversification, access to Middle Eastern credit exposure, access to Middle Eastern equity markets (in the case of the convertible Sukuk) and, in most cases, relatively attractive valuations compared to similarly rated traditional bonds.



even in Islamic countries, implying the coexistence of Shari’ah compliant products and conventional finance in most countries.9

The total stock of Sukuk (domestic and international) amounts to just 3½% of the collective GDP of the 57 member countries of the Organization of the Islamic conference (OIC)10.

S&P, for instance, estimates total Shari’ah compliant assets at USD400bn, which would be roughly equivalent to 18½% of OIC broad money and roughly 10% of their GDP. S&P also estimates Islamic banking assets to comprise roughly 20% of total in the Gulf.11

The Dubai International Financial Centre (DFIC) estimates the current market for Islamic financial products at USD260bn worldwide and forecasts it to grow 12-15% annually. It estimates current market penetration at 20% of the Arab population, though predicts that number to rise drastically to 50-60% of total savings held within the next decade.

However, the share of Sukuk bond issues in total securitized debt appears to be rising much faster than financial penetration in banking system assets.

In Bahrain, one of the countries most actively promoting Sukuk issuance, Islamic assets still only comprise around 15% of total banking system assets and less than 10% of non-bank financial assets. However, Sukuk issuance already comprises 75% of total outstanding international bond debt.

In Malaysia, which has perhaps the most developed Islamic bond market, Sukuk now comprise a little under 50% of all outstanding domestic and international bonded debt and around three out of every four new corporate bonds being issued is a Sukuk. Islamic banking system assets, however, are still only around 12% of total banking system assets. The government aims to bring this share to 20% by 2010 under its Financial Sector Master Plan.

This coexistence of Shari’ah compliant products and conventional finance is important in that it underscores that the true magnitude of potential demand for Sukuk in Islamic countries is likely as much a function of how much domestic money crosses over from conventional finance products into Shari’ah compliant products, as it is a function of tapping into new pools of currently idle, non-financially intermediated, resources that find themselves lacking Shari’ah compliant investment products. For instance, we estimate end-2006 total net foreign assets in the GCC countries at USD850bn12, up from USD280bn in 2000, and project these to rise to USD1025bn by end-2008 based on our current oil price baseline. Clearly the bulk of GCC NFA assets is currently not invested in Sukuk, and the projected NFA increase for this group of six countries alone far outstrips any estimate for Sukuk growth in the next two years, but it also suggests there is a potential wall of (oil) money that could cross-over and provide sustained demand for Sukuk for many years to come.

9 At the two extremes of the spectrum are Saudi Arabia (its retail banking sector is 90% Shariah compliant) and Oman, where the Sultanate has so far not permitted Islamic banking. 10 Using membership of the Organization of the Islamic Conference or the Islamic Development Bank has some intuitive appeal as these countries are, with some minor imprecision, self-identified Muslim states and have legal systems that are at least partially influenced by Shariah principles. The 57 OIC member states have a combined population of 1.4 billion, of which roughly 1.1 billion are Muslim (based on 2004 UN/WB censuses). This is close to the global estimate of the number of Muslims of roughly 1.5 billion. Countries with large Muslim populations that are not members of the OIC are India (over a 100 million), and Ethiopia (17 million). 11 See “Islamic Banks in Malaysia Less Profitable than Gulf Counterparts”, Standard & Poor’s (July 5, 2006). 12 NFA statistics are by definition compiled on a residency basis and, as such, would exclude any investment by, for example, the Abu Dhabi Investment Authority into Sukuk’s issued by a UAE entity. The purchase of a Sukuk by any other country would, however, be included.



Figure 9: Potential demand for Shari’ah assets is huge, and stems not just from

Muslim majority countries. Population GDP (USD bn) Int'l Debt Stock (USD bn)

Total Muslim % M3/GDP TotalScaled by % Muslim pop. Total Sukuk

Indonesia 201.2 88.2 42.0 364 321 19 -

Pakistan 164.7 97.0 46.4 129 125 2 0.6

Bangladesh 150.4 83.0 54.7 65 54 - -

India 838.6 12.1 73.8 887 107 27 -

Turkey 71.2 99.8 54.6 392 392 48 -

Nigeria 135.0 50.0 20.7 115 58 1 -

Iran 60.1 99.6 36.9 212 212 2 -

Egypt 48.2 94.1 101.6 107 101 5 -

Morocco 33.8 98.7 114.4 57 57 1 -

Algeria 33.3 99.0 55.1 114 113 - -

Saudi Arabia 27.6 100.0 50.7 349 349 3 1.5

Malaysia 17.5 58.6 133.2 151 88 33 2.2

UAE 4.4 96.0 64.6 168 162 39 17.1

US 301.1 1.0 75.3 13,245 132 4714 0.2

EU 493.0 3.5 76.5 14,527 509 11385 0.1

Source: UN/WB censuses 2004, CIA factbook, Haver, Bloomberg, BIS, IMF, DB Global Market Research

Estimating potential supply of Sukuk From a supply perspective, the bulk of issuance is likely to continue to originate from Islamic rather than non-Islamic countries, even if here too there will be a difficult to estimate cross-over component. And the bulk of that supply is likely to originate from the corporate rather than the government or financial sector, at least in the Middle East:

The lack of potential supply from governments is intuitively premised on their current fiscal positions. Approximately half the countries in the Middle East are oil exporters and run fiscal surpluses, implying limited borrowing requirements13. Of total international issuance out of the Middle East since 2002, only 7.2% was issued by sovereigns (15.4% if domestic Sukuk issuance is included as well). That said, many oil exporters are embarking on multi-year investment programs often financed through public-private partnerships or state-owned enterprises (see below). And there are also a number of large non-oil exporting countries with significant Muslim populations and sizeable international debt stocks that have yet to issue Sukuk (Figure 9).

Banks in the Middle East, for their part, tend to be flush with liquidity, in part because of a lack of Shari’ah compliant investment products on the asset side of their balance sheets to absorb the non-remunerated Shari’ah compliant deposits. This implies that while banks are likely to be an important source of future demand, the incentive to issue Sukuk themselves is relatively low.

There is, however, an enormous pipeline of potential corporate issuance (which will tend to include quasi public investment and issuance by state-controlled enterprises). The IMF in its September 2006 Regional Economic Outlook for the Middle East estimated GCC investment plans for 2006-2010 at USD700bn, split roughly equally into the oil and gas sector (funded mainly by national oil companies), infrastructure (funded by public-private partnerships) and real estate (financed principally by the private sector). In a more recent report the IMF seemed to have scaled down these estimates somewhat, but still put GCC infrastructure investment needs for the next two to three years at USD50bn (a

13 In its latest Regional Economic Outlook on the Middle East and Asia, the IMF classifies 14 out of 30 countries in the region as oil exporters; only two of which, Iraq and Syria, have fiscal deficits (almost all countries in the region are members of the Organization of the Islamic Conference). The average fiscal surplus in the Middle East and North Africa for 2007 is estimated at +4.7%, among oil exporters as a group +8.9%GDP and among the GCC +16% of GDP.



subset of the aforementioned total Middle East need). The Governor of the Central Bank of Malaysia has consistently cited a USD1trillion infrastructure investment need for Asia in the next five years, and a similar USD500bn need for the Middle East.14

In our view, if we assume that only 10% of the region’s investment needs will be met by international Sukuk issuance this would still imply a doubling of the existing international Sukuk stock within two years, reaching close to USD100bn by 2010. Indeed, the recent shift in Sukuk offerings from Ijara structures toward Musharaka/Mudaraba issuance is in part explained by the need to satisfy the expansion demands of some of the leading infrastructure, utility and investment companies in the region. So we are starting to see the tip of the investment iceberg. The sleeping giant in all this, and likely a key determinant as to whether the current pace of Sukuk expansion can be sustained, is Saudi Arabia, which is purported to be embarking on a USD250bn investment program of its own, and has plans to displace Dubai as the region’s financial centre in the medium term. To date, however, Saudi Arabia has only issued three international Sukuk in the amount of USD1.5bn.

Factors likely to affect the pace of growth of the asset class Sukuk constitute an expansion of the EM asset class and provide a unique opportunity to gain exposure to the previously difficult to access Middle Eastern region and to diversify portfolios. However, how fast and furious the growth of the Sukuk asset class will be is likely to depend on the ability to continue expanding the investor base, to improve liquidity and transparency, to create a more unified regulatory framework, and to move to some standardization in the structures being used (at present each transaction is different). We identify the following 10 factors (in no particular order) as key determinants of future Sukuk asset class growth:

1. Ability to reduce Shari’ah interpretation risk. Islamic jurisprudence lacks homogenous interpretation, both within and across countries, leading to divergent rulings on the religious compliance and eligibility of certain assets and transaction structures for securitization. This has effectively led to a segmentation between the Malaysian and Middle East Sukuk market, and poses a potential risk for market fragmentation moving forward. The central bank governors from both Bahrain and Malaysia have in a number of speeches called for a harmonization of Shari’ah judgments.

2. Greater standardization and regulatory alignment. Recent efforts at standard setting have helped alleviate some of the legal uncertainty that surrounds Islamic jurisprudence and the lack of market practice. For instance the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) runs a Shari’ah board of 17 religious scholars whose role is, inter alia, to unify the various opinions issued by religious scholars on behalf of individual institutions. However, only eight countries have so far adopted AAOIFI standards as mandatory. In addition, in 2002, the Islamic Financial Services Board (IFSB) was inaugurated in Malaysia, comprising 88 member countries, serving as an international standard setting body of regulatory and supervisory agencies and to develop new, or adapt existing, international finance standards consistent with Shari’ah principles and harmonization of practices within the Islamic finance service industry. Other important bodies are the Islamic International Rating Agency (IIRA) and the General Council for Islamic Banking and Finance Institutions (GCIBFI).

3. Liquidity. So far, the dominant tendency by most investors is still to treat Sukuk as buy and hold investments inhibiting both secondary market liquidity and price discovery. This is attributable to a lack of alternative Shari’ah compliant investment products (e.g. for insurance companies, banks and large institutional investors dominated by government controlled funds), the still limited amount of issuance so far, the shortage of paper

14 See speech by Zeti Akhtar Aziz, “Potential Role of Islamic Finance in Strengthening the New Silk Road” (March 28, 2007).



available for trading, and small issue size (with a few notable exceptions). Also, in some markets the local institutional investor base is still underdeveloped and financial systems remain heavily bank centric. Thus, while the pace of primary market issuance has been impressive, an improvement in secondary market liquidity is likely needed to open the Sukuk market up to a wider base of non-Islamic asset managers.

4. Transparency & ratings. One factor that is likely to significantly enhance secondary market liquidity is an increase in the number of credit rated Sukuk. This has the dual benefit of generating research assessing the originator’s credit risk and providing pricing guidance. We have seen a marked increase in hedge fund demand for Sukuk in recent months as several of the new issuers obtained credit ratings.

5. Lack of alternatives. The flurry in Sukuk issuance in recent years, and the strong demand from non-Islamic investors, would likely not have been as pronounced had it not been for the significant yield compression in EM external debt. Similarly, demand from Islamic investors would likely not have been as strong if regional equity markets had not slumped (see Figure 10).

Figure 10: The surge in middle-eastern Sukuk issuance coincided with the turn in the

Saudi stock market

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6. Changes in tax treatment. Withholding taxes, characterization of income (e.g. whether a stream of payments within a Sukuk represents interest, principal or dividend) and the categorization of the transaction itself (loan, equity investment or asset sale) are common tax issues that arise in Sukuk sales. The UK government recently announced draft legislation that will give companies issuing Sharia compliant bonds the same tax relief as those issuing conventional bonds by allowing them to offset the coupon payments on the securities against the companies profits for tax purposes.15 Moving forward, similar regulatory/tax changes could remove comparable roadblocks in other jurisdictions.

7. Market externalities. Greater demand for Sukuk is likely to go hand in hand with capital market development (particularly the Islamic insurance industry, Takaful).

8. Competition. Several Islamic countries (Bahrain, Malaysia and the UAE) are vying to become a regional center of Islamic finance and there is also competition from advanced economy exchanges such as the Third Market (Vienna) and of course London. This

15 Earlier the government had also lifted the double stamp duty on Islamic residential mortgages and commercial property loans. In the past these loans were subject to two charges as an Islamic loan involved a bank buying a property, then selling it back to an individual or business for a higher price/fee.



competition is likely to encourage innovation, greater transparency and liquidity. The Dubai International Financial Center, for instance, is actively trying to shore up local supply and consolidate secondary market trading (the Dubai International Financial Exchange, DFiX, currently boasts the highest market value of Sukuk listed across the globe). Malaysia last year liberalized restrictions to issue foreign currency denominated financial instruments in Malaysia. Cross-listing of bonds across exchanges is also likely to be an important factor.

9. Government benchmarks, in order to set successful precedents for Shari’ah compliant structures, solve possible first mover problems (in new markets) and provide a pricing benchmark for corporates.

10. Limited quality assets available for Ijara securitization. Shari’ah requires that all financing is raised for trading in, or construction of, identifiable assets, which implies that there is a stronger constraint on issuance size (e.g. upsizing of the deal) than in conventional debt issuance.

Against these ten factors which could help promote the growth of the asset class, is one key factor which could act as a limiter:

Oil prices. One of the reasons Sukuk issuance has taken off is the sharp increase in liquidity in many Islamic countries that are oil exporters. A sharp reversal in oil prices would potentially affect the level of demand.

Credit Risk – how rating agencies approach Sukuk

One of the principal catalysts for the development of the Sukuk market is likely to be the extension of rating coverage to Sukuk issues – thus far only around a third of internationally issued Sukuk has been rated. In view of the added complexity of Sukuk structures and the legal uncertainty produced by the co-existence of commercial law and Shari’ah law, we briefly review the approach to Sukuk ratings by the three main rating agencies16.

Figure 11: New Sukuk are increasingly

being rated...

Figure 12: ...but the majority of the

market remains unrated

0

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2001 2002 2003 2004 2005 2006 2007

All issuesRated

Amount of International Sukuk Issued,US$bn

Unrated, 31

Rated, 18

Proportions by number of deals

Source: Bloomberg, Deutsche Bank Source: Bloomberg, Deutsche Bank, as at mid-August 2007

All three rating agencies have stated that their current rating methodologies and rating scales can accommodate Islamic debt instruments. In the vast majority of cases so far, the rating agencies have treated Sukuk as unsecured rather than secured credit instruments, with the rating reflecting the originator’s credit risk rather than that of the underlying Sukuk assets. This can be largely attributed to the purchase undertaking, which fundamentally alters the

16 This section is based on the following documents: (1) “Fitch’s Approach to Sukuk” (Fitch, March 2007); (2) “Demystifying Corporate Sukuk” (Fitch, March 2007); (3) “Shari’ah and Sukuk: A Moody’s Primer” (Moody’s, April 2006); (4) “Islamic Finance Outlook 2006” (and collection of articles therein; Standard & Poor’s, September 2006); (5) “The Islamic Financial Industry Comes of Age” (Standard & Poor’s, October 2006).



credit risk dynamics of the Sukuk structure. More to the point, rating agencies have pointed out that:

Sukuk are often not true securitizations as the investors do not have recourse to the underlying assets in the event of default. Rather, default would accelerate the purchase undertaking and, if not fulfilled, would trigger a claim on the originator. This claim would be pursued through the commercial court and Sukuk holders would rank as senior unsecured creditors of the originator, similar to the situation in a conventional bond default.

Investors’ risk to the underlying assets is contractually limited and the true credit risk ultimately relates to the originator. For instance, the Sukuk payment stream may be independent of the performance of the underlying asset. In many cases the originator provides a liquidity facility to ensure payments to creditors equal the contractual periodic distributions due on the Sukuk, hence eliminating any volatility in the cash flows deriving from the assets. In addition, because the purchase undertakings take place at a pre-agreed price, the investor is shielded from any valuation risk on the underlying assets.

The fact that credit risk has tended to relate to the originator and not the underlying asset performance has meant that, in practice, long-term ratings of Sukuk do not exceed the originator’s/issuer’s rating. They could, however, have a lower rating if there are additional risk factors specific to the Sukuk.

Only in a minority of cases have rating agencies treated Sukuk as asset-backed securitizations, which in those instances can lead to a higher rating than the unsecured rating of the borrower. For this to be the case, Sukuk holders would need to hold beneficial title over the assets and be able to realize ownership over the assets. This will tend to require (i) a true sale of the assets to the SPV, i.e. the collateral needs to legally belong to the SPV with no prior liens, mortgage, security or other encumbrances and; (ii) bankruptcy remoteness for the SPV, i.e. if the originator goes bankrupt the underlying collateral would be protected within the SPV from a “claw back” (reclaim) by an administrator of the insolvent estate. As recently as March 2007, Fitch noted that none of the transactions it had reviewed satisfied these requirements.

Ratings assigned to Sukuk do not imply confirmation that they are Shari’ah compliant, nor do they require Sukuk to be compliant to be rated17. The rating agencies also do not opine on the validity of a Shari’ah board’s recommendation or decision, and it is recognized that other Shari’ah scholars may disagree with the originator’s Shari’ah board18. Such instances of disagreement are generally not expected by the rating agencies to affect the legal enforceability of the Sukuk (though they may affect demand for, and liquidity in, the Sukuk but that is separate from the assessment of credit risk). Internationally issued Sukuk are generally governed by English or NY law – similar to a normal bond – but like a normal bond enforcement of a claim would likely be subject to review of the courts where the originator is domiciled. These courts would generally act in accordance with commercial law. To the extent the local courts are influenced by Shari’ah law this adds uncertainty to any judgment and may complicate recovery, but uncertainty relating to the legal enforceability of a claim, and risks related to local courts, are also present under commercial law and would be embedded in an issuer’s rating.

17 S&P, however, notes that all Sukuk it has rated are structured with the approval of a Shari’ah board. 18 If Shari’ah non-compliance is included in the documentation as a dissolution event, the rating agency may perform liquidity analysis to ensure the originator has sufficient available resources for the purchase undertaking, if the event were to occur. Generally, dissolution events in Sukuk documentation are similar to events of default in conventional bond prospectuses.



Sukuk Pricing and Secondary Market Behaviour

The increasing number of Sukuk that have been assigned ratings by the international credit rating agencies has certainly been an important factor in helping to broaden the appeal of the asset class among international investors. In addition to providing specific research on the issues, the provision of a rating provides a means of comparing the pricing of such Sukuk with comparably rated traditional corporate bonds. In Figure 13 we illustrate the rated Sukuk that have been issued over the past year, along with the average level of the spread of similarly rated US corporates as observed at the time of the relevant Sukuk issuance. It should be noted that there is a wide range of spreads within each rating cohort in the US corporate universe, hence the relative spread of any individual Sukuk to the average of similarly rated US corporates should not be taken as a clear indication of richness or cheapness. Nevertheless, the fact that the Sukuk have priced consistently wide to US corporates is perhaps indicative of a structural factor in the pricing of the asset class. Namely, that Sukuk are cheap to comparable credits in the US. Such cheapness would certainly explain the significant appetite for recent Sukuk from international institutional investors, but it could also be argued that some cheapness is justified given the additional complexity of Sukuk documentation, even if – ultimately – the economics of the instrument from the perspective of the holder are virtually identical to those of a traditional bond.

Figure 13: Recent rated Sukuk have been consistently priced wide of comparably

rated US corporates at issue

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Issue Spread Spread of US Corps of equivalent rating and tenorSpread overUS Libor Curve, bp


The development of an active secondary market has substantially lagged the primary market, although the first half of 2007 has seen a significant increase in turnover. Figure 14 lists the current most traded Sukuk with an indication of their approximate relative liquidity.

Of the five most actively traded Sukuk, two are pure fixed-income Sukuk, while the other three are equity linked.

Pure fixed-income Sukuk

DP World 17 sees the most diversified interest with frequent trades by Asian/US/European as well as ME money managers. A normal ticket size would be USD 5mm, although trades up to USD 25mm have been done. An average day would see about USD15-20mm of DP World 17s trade.

DIFCDU was extremely popular soon after issuance with trades of USD 25mm commonplace. The average ticket size has now fallen to USD 5mm. An average day would see about USD10-15mm of DIFCDU trade.



Equity-linked Sukuk

ALDAR is by far the most active sukuk in terms of frequency of trades on a given day, due to the fact that the equity conversion is well in-the-money and hence pricing is governed entirely by the underlying stock – which is itself active. The average ticket size is around USD 5mm. On a quiet day daily volume would be around USD 10-20mm, but this can go up to USD 60mm on a day in which the underlying stock is volatile.

Nakheel is fairly active and popular with hedge funds in particular. Typical trade size would be USD 10mm, but can be up to USD 50mm. An average day would see around USD 20-25mm trade in the market.

PCFC is event-driven thanks to the proximity of its maturity (Jan 2008) and the implications of an IPO prior to then (see Appendix A for details). Average trade size is around USD 5mm. However, trading activity is rather infrequent. A quiet week could see USD 5-10mm trade, whilst an event-driven week (IPO speculation) could see USD 70-100mm trade in the market.

DB’s Emerging Market interactive pricing and analysis platform – QuantEM – now includes the most liquid Sukuk with daily prices, yields and spreads along with historical data. QuantEM is available to DB clients at http://gm.db.com/quantem. See Figure 15 (on page 21) for an illustration of the QuantEM sukuk screen.

Figure 14: Summary of current most liquid Sukuk Amount Issued Rating

Liquidity Ticker Originator Issue Date Original Tenor Maturity Coupon (USD mm) Structure Equity LInked S&P Moody's Fitch

ExcellentDPWORL DP WORLD SUKUK Jul 07 10 Jul 17 6.25 1,500 Mudarabah A+ A1DIFCDU DUBAI SUKUK Jun 07 5 Jun 12 L+37.5 1,250 Mudarabah A+ A1ALDAR ALDAR FUNDING Mar 07 5 Nov 11 5.767 2,530 Mudarabah YNAKHL NAKHEEL DEVELOP Dec 06 3 Dec 09 Complex* 3,520 Ijara YPCFC PCFC DEVT FZCO Jan 06 2 Jan 08 Complex* 3,500 Musharaka Y

GoodDARARK DAAR INT SUKUK Mar 07 3 Mar 10 L+200 600 IjaraAABAR AABAR SUKUK LTD Jun 06 4 Jun 10 6.894 460 Mudarabah YEMIRAT WINGS FZCO Jun 05 7 Jun 12 L+75 550 MusharakaPKSTAN PAKISTAN INT Jan 05 5 Jan 10 L+220 600 Ijara B+ B1DGSI DUBAI GLOBAL Nov 04 5 Nov 09 L+45 1,000 Ijara

OkEIBSUK EIB SUKUK LTD Jun 07 5 Jun 12 L+30 350 Musharaka A A1eIIGF IIG FUNDING LTD Jun 07 5 Jul 12 6.75 200 Mudarabah YGOBLT GOLDEN BELT May 07 5 May 12 L+85 650 Ijara BBB+ Baa1DIBUH DUBAI ISLAMIC BA Mar 07 5 Mar 12 L+33 750 Musharaka A A1

PoorADIB ABU DHABI ISLAMI Dec 06 5 Dec 11 L+40 800 Musharaka A2 ASIB SIB SUKUK CO LTD Oct 06 5 Oct 11 L+65 225 Ijara BBBTABRED TABREED 06 FIN C Jul 06 5 Jul 11 L+125 200 Hybrid BBB-QATAR QATAR GL SUKUK Oct 03 7 Oct 10 L+40 700 Ijara AA-

Source: Deutsche Bank, ratings agencies, company data



Appendix A – Equity-linked Sukuk As has previously been mentioned, the introduction of Sukuk with convertible features was a key catalyst for the asset class, bringing in new investors and allowing for larger issue sizes. Since these Sukuk are among the most actively traded Sukuk and also given that they have rather more complex terms than the majority of Sukuk, it is worth briefly reviewing the different types.

The equity-linked Sukuk can be divided into two groups: true ‘convertible’ Sukuk and Sukuk bearing pre-QPO subscription rights.

Pre-QPO Sukuk

Pre-QPO Sukuk include QPO subscription rights which give the Sukuk holder the right to participate in any Qualifying Public Offering of the obligor (and generally also associated companies).

PCFC 2008 The 2Y Sukuk issued by the Dubai Ports, Customs and Free Zone Corporation is a zero-coupon issue which may be redeemed in part through the issue of PCFC shares on the occurrence of one (or more) QPOs.

In the event that there is no QPO during the life of the Sukuk, the accumulated annual return is 10.125%. Holders will receive the principal amount, plus this higher accumulated return, in cash. For a USD100 face amount of Sukuk, this equates to a redemption amount of USD120.25

In the event of a QPO, holders will receive an accumulated annual return of 7.125% up to the date of the QPO. The principal amount of the notes, plus the accumulated return, will be dispersed 70% in cash, 30% in QPO shares (at the QPO price). 50% of the shares are delivered on the QPO redemption date, the remaining 50% being delivered after a ‘lock-up’ period of three months. The size of the QPO may be less than would be required to redeem the entire Sukuk, in which case the redemption is conducted on a pro-rata basis. The terms allow for the Sukuk to be redeemed in parts via a sequence of separate QPOs.

Nakheel 2009 The 3Y Sukuk issued by the Nakheel Development Corporation in December 2006 are somewhat simpler in that they carry pre-QPO subscription rights, giving the Sukuk holder the right to participate in any QPO at a discount to the QPO price of 5%. The yield on the Sukuk is 6.345%, although only half of this is paid on a periodic basis (semi-annually) during the life of the Sukuk. At final redemption (which will be in December 2009 regardless of whether a QPO occurs or not) the remaining half of the yield is paid. For a USD100 face amount of Sukuk, this equates to a redemption amount of USD109.5175 (100 plus 3.1725% for three years).

As with PCFC, the yield on the Nakheel Sukuk is reduced in the event that a QPO occurs.

In the event that there is no QPO during the life of the Sukuk, an additional 2% of the face amount is paid to Sukuk holders.



If a QPO does occur, Sukuk holders have the right to participate in the QPO at a discount of 5%. The amount of QPO shares available to Sukuk holders at any QPO depends on the total size of that QPO (up to 30% will be available to Sukuk holders) and only up to 25% of the face amount of the Sukuk. In the event that less than the full 25% of QPO subscription rights are attributed during the life of the Sukuk, an additional payment is made to Sukuk holders on a sliding scale from 2% to zero depending on the proportion of rights attributed (between zero and 25%). As with PCFC, the QPO shares are also subject to a lock-up period: 34% are delivered immediately, 33% after one month and the final 33% two months after the QPO.

For the purposes of valuing the pre-QPO Sukuk, it is simplest to consider two alternative cashflow streams for each – one assuming no QPO takes place, the other assuming a full QPO occurs. Within QuantEM we display the yields and spreads corresponding to these two alternatives given the current price of each Sukuk. In the QPO case we conservatively assume that there is no incremental value in the QPO shares and we also ignore the QPO discount in the case of Nakheel.

At current prices, the spread over the US libor curve for PCFC-08 (mid price 115.625) is +345bp assuming no QPO, but is -797bp assuming a QPO takes place. With less than six months until maturity, the pricing of this Sukuk is highly sensitive to whether a QPO takes place or not. Certainly the market current appears to attach a high probability to there not being a QPO.

Convertible Sukuk

At the time of writing, five true convertible Sukuk had been issued. Two of these are among the most actively traded international Sukuk.

AABAR 2010 Exchangeable at anytime between June 28, 2008 and the scheduled redemption.

Converts to 917.8522 shares. Current share price is AED 3.59, implying a parity of USD 89.71. The current price of the Sukuk is 106.50 (mid), which equates to a libor-spread of -57bp.

Even though the exchange is currently out-of-the money, the fact that the Sukuk is trading with a negative spread over the US libor curve suggests that a small value is being attached to the exchange option.

ALDAR 2011 Exchangeable at anytime between September 10, 2007 and 25 day prior to scheduled

redemption.

Exchange for 645.161 shares. Current share price is AED 6.63, implying a current parity of USD116.46. This equates to a libor spread on the Sukuk of -342bp.

The exchange is substantially in-the-money and as a result the price of the Sukuk is governed entirely by the price of the underlying stock.

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Figure 15: DB’s Emerging Market Pricing Platform – QuantEM – provides data and analysis on the most liquid Sukuk

http://gm.db.com/quantem




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