S&P Global Ratings believes that sukuk issuance volumes will decline in 2022 as lower, more expensive global and regional liquidity, increased complexity, and reduced financing needs for issuers in some core Islamic finance countries, thanks to higher oil prices, deter the market. Corporate entities' cautious capital expenditure growth also supports our view.

The market has overcome hurdles related to the implementation of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)'s Standard 59. Yet, future standards developments and certain Sharia scholars' preference for a higher proportion of profit and loss sharing in sukuk could pose additional legal challenges. What's more, we believe that if sukuk become an equity-like instrument, investor and issuer appetite will likely diminish.

Therefore, standardizing sukuk structures and satisfying the needs of all stakeholders could be a plausible way for the market to maintain its appeal. The market is also being supported by the energy transition and increased awareness of environmental, social, and governance considerations among regional issuers in key Islamic finance countries. Moreover, the spread of automation using fintech solutions will likely foster sukuk market growth in the future.

Issuance Numbers Won't Recover This Year

In first-half 2022, total sukuk issuance reached $74.5 billion compared with $93.3 billion for the same period a year earlier (see chart 1). Most core Islamic finance countries saw declines, with only a few exceptions--such as Turkey, Bahrain, and the United Arab Emirates (UAE)--presenting marginally higher numbers (see chart 2). Issuance in foreign currency also plummeted (see chart 3).

Chart 1

Chart 2

Chart 3

We have revised down our sukuk issuance forecasts for 2022 to about $130 billion from our initial projection of $145 billion-$150 billion, and we see further risks building. Three factors explain the negative trend:

Lower and more expensive global liquidity.  

• Historically high inflation has prompted major central banks to change policy stance and accelerate rate increases, which has reduced global liquidity and made it more expensive. Investors' risk aversion has also increased, with major segments of the capital markets (for example, speculative-grade issuers) experiencing significantly lower activity in first-half 2022 compared with 2021. The sukuk market, as a component of the global capital market, is not immune to global trends.

Issuers' reduced financing needs.  

• The rise in oil prices since 2021 has boosted the balance sheets of several issuers in core Islamic finance countries (see chart 4). We were therefore not surprised to see a decrease in issuance in first-half 2022. That said, in Saudi Arabia we note an increase in local currency issuance volumes, since the government aims to develop the local capital market. We also observe corporates' continued caution regarding capital expenditure plans. The scars of the pandemic and uncertainty related to the financing environment have led many to rein in growth investments, turn to banks for funding, or start deleveraging.

Chart 4

Complexity is still an issue.  

• Issuers are increasingly realizing that sukuk are more complex and time-consuming than conventional bonds, although some players are taking the sukuk route because they expect to diversify their investor base. The good news is that the market seems to have overcome difficulties related to AAOIFI Standard 59 implementation. However, if Sharia scholars push to further weaken legal documentation, and sukuk instruments lose their fixed-income characteristics while adding significant risks compared with bonds, sukuk's attractiveness and market prospects will likely reduce.

Resolving Risks Related To AAOIFI Standard 59 Helped

Many hybrid sukuk are structured around a combination of tangible assets and commodities. Standard 59 altered the requirements for a transaction feature that is necessary for Sharia compliance: the tangibility ratio. Before the adoption of the standard, issuers were required to have at least 51% tangible assets and a maximum of 49% commodities at the transaction's inception. The maintenance of this ratio through the lifetime of the transaction was on a best-effort basis, and remedial actions in the event of a breach were unclear. With the adoption of Sharia Standard 59, the maintenance of a 51% tangibility ratio became a legal requirement throughout the transaction's lifetime and the remedies for a breach were clarified.

From a creditworthiness perspective, Standard 59 created three main risks: exposure to residual asset risks, a potential change to investors' ranking in a liquidation scenario, and higher liquidity risk for issuers and investors.

To resolve the issues created by this standard, lawyers introduced the following changes:

A conservative definition of a partial-loss event that makes this unlikely to occur (even if one of the assets is subject to some form of impairment), which addresses exposure to residual asset risk.  For some structures, residual asset risk increases as a partial loss event (in addition to total loss event) becomes relevant. Indeed, in a transaction with several assets, if one or more are destroyed, the tangibility ratio could be breached, and investors may not be fully reimbursed without recourse to the sponsor. Liquidity-strapped issuers could use some of the language in the new definition of a partial-loss event to manage their payment obligations if needed.

The sponsor is obliged to remain in control of the assets, thereby minimizing the risk of investors' rank changing in a liquidation scenario.  Standard 59 affects the language related to the indemnity typically offered by the sukuk sponsor as an independent entity in case it fails any of its contractual obligations. This could make sukuk creditors akin to subordinated creditors because contractual obligations might not be perceived as having the same ranking as financial obligations. To resolve this issue, lawyers introduced an obligation for the sponsor to remain in constructive or actual holding/control of the assets. With this, the sponsor can indemnify investors since the sukuk obligation is no longer seen as a debt because tangible assets are involved. However, this obligation could be seen as somewhat contradicting the sale of the assets to the special purpose entity issuing the sukuk at inception.

Increasing liquidity risk for issuers and investors is still unresolved but instances of dissolution are rare.  Standard 59 creates new potential scenarios for early sukuk dissolution. If the issuer has insufficient unencumbered assets on its balance sheet, there is prepayment risk for the underlying assets or, in a partial loss event, the sukuk could need to be repaid before maturity. For some issuers, this could be problematic since it requires liquidity planning. This risk is unresolved, but early dissolution is expected to occur in rare cases. Issuers or sponsors have an incentive to keep transactions rolling to avoid the crystallization of this risk.

At some stage, the opposing forces of Sharia scholars advocating more equity-like characteristics and investors preferring more debt-like characteristics could disrupt the market. This may materialize if scholars question the valuation mechanisms for underlying assets, the setting of a purchase price at the time of issuance, or the payment of rent that is uncorrelated with the value of the underlying assets. In our view, if sukuk become an equity-like instrument, investors and issuers might lose interest in the market. Therefore, standardizing and satisfying the requirements of all stakeholders could help the industry remain attractive. We note that there are sukuk structures similar to the full spectrum of instruments, from fixed income to equity.

Sustainability Sukuk Are Becoming More Prevalent

Over the past six months, we note several sukuk transactions with a sustainability tag that have come to market (see chart 5). From green to social, we expect to see higher volumes as issuers meet investors' demands.

Chart 5

We see two main opportunities. First, many Islamic finance countries are developing and implementing strategies to transition to green economies and these could imply future growth potential for green sukuk issuances. We expect to see some activity in this space as issuers aim to remain on global investors' radars. Second, the social aspects of Islamic finance remain appealing. This is especially relevant with the economic effects of the pandemic and the Russia-Ukraine conflict continuing to surface in the form of higher inflation and unemployment, especially in fiscally constrained countries.

Digital Sukuk Could Foster Greater Financial Inclusion

Digital sukuk could provide a quicker and cheaper way for issuers to tap Islamic finance markets due to the limited number of intermediaries involved. The benefits may also include enhanced security, traceability, and integrity of the transaction, which could further strengthen compliance with Sharia. However, this assumes the availability of reliable technology and the readiness of legal frameworks to accommodate these instruments. It also requires the presence of standard legal documents that can be used as a template for sukuk issuance.

Reducing the time, cost, and minimum issuance volume requirements in this way could open the sukuk market to a broader range of issuers. Investors in digital sukuk will continue to bear traditional risks, however, including credit market and liquidity risk. They will also be exposed to higher operational risks stemming from technology stability and cyber risks. In addition, they would need a vehicle to transact digitally, such as a stable Islamic coin or a central bank digital currency.

Related Research

• Islamic Finance 2022-2023: Same Constraints, New Opportunities, June 6, 2022
• Growing Belief In Southeast Asia's US$290 Billion Islamic Banking Market, May 11, 2022
• Lower Global Liquidity And Increased Complexity Are Likely To Hold Back Sukuk Issuance In 2022, Jan. 18, 2022