Asset-Backed Sukuk

Asset-backed sukuk are sukuk in which the originator transfers the underlying assets to the issuing vehicle by way of a true sale, so that the certificate holders become the owners of those assets in a legally effective way. If the originator defaults, investors can look to the assets themselves for recovery, and their return depends on the performance of those assets rather than only on the originator's promise to pay.

They are contrasted with asset-based sukuk, the more common form, in which investors hold a beneficial interest in assets but the structure is designed so that they ultimately rely on the originator's credit. The distinction matters to investors, rating agencies and Sharia scholars alike.

A typical structure uses a special purpose vehicle (SPV) that is bankruptcy-remote from the originator. The steps are broadly:

1. The originator sells identified assets, such as property, equipment or receivables permissible under Sharia, to the SPV.
2. The SPV issues sukuk to investors and uses the proceeds to pay the purchase price.
3. The assets generate income, for example rental payments under an ijarah lease, which the SPV passes to sukuk holders.
4. At maturity the assets are sold or otherwise realized, and the proceeds repay investors.

For the sale to be true, the transfer must be legally effective under the law governing the assets, the originator must not retain control or the economic risk of loss, and the sale must withstand challenge in the originator's insolvency. Credit enhancement, if any, comes from the asset pool and the structure rather than from a full guarantee by the originator.

In an asset-based structure, assets are transferred only in beneficial terms, often without registration, and the originator typically gives a purchase undertaking to buy the assets back at a price equal to the face value of the sukuk. That undertaking, usually a unilateral promise or wa'd, means investors are repaid in full unless the originator itself fails, and in that case they rank broadly as unsecured creditors. Economically the result resembles a conventional bond.

In an asset-backed structure, investors take genuine asset risk. If the asset value falls, their recovery falls; if the originator fails, the assets sit outside its estate. The position is closer to owning a real asset outright, such as property or a stake in timberland, than to lending money. Rating agencies accordingly rate asset-based sukuk mainly on the originator's credit, and asset-backed sukuk on the asset pool and structure, as they would a securitization.

Scholars have long argued that sukuk should represent real ownership of assets, not simply debt, since trading in debt at a discount raises concerns about riba. In 2008 the Sharia board of AAOIFI issued guidance stating that sukuk must represent ownership of assets and questioning repurchase at face value in profit-sharing structures such as musharakah and mudarabah. Asset-backed sukuk most fully satisfy that principle. Structures that fail to do so expose holders and institutions to Sharia non-compliance risk.

Asset-backed sukuk remain a small share of the market. Obstacles include legal systems that restrict transferring public or strategic assets, registration costs and transfer taxes, which some jurisdictions address through tax neutrality provisions; governments' reluctance to part with assets; and investor preference for bond-like credit exposure. A 2006 issue by East Cameron Partners in the United States, backed by oil and gas interests, is often cited because the issuer's later bankruptcy tested how a sukuk true sale would be treated in court.

• Asset performance risk: rental income or asset values may fall.
• Legal risk: a court may recharacterize the transfer as secured lending.
• Liquidity risk: secondary markets for sukuk are relatively thin.
• Enforcement risk: taking possession of and selling assets across borders can be slow.

These features make asset-backed sukuk closer to securitizations than to conventional bonds, and analysis of them draws on both Islamic finance and structured finance practice.