Published March 18, 2009

Islamic investors snap up rental bonds as risks rise

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(KUALA LUMPUR) As the global downturn drags on, battering investor confidence and asset values, Islamic finance markets are expected to increasingly favour the certainty of lease-based bonds over profit-sharing structures to minimise risks.

With key sectors such as Dubai property and Malaysian manufacturing in a slump, Islamic banks have grown wary about financing through the once-popular musharaka structure that requires lenders to share a project's risks and rewards.

'Musharaka-based sukuk involve market exposure and not solely exposure to default risk as with ijara sukuk,' said Rodney Wilson, an Islamic finance specialist with the Qatar Foundation.

'Given the current uncertainty in equity markets, I do not believe many potential sukuk investors would want musharaka sukuk in present circumstances. If the market revives and confidence is restored, this may change, but this is unlikely in 2009.' Issuers and investors are expected to lean towards ijara or rental-based financing where possible, or look to create new lending structures in the US$100 billion sukuk, or Islamic bonds, market.

In musharaka, parties contribute capital to a venture with profits to be shared according to an agreed ratio, while losses are generally divided as per the capital contribution ratio.

Sukuk ijara, rental bonds that are embraced by syariah scholars worldwide, were the most popular form of Islamic bonds last year, according to rating agency Moody's.

Standard & Poor's estimated that more than 45 per cent of Islamic bonds issued in 2008 were structured according to the ijara principle. Ijara is a lease where a bank buys an asset and rents it to its client for a fee that includes the purchase price and the profit rate to be earned by the bank during the rental period.

Favoured for its relatively simple structure and widespread endorsement by syariah scholars, sukuk ijara received a boost in popularity after an industry regulator cast doubt on the validity of sukuk mudaraba and musharaka.

The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) ruled last year that repurchase undertakings - pledges found in most Islamic bonds that the borrower would pay back their face value at maturity - violate the duty to share risk in sukuk mudaraba and musharaka.

Issuance of musharaka and mudaraba sukuk fell 83 per cent and 68 per cent respectively last year, Moody's said.

Some bankers and scholars attributed the drop to the AAOIFI ruling, which has prompted the industry to take a fresh look at current structures.

'Due to the current turmoil and the failure of conventional structures, especially the highly-leveraged ones, more investors are expected to be drawn into learning what the syariah-compliant structures are about and that could re-define musharaka and mudaraba sukuk as a class of its own,' said Helmi Harunarashid, treasury and capital markets general manager at Bahrain's Elaf Bank. -- Reuters