The continuing allure of sukuk investments and their risks

The continuing allure of sukuk investments and their risks

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There has been a perceptible rise in interest in sukuk investment by both private individuals and governments issuing sukuk bonds like the Saudi Ministry of Finance monthly sukuk offerings.

This has prompted the global index provider Financial Times Stock Exchange Russell to announce that Saudi Arabia’s sukuk will be added to its local currency Emerging
Markets Government Bond Index effective from April 2022 and will comprise 2.75 percent of the index. The current outstanding Saudi government sukuk is around SR306 billion ($81.6 billion). All investments however face risk, as risk adversely affects the value of any asset pricing, irrespective of whether those are conventional bonds or Shariah-compliant sukuk.

While some investors might feel that sukuk risk is minimal compared with conventional bonds, sukuk faces a different type of risk. The most important is the market risk or the price fluctuation or risk interest to the entire market that cannot be avoided through diversification. Then there is operational risk, which involves the structure of the sukuk issuance, as well as Shariah-compliance risk, the result of the sukuk issuer’s breach of responsibilities with respect to compliance with Shariah guidelines. Finally, there is default risk like conventional bonds, which is the risk that an asset becomes irrecoverable due to a total default or delay in payments. Despite these risks, many governments in the Middle East prefer to issue sukuk instead of conventional borrowing, especially for large development projects and fund managers and investors have now added such investments in their portfolios.

According to the Saudi Capital Market Authority, the inclusion of the Saudi sukuk in the FTSE Russell EMGBI index will contribute to expanding the base of investors and improve its level of liquidity.

The basic essence of a sukuk lies in the concept of “asset monetization,” which is a securitization of tangible assets like real estate or other cash-generating assets through the process of issuing sukuk against future cash flows. The sukuk, in essence, transforms a physical tangible asset’s future cash flows into present cash flows.

Unlike a conventional bond, where it represents a pure debt of the issuer, a sukuk represents both risks on the creditworthiness of the issuer as well as an ownership stake in the existing or well-defined asset or project.

At maturity of the sukuk, the Special Purpose Mudarababah established to hold the asset starts winding up first by selling the assets back to the original seller/owner at a pre-determined price and then paying back to the sukuk investors.

The price is pre-determined to protect capital loss to investors, hence the increased attractiveness of such an investment class.
As such, sukuk with well-defined asset leases and income flows are generally a good investment for those seeking longer-term investment planning, or for retirement planning, especially with investment-grade rated sukuk.

As financial markets become more complex and international investors and regulators have increased their reliance on the opinions of credit rating agencies, ratings are often graded into two broad categories — investment grade and non-investment grade and rating agencies, such as Standard and Poor’s or Moody’s, which assess the quality of the various sukuk issued by measuring their default risk.

Default rates are very low for the higher-rated AA or AAA sukuk as the majority of sukuk issued by Gulf countries — Saudi Arabia in particular — have received high credit ratings due to their issuance by well-known government and semi-government entities, such as Saudi Basic Industries Corp., Saudi Electricity Co., Saudi Telecommunication Co., and Saudi Aramco. Ratings on sukuk then reflect the creditworthiness of the issuer and the stability of the sukuk, as the performance of the sukuk issuer highly affects the final ratings of the sukuk itself rather than the guarantees.

As noted, sukuk is a growing source of Islamic financing, and credit ratings will play an important role in assessing sukuk creditworthiness. This is to ensure that the cost of sukuk issuance remains low, making them attractive to an investment portfolio and enabling high-quality sukuk to be launched. Issuers of sukuk expect that an efficient, transparent, and rated sukuk market will ultimately lower their cost of funding, and conversely, investors would prefer sukuk as it widens their opportunity with more choice on the maturity and portfolio selection as well meeting their religious and social beliefs.

• Dr. Mohamed Ramady is a former senior banker and professor of finance and economics at King Fahd University of Petroleum and Minerals in Dhahran.

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