Fitch Ratings-Dubai/London: The Accounting and Auditing Organization for Islamic Financial Institutions’ (AAOIFI) Sharia Standard No. 62 could affect the credit profiles of new sukuk and may entail assessing potential implications for an obligor’s Issuer Default Rating (IDR) and debt ranking, Fitch Ratings says. The impact will depend on the finalised standard, which jurisdictions and entities adopt it, and, most importantly, how it is reflected in sukuk documentation.

The timeline for finalising Standard No. 62 – part of AAOIFI’s continuing efforts to align Islamic market standards with sharia principles – is not yet known. Draft texts have featured provisions that would require transfer of legal ownership of the underlying sukuk assets, and related risks, to sukuk holders, who would have recourse to these assets, among other areas.

A full assessment of Standard No. 62 will depend on the exact requirements and stipulations of the finalised text, and the resulting changes in sukuk documentation. Introducing asset-backed or quasi-equity structures could expose sukuk investors and issuers to additional credit, market, legal, operational, and liquidity risks compared to conventional bonds.

The potential emergence of asset-backed structures comes amidst a lack of established securitisation markets in most major Islamic finance jurisdictions across both bonds and sukuk, which could give rise to legal and regulatory uncertainty.

It is unclear if sovereigns, which are major sukuk issuers, would be willing to transfer sovereign assets to certificate holders due to multiple factors, including foreign-ownership restrictions. Corporates and financial institutions might deem it impractical to transfer assets if this materially affected their balance sheet and credit profile. This does not arise with asset-based sukuk, which do not typically involve removing assets from the obligor’s balance sheet. Transferring assets from the balance sheet can also be one of the main attractions of asset-backed financing, depending on the circumstances.

If implementing Standard No. 62 involved secured sukuk with additional security for investors, it is possible these could be rated above an issuer’s senior unsecured debt ratings. However, most Islamic finance jurisdictions lack precedents on bankruptcy court treatment of sukuk holders in a default, and issuing sukuk as secured debt would compound uncertainty over recourse, enforcement, debt ranking, and recoveries. Fitch classifies 60% of the reported Muslim-majority countries in the lowest category of Group D under its Country-Specific Treatment of Recovery Ratings Criteria, where recoveries given default range from average to poor and there are no notching benefits for secured debt.

Although some sukuk, such as mudarabah sukuk, resemble equity-like investments, further movement towards quasi-equity structures or equity products could affect rateability under Fitch’s Sukuk Rating Criteria. For example, if the repurchase price on maturity were subject to market risk affecting the repayment amount to sukuk holders, an instrument would be unratable.

Who adopts the standard will be crucial to determining its impact, as will whether implementation is phased or immediate. Market fragmentation could increase if adoption and implementation varied by jurisdiction or entity. Fitch assesses the impact of AAOIFI standards on a case-by-case basis, as adoption and interpretation vary significantly between regulators and institutions.

As well as credit implications, there may be an impact on sukuk issuance trends, and on market access for some issuers. Disruption could be minimal if the adoption of the new standard ultimately results in most sukuk continuing to be senior unsecured pari passu obligations of the issuer without asset recourse. For example, the introduction of Standard No. 59 from 2021 led to new clauses in sukuk documentation with stricter tangibility ratio requirements and new dissolution triggers. However, it did not fundamentally alter existing structures that create an economic effect similar to conventional bonds.

Fitch does not believe adopting Standard No. 62 would have automatic implications for existing sukuk ratings, as the amendments involved would usually require the consent of sukuk holders. If this were forthcoming, Fitch would review the updated documentation to assess any credit implications.

AAOIFI Sharia Standard No. 62 was among the topics on Fitch’s Islamic Finance webinar on 19 November. A replay is available here.

Media Contact:
Matt Pearson
Senior Associate, Corporate Communications
Fitch Group, 30 North Colonnade, London, E14 5GN
E: matthew.pearson@thefitchgroup.com