The RAM-rated sukuk market had earlier experienced an influx of debt-based sukuk such as Murabahah and BBA. At the time, underlying sukuk contracts followed a linear, straightforward approach; sukuk had been raised pursuant to a contract of sale, with the most common based on the principles of Murabahah and BBA – the earliest form of sukuk contract and structuring. The origination of debt-based sukuk was underpinned by the BBA concept, whereby the sale contract between the issuer and the seller consequently results in an obligation from the issuer.
On the other hand, Islamic partnership contracts are best represented by equity-based principles, i.e. Mudharabah and Musharakah, which are – simply – Shariah-compliant modes of pooling capital. Partnership-based sukuk departs from a typical debt-based arrangement to a profit- and loss-sharing agreement that seeks to provide a pay-off to the sukuk investors. This is based on the performance of the underlying business in which the sukuk investors have undivided proportionate interest in the partnership venture.
Murabahah and BBA had been followed by other principles such as Mudharabah and Musharakah, which proved sustainable in the market, particularly in RAM’s rating history.
This article will focus on the trend of debt- and equity-based contracts, as well as the dominant underlying Shariah principle in RAM’s portfolio.
Composition of Islamic contracts – the evolution
The composition of Islamic contracts has undergone significant evolution, with debt-based structures having dominated the scene until 2005. Sukuk issues based on the debt contract come up to RM64.2 billion to date. In the first decade of RAM’s presence in the sukuk market, Murabahah and BBA had formed the underlying principles that had facilitated sukuk issuance (refer to Charts 1 and 2).
The transition of Shariah contracts had also been in tandem with the market’s understanding of sukuk. Between 1990 and 2000, the Malaysian sukuk market had been in its nascent stage. Much attention had been focused on the introduction of the market, the players, and the concept as well as the mechanism of sukuk – a phase when ”awareness” by the stakeholders (including potential investors and issuers) had been key to the growth of sukuk structures.
With the release of the Securities Commission’s (“SC”) Islamic Securities (“IS”) Guidelines in 2004, the market started to realise that sukuk also represented the securitisation of “tangible assets” under lease, implying that the definition is not strictly limited to a pure debt facility. This had led to an exploratory phase for the Malaysian sukuk market, during which it had ushered in a new breed of sukuk using equity or partnership contracts. The IS Guidelines allowed the development of more diversified and innovative sukuk structures that applied participatory or equity contracts, with no direct creation of debt obligations evidenced by the sukuk. Notably, the ability to structure sukuk without resorting to primary debt creation helps to dispel Shariah concerns on Bai Inah and Bai Al Dayn.
Sukuk rating for RAM kicked off with the debt-based RM300 million Murabahah sukuk issued by Petronas Dagangan Berhad in 1994. It had also been the first Islamic instrument to be listed on the Kuala Lumpur Stock Exchange (now Bursa Malaysia). At that time, and as with markets in their early developmental stages, the number or choice of structures had been limited – confined to only debt-based sukuk. Equity contracts, particularly Musharakah (Esso Malaysia Berhad’s Islamic commercial paper was the first RAM-rated Musharakah issue in 2004), experienced a boom in 2006, mainly attributable to a “shift in mindset” that had resulted in significant issues from Rantau Abang Capital Berhad and Projek Lebuhraya Utara-Selatan Berhad.
The partnership-based contract would later be a prominent feature in the sukuk market, with issuers steadily embracing the idea of moving towards risk-sharing contracts in the Malaysian sukuk market. Last year, however, marked a significant return to debt-based contracts; Murabahah recaptured the market, largely due to the increasing use of the concept of commodity Murabahah via Tawarruq (refer to Charts 3 and 4 for the trend of debt- versus partnership-based contracts). The spike in the use of the Murabahah contract had been driven by the ongoing innovations in Malaysia and the push for liquidity. One such initiative is to set up the world’s first Shariah-compliant commodity-trading platform that offers an infrastructure for Islamic liquidity and promotes cross-border transactions. In Malaysia, the Commodity Murabahah Programme (“CMP”) had been designed as the pioneer commodity-based transaction, where the underlying assets are contracts based on crude palm oil. Commodity Murabahah transactions formed the bulk of RAM-rated issues in 2012, valued at RM23.3 billion and constituting 63.8% of all RAM-rated sukuk issues for the year. The increased use commodity Murabahah had boosted debt-based sukuk and become the preferred type of Islamic contract in 2012. Nonetheless, we believe that Musharakah will maintain a strong presence in the near to medium term given the market’s increased familiarity with it and the structure’s element of “fairness” based on the concept of risk-reward sharing.
The other equity-based contract – Mudharabah – made its debut in 2005 (PG Municipal Assets Berhad’s RM80 million Mudharabah bonds programme). Although Mudharabah entered the market during this period, the utilisation of the profit-sharing contract did not reach the heights achieved by its partnership-based counterpart, with the largest only coming up to 7.7% in 2011. As the sukuk market develops in terms of issuance, each new issue represents a step up the ladder of sophistication. Sukuk issues have begun moving away from ”plain vanilla” debt-based contracts to partnership-based ones that focus on the specific underlying Shariah-compliant business venture to generate income for investors.
Since their inception up to 2012, the top 3 types of contracts or Shariah principles utilised have been Musharakah (43.3%), Murabahah (18.7%) and BBA (12.1%). Notably, Musharakah commanded the lion’s share of the pie in 2007, mainly driven by the bumper issuance that year, when Cagamas Berhad (“Cagamas”), Binariang GSM Sdn Berhad (“Binariang”) and Malakoff Corporation Berhad accounted for a collective RM62.1 billion of the RM65.9 billion of Musharakah-based issues. Cagamas’ sukuk was a landmark at the time; it was the largest funding programme (RM60 billion Conventional and Islamic CP and MTN) in South-East Asia, and also the first of its kind with an unusually long tenure (40 years) in the region.
In December 2007, the SC approved an application from Maxis Communications Berhad – the provider of mobile telecommunication services in Malaysia – through its special-purpose company, i.e. Binariang, to issue a substantial sukuk. A total of RM15.4 billion of sukuk Musharakah – comprising RM12.1 billion nominal value of Islamic MTN, RM300 million nominal value of Islamic CP and RM3.0 billion nominal value Cumulative Non-Convertible Islamic Junior Sukuk had been issued to both domestic and offshore investors. The sukuk issue had been oversubscribed 2 times.
Considering the form of contract
The evolution of sukuk contracts and the development of their transaction structures have been essentially shaped and influenced by 2 main factors:
Market and commercial considerations
Both the abovementioned factors are closely inter-linked and cannot be exclusive of each other. The market and commercial factors determine the market demand for and viability of sukuk instruments while Shariah-compliance determines the validity and recognition of the sukuk products as true Islamic financial instruments.
The market and commercial considerations provide the context in which sukuk can be issued and transacted, based on the economic needs of issuers in raising and mobilising capital that can meet investor demand in the market. More specifically, these factors entail the following:
The market looks at sukuk as the Islamic and Shariah-compliant alternative to fixed-income securities. Market participants or stakeholders would expect sukuk to behave like conventional bonds in terms of capital preservation, frequency of periodic distributions, rate of return, and other additional investor-protection mechanisms. The early use of debt-based structures commensurates with the fact it is not difficult to meet the fixed-income characterisation.
When the market started to adopt partnership-based contracts, such fixed-income characteristic had created some contradictions in terms of meeting Shariah-compliance requirements. Since partnership-based sukuk is equity-like in nature, involving the sharing of profit and loss, there should be no guarantee on capital and profit. Despite this, the structure itself is still evolving, with ongoing resolutions to improve the Shariah-compliance aspect. For example, the Accounting and Auditing Organisation for Islamic Financial Institutions (or AAOIFI) made a pronouncement in February 2008 that restricted the use of certain credit enhancements in Musharakah, Mudharabah and Wakalah sukuk. Following that, the popularity of Musharakah sukuk in some regions had waned, although this had also been influenced by the overall decline in sukuk issuance amid the global credit crunch towards the end of 2007 through to 2008.
The domination of Musharakah is a testament for issuers attempting to uphold the principles and spirit of Islamic finance, i.e. to adopt a risk-sharing approach. In an effort to preserve the “purity” of the structure, Musharakah sukuk are moving away from “guarantee” mechanisms. Instead, the purchase-undertaking clause is incorporated to mitigate the risky nature of the principle, to facilitate the stable income that can match that of other fixed-income instruments.
The type of contracts utilised by RAM-rated sukuk issues has undergone a noticeable transition, from pure debt-based sukuk (largely dominating a full decade from the early 1990s) to partnership-based sukuk (which surfaced in 2004). Musharakah started gaining traction in 2006, albeit still lacking market share. As a form of equity financing, Musharakah is considered closer to the Shariah’s aim of ensuring gains and losses are shared equitably. Musharakah contracts accounted for almost half of all RAM-rated sukuk cumulatively as at end-2012, although the market has witnessed the increasing popularity of commodity Murabahah structures, most notably in 2012. This development was spurred by the increase of cross-border flows from various foreign entities looking to utilise the commodity Murabahah via Tawarruq contract (refer to Table 1). The increase usage of the contract also signals the gradual convergence of opinions for the contracts available in the Malaysian sukuk market.
The evolution in Islamic contracts follows a similar trend for various sectors within RAM’s portfolio where debt-based structures dominated proceedings and gradually shifted to partnership-based contracts. For example, for the infrastructure sector, Musharakah gained prominence in 2006 constituting 76.1% of the total market share. While Musharakah proved to be a retainable structure, Murabahah and Ijarah regained a foothold in 2012 (refer to Chart 6).
We expect the Malaysian sukuk landscape to continually evolve, with a balance between partnership- and debt-oriented structures in the medium term. For partnership-based contracts, in particular Musharakah, the regular use of the structure is largely due to its familiarity and attractiveness vis-à-vis preserving the true spirit of the Shariah. In terms of debt-based structures, the establishment of the commodity Murabahah platform and the straightforward approach of debt-based instruments as well as its close resemblance to products with debt characteristics will help maintain its presence in the sukuk market.