Sukuk Rating Process Influenced by Sharia, but Does Not Confirm Sharia-Compliance

Sharia (Islamic rulings) influences the sukuk rating process, says Fitch Ratings, through sukuk structuring, recourse to the obligor, debt ranking of obligations, amount paid on maturity, acceleration of repayment prior to maturity, enforceability of investor rights, and recovery upon default. Most international sukuk are structured to create an economic effect similar to bonds, and in a sharia-compliant manner. Whilst Fitch assesses sharia non-compliance if it has credit implications, sukuk ratings do not imply any confirmation that the sukuk are sharia-compliant.

Sukuk generally have more complex structures than conventional bonds due to sharia requirements. Sharia mainly influences the credit profiles of sukuk during three stages: initiation and issuance, during the tenor of the sukuk, and at maturity or occurrence of a dissolution event. If the sharia implications cannot be quantified under Fitch’s criteria for rating sukuk, this may mean that the sukuk are not rateable by Fitch.

Upon initiation and issuance, the structure of sukuk could be determined by multiple factors, such as the assets available with the obligors and the assets’ characteristics, issuance purpose, tax and regulatory considerations, target investor base and sharia requirements.

During the tenor of the sukuk, non-compliance with sharia principles could trigger several credit events. In many international sukuk issued since 2021, the tangibility ratio falling below 33% would result in the exercise of put options by sukuk investors to redeem the dissolution distribution amount, along with delisting the certificates, with potential liquidity implications for the issuers. Sukuk investors could have an advantage over bond investors in their ability to accelerate repayment before maturity.

Sharia can also influence payment upon maturity. Among Fitch-rated sukuk, contractual commitments include timely full payment of sukuk principal and periodical distribution during the life of the sukuk, and on maturity or any dissolution or default event. However, for some sukuk structures, the sharia scholars require the repurchase price on maturity or an event of default to be at the fair market value, rather than a fixed amount (such as the original sale price). This could impact the amount repaid to the sukuk holders, making the sukuk unrateable under Fitch’s sukuk rating criteria.

Enforceability of investor rights, recoveries upon issuer default, recourse, and debt ranking could be complicated by the differences in the underlying Islamic contractual arrangements. Recovery and enforceability are significantly different among jurisdictions. This is not only applicable to sukuk but also to the conventional bonds issued in the same country.

Sukuk issued on the international capital markets are typically governed by English law, but part of the documentation and any judgement would also be governed and reviewed by the courts where the originator is domiciled – and would be subject to local restrictions on enforceability. A local court’s interpretations of commercial laws may be influenced by sharia considerations in many Muslim-majority countries, which adds further uncertainty to any judgement.

There is also a lack of legal precedents. Only 0.24% of all issued sukuk to end-1Q23 have defaulted. Bankruptcy regimes in key sukuk-issuing jurisdictions are still in the early stages of development, remaining largely untested. It remains to be seen how bankruptcy courts treat sukuk defaults compared to bond defaults, whether investors will have full recourse to the issuers, and if sukuk holders will be able to enforce their contractual rights in local courts.

Fitch’s Sukuk Rating Criteria applies to originator-backed (or “asset-based”) sukuk structures, and the sukuk rating is driven solely by the originator’s rating. Most Fitch-rated sukuk are senior unsecured obligations of the issuer and rank pari passu with other senior unsecured obligations, including bonds. Of Fitch-rated outstanding sukuk, 78.5% were investment-grade in 1Q23.