Two years ago, Shariah-compliant bonds, or sukuk, began facing the first major test of their structures. The global crisis, paired with overinvestment in the Gulf Region, conspired to trigger a number of defaults that some observers believed would prompt investors to drill deeper into deals, and possibly favor those that were true securitizations.

Then last year sukuk roared back to life - by Standard & Poor's account, volume hit a record $51.2 billion (See graph below). In the first two months of this year, the figure is $16 billion, suggesting that the renewed energy has not petered out.

But as it has turned out, the asset-based model, where investors do not have recourse to the collateral, has re-asserted its overwhelming primacy.

Participants in the field say that the game is not over for asset-backeds. A number of factors explain why they have not made their mark in the crisis aftermath, and the time line for more substantial change in this arena could be longer than just a couple of years.

Sukuk in Trouble

The sukuk market was roiled in 2009-2010 by defaults of major issuers such as the U.S.'s East Cameron Partners, Kuwait's Investment Dar and the Saudi Saad Group, as well as by Dubai World's debt restructuring, which included the sukuk of property unit Nakheel.

During workouts, some investors were apparently dismayed to learn that they had no recourse to the assets linked to deals. As a way of avoiding paying interest - forbidden under Shariah law - sukuk are linked to a tangible asset. But the majority of transactions are asset-based as opposed to asset-backed, meaning that investors do not have recourse to the collateral per se but rather to the cash flows.

Not all sukuk in trouble, however, failed the true-sale test. Structured explicitly as an asset-backed, the East Cameron Gas Co. sukuk proved to participants that this approach to sukuk works, at least under U.S. law.

One of the reasons for its asset-backed structure was the risky nature of the transaction, which scored a 'CCC+' rating from S&P at issuance.

East Cameron was a 13-year sukuk for $165.6 million issued in 2006. The deal was backed by overriding royalty interests (ORRI) linked to gas and oil compounds extracted from deposits in the Gulf of Mexico. S&P downgraded the transaction to 'CC' in January 2009 when the structure hit a trigger, breaching a 90% minimum stressed reserve level of the hydrocarbon mix threshold.

In March 2009, the agency cut the deal to 'D' on skipped payments and withdrew the rating, the latter event in response to a failure to receive servicer reports.

The deal initially stood at 'CCC+' largely because significant amounts of the energy deposits that collateralize the deal were proven undeveloped at that time. Merrill Lynch was the sole bookrunner and co-arranger with Beirut-based BSEC.

The breach occurred after the originator, East Cameron Partners, filed for Chapter 11 in Louisiana. The company also sought to basically re-characterize the true sale of the ORRI to East Cameron Gas as a secured loan. When the deal closed, the structure's legal opinion characterized the transfer as a true sale, giving investors claim to the underlying assets. A judge in the case initially ruled that the true sale was valid but left room open for the originator to make further arguments.

In March of last year, the judge ordered the parties to transfer the title of the leases to the sukuk holders, upholding the true-sale nature of the structure. During the bankruptcy, the sukuk holders extended debtor-in-possession loans to the originator for about $4.8 million and eventually purchased the bulk of East Cameron Partners' assets in a 363 sale for a credit bid. As a result, the investors ended up recovering value. They retained the ORRI handed over via the true sale and purchased the originator's residual working interest in the oil and gas assets through the credit bid, essentially converting the debtor-in-possession loans to equity.

Deals of the asset-based variety obviously did not end up with investors snagging the collateral, and yet it appears that not everyone was always clear about the fact that these were not true ABS. "[Through the crisis] an asset-based sukuk was far more likely to end up in dispute through the law courts than an asset-backed," said Lee Sims, head of treasury and capital markets at Gatehouse Bank, a London-based Shariah-compliant investment shop.

Despite this, asset-backeds have made a poor showing in the revival that the sector staged last year.

Corporates Could Spur Asset-Backeds

One reason for this is that the sector most apt to produce an asset-backed - namely corporates and banks - made up a tenth of all issuance last year.

As S&P pointed out in a recent report, on a cumulative basis between 1996 and 2010 sovereigns and quasi- sovereigns made up 53% of sukuk, with 41% placed by corporates and 6% by financial institutions. Since mid-1998, however, the sovereign and quasi-sovereign issuers have all but monopolized the market. Last year they made up 90% of issuance (See chart below).

Sovereign sukuk issuers are a bad fit for asset-backeds. The idea of investor recourse to a government-owned asset, for starters, is tough to imagine. In sovereign deals, an asset in a sukuk is often state-owned land. "Would investors have recourse to state land? The answer is no," said Sims. "What they will have recourse to are the cash flows provided from that land or property."

In addition, from the investor perspective, recourse to the asset matters far less when a deal is linked to a sovereign, especially a highly rated one. "The recourse doesn't even cross their risk departments, simply because it's a sovereign issue," Sims added.

It is with corporate issuers that the asset-backed vs. asset-based decision will matter to investors, he said. "The corporate market is where investors will be far more savvy [about] where the recourse is," Sims added. He said that the market is moving toward an environment where more investors will expect to see an asset-backed sukuk unless the issuer is sovereign or quasi-sovereign.

But there first must be significant corporate issuance for this potential to emerge, and corporate issuance may take longer to gain traction than a year into the sukuk comeback.

A more robust global economic recovery is key for corporates and financial institutions to come back to the sukuk market in earnest, sources said.

"Privately- owned corporate companies coming back meaningfully to the market is not a prime expectation in the medium term, unless the global economy shows signs of longer-term stability," said S&P Credit Analyst Paul-Henri Pruvost. But he adds that anecdotal evidence suggests that in the Gulf Cooperation Council (GCC) - Saudi Arabia, Kuwait, Bahrain, Qatar, the United Arab Emirates, and the Sultanate of Oman - investors may be already showing signs that asset-backeds will eventually be more welcome. While they are going into sovereign and quasi-sovereign sukuk often for liquidity purposes, they have turned down other deals either because documentation was insufficiently clear or because they were, at times, uncomfortable with the asset-based structure.

Pruvost believes that Shariah-compliant investors and others that buy into these deals will eventually appreciate the differences between the asset-backed and asset-based sukuk more. He does not, however, think the handful of recent restructurings served as the ultimate test cases. "This is still new. There is still little track record of investors, banks [and other participants] coming together and saying 'look, we have a sukuk that is defaulting; we have to understand what it means, especially in terms of practical considerations around defining conditions, proportions and timing of recoveries,'" Pruvost said.

Reign of Malaysia

Since their comeback, sukuk have not only been heavily skewed toward sovereign issuers. They have been linked overwhelmingly to a single country: Malaysia. About 78% of all sovereign and quasi-sovereign deals came from the Asian country in 2010. This reversed the trend before the crisis, when Gulf countries such as Saudi Arabia, Bahrain and the United Arab Emirates were able to make significant inroads into what had been previously been Malaysia's turf.

Still, the GCC nations are expected to increase their share of the sukuk market over the next five years, according to the S&P report. Qatar and the United Arab Emirates in particular are good candidates, featuring, according to the agency, "relatively sizable and advanced domestic Islamic banking industries, as well as huge infrastructure projects that will require substantial financing."

Nevertheless, funding projects will not necessarily be the main impetus for sukuk issuance from the region. Many of these countries have deep coffers and will also be using sukuk to provide Islamic liquidity instruments and create benchmarks as well as to actually finance themselves. "Here it's the opposite of the U.S. and Europe: most of the governments are relatively underleveraged," said Khalid Howladar, senior credit officer at Moody's Investors Service. "But it's maybe not a bad thing for fiscal discipline to have a little debt."

Bahrain Unrest

One question mark hanging over issuance is social unrest and calls for political change in the region. This has caused sukuk spreads in general to edge out more than other types of emerging market debt, even for issuers domiciled in countries seen as stable.

Among the major countries for sukuk issuers, serious political instability has for now been confined to Bahrain and, to a smaller extent, Oman. Governed as a constitutional monarchy, Bahrain is currently under martial law following protests calling for political reform. The turmoil has exposed fissures between a Shiite majority and a Sunni minority, which rules the country.

"The only real issue for me would be Bahrain," said Gatehouse Banks' Sims. "I have a great deal of confidence that the right things will happen in Bahrain. The overall environment will be...very conducive to business within the Gulf."

Pruvost pointed out that Bahrain had been a pioneer in issuing sukuk, and the country's central bank floats sukuk treasurys regularly. "We don't think [the political unrest] will really imperil the sovereign capacity to issue sukuk going forward," he said, "since amounts issued are small relative to the kingdom's liabilities, and the market is still hungry for soundly rated paper. There might be an increase in the risk premium, however."

Regardless of how political change shakes out in Bahrain or other countries in the region, Pruvost added that over the next three years Malaysia's dominance is likely to hold.

Megabank to Tackle Liquidity

Sovereigns are not necessarily in competition with corporates. Greater issuance by sovereigns helps build a curve that is helpful for price discovery when corporates float deals. Government benchmarks that would facilitate long-term sukuk are lacking in most markets.

And on the buy side, while conventional dynamics of cost and return govern sukuk just like any other debt instrument, there is still the unmet appetite of Islamic banks. "Vanilla issuances by sovereigns haven't fixed the liquidity problem for Islamic banks - there isn't enough volume," said Moody's Howladar. "They're saying, 'I need liquid investments. Where are the liquid sukuk to park my cash short-term while I'm looking for lending and financing opportunities?'"

With this problem as one of the catalysts, the central banks of 12 countries and two multilaterals with interest in Shariah-based financing founded the International Islamic Liquidity Management Corporation (IILM). According to the Islamic Financial Services Board (IFSB), one of the main objectives of the IILM will be to "facilitate greater investment flows of Shariah-compliant instruments across borders."

The IILM will likely issue triple-A sukuk, Howladar said. "They can withdraw and put liquidity in the system as needed, making a two-way market," he added. "It's no small achievement to bring together all these central banks."

News reports indicate that the IILM may issue its first deal this year. Whether the bank will push a particular sukuk structure remains to be seen. As a multilateral bank it will likely go for the asset-based model.

At press time, it was unclear that much progress had been made in the months since the bank's inception. The IILM apparently had no Web site, and an e-mail to the IFSB regarding the IILM was not answered.

The political will behind the bank, however, would seem to give it a better chance of creating some sort of unity in a notoriously fragmented market.

Recommendations put out by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOFI) in early 2008, which basically endorsed asset-backed deals, do not seem to have triggered any standardization. "The AAOFI statements were pretty clear, and the institution's quite prominent but it doesn't really seem to have affected the shape of the sukuk market," said Howladar, who added that nonetheless it could yet be an important engine for change.

Pruvost added that with a lack of a centralized authority or guiding principles, participants make their own interpretations of initiatives and statements put out by the AAOFI or IFSB. "The main issue here is still standardization," he said. "You've got jurisdictions here and there dealing with sukuk defaults, but no overall framework."

Beyond Malaysia and the GCC

In addition to the IILM, there are countries outside Malaysia and the GCC that have expressed an interest in entering the market. Kazakhstan, for instance, has been making statements to the press to that effect, including talk about corporate sukuk issuance as early as the summer. Turkey, meanwhile, has been passing laws that would facilitate sukuk issuance. "[Turkey] would be really impressive given the secular nature of the country," said Gatehouse's Sims. "What we'll see is a move to the East, the Stans, and it will be correlated to an overall pick up in the economic cycle."

And in the countries where sukuk have deeper roots, their use will continue to be shaped by the same rules of supply and demand, risk and return, as other, secular financial products. "Sukuk market growth is a function of the regional debt market," Howladar said.

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