Deustsche Bank Introduction To Sukuks

GEMS: Middle East
Emerging
Markets
30 August 2007
Bond Market Guide Primer

Table of contents
Introduction to Sukuk Introduction ........................................................ Page 2

Global Markets Research
Shari’ah concepts in Islamic Finance ................. Page 3

Sukuk as a vehicle for Shari’ah compliant
financing and investment ................................... Page 4
A brief history of the development of the
Sukuk market...................................................... Page 8
Expectations for market development ............. Page 10
The market for Sukuk - Islamic Bonds - is growing rapidly with a total amount
Credit Risk – how rating agencies
outstanding in excess of USD 80bn. The fastest growing class of Sukuk is Sukuk approach Sukuk ................................................ Page 15
issued under New York or English law, designed to mimic Global bonds. Issuance Sukuk Pricing and Secondary Market
of this ‘international Sukuk’ in 2007 (USD 10.9bn so far) already exceeds the total Behaviour.......................................................... Page 17
amount issued in 2006. In this article we aim to provide a comprehensive primer Appendix A – Equity-linked Sukuk .................... Page 19
on international Sukuk. We discuss the origins of the market, the various types of
Sukuk and the potential future evolution of the market. Research Team
Marc Balston
Strategist
(+44) 20 754-71484
marc.balston@db.com
Arend Kapteyn
Chief Economist
(+44) 20 754-71930
arend.kapteyn@db.com
Sukuk Market Size

Outstanding amount
US$ bn
90
80 International Sukuk
70 Domestic Sukuk
60
50
40
30
20
10
0
00 01 02 03 04 05 06 07
Source: Bloomberg, Deutsche Bank
Geographic Distribution
Amount Outstanding, US$bn
60
50 Domestic Sukuk
40
International Sukuk
30
20
10
0
Asia Middle East
Deutsche Bank AG/London

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DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1
30 August 2007 Bond Market Guide
Introduction
Sukuk are often thought of as the Islamic equivalent of bonds and while such a comparison
captures many of the characteristics of Sukuk, it is important to understand to what extent
this comparison is valid. In essence, Sukuk exist as a means of translating established
Shari’ah compliant financing tools into a form which in many ways mimics that of traditional
bonds, and by extension provides the degree of standardisation, transparency, transferability
and liquidity which has made the international bond markets such a powerful and efficient
vehicle for financing and investing. It is important to note that while Shari’ah is clearly central
to the concept of Sukuk, it does not generally act as the legal basis for the securities. The
majority of international Sukuk are governed by English or New York law but are structured in
a way as to be Shari’ah compliant, for the benefit of issuers and investors who seek to
manage their affairs in accordance with Shari’ah principals.
It is somewhat misleading to think of Sukuk as being designed specifically for Muslim

investors (and/or issuers). Certainly an entity need not be Islamic in order to issue or to buy a
Sukuk. A better way to think of a Sukuk is as a conventional bond, but one which has been
constructed in a way as to be Shari’ah compliant. A useful analogy can be found in the food
industry. Many mass produced foods are manufactured in a way that allows them to be
certified as halal, kosher, organic etc. Such certification is clearly designed for certain groups
of consumers, but it does not prohibit other groups from consuming the product. Indeed,
some food lines are only produced in such certified form as it is cheaper than producing
several different lines.
The first Sukuk were issued in the Malaysian domestic market in the mid-1990s and since
then over USD 125bn have been issued globally. Sukuk can be divided into two main groups:
Malaysian domestic Sukuk (primarily ringgit-denominated and governed by Malaysian law)
and international Sukuk (being primarily USD-denominated and governed by English or US
law). Although the former group is the older and larger of the two, the market for
international sukuk is growing rapidly and it is this group that forms the focus of this article.
Although the international Sukuk market is a comparatively young market, the first
international Sukuk having been issued in 2001, its size already exceeds USD27bn and is
growing rapidly, USD10.9bn having been issued in the first six months of 2007. The main
source of issuance is from corporate issuers in the GCC1 countries – in particular from the
UAE – looking to finance construction projects.
The cash flows and credit risk of a Sukuk are remarkably similar to those of a conventional
bond. As a result, the specific way in which a Sukuk has been constructed so as to be
Shari’ah compliant is generally not of importance to an investor who is not concerned by its
Shari’ah compliance. However, since Sukuk documentation differs considerably from that of
a normal bond, it is valuable to understand some of the key principles, characteristic and
terminology that are commonly employed. This is one of the key objectives of this article: to
give the reader the background to allow them to interpret a Sukuk prospectus – even from
the perspective of determining the cash flows.
In this article we will discuss the key Shari’ah principles that relate to Islamic finance and look
at how the various key types of Sukuk have been developed in order to meet these principles
(in order to be Shari’ah compliant). We will also look at the history of the Sukuk market, some
recent developments and our expectations for the future evolution of the market. We will
discuss how the rating agencies approach credit risk of Sukuk and finally we conclude by
examining in more detail some of the more liquid Sukuk structures.
1
Gulf Cooperation Council – comprising Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates.
Page 2 Deutsche Bank AG/London

Shari’ah concepts in Islamic Finance

There are many concepts within Shari’ah which limit the degree to which conventional capital
market techniques can be applied, but the most fundamental is the prohibition of Riba. Riba –
often interpreted simply as interest – is considered to be any pre-determined return on
money, in other words, the generation of income from money alone. While interest is
prohibited, Shari’ah does allow for financing to be provided (or accepted) in the event that it
is linked to certain identifiable assets (e.g. for the trading of those assets, or for their
construction).
Aside from the prohibition of riba, Islamic finance also prohibits:

Investment in companies that manufacture certain forbidden – haram – products, such
as tobacco, alcohol, firearms, pork products and also investment in companies in the
entertainment industry, casinos, hotels, restaurants, adult entertainment etc. (which
restricts the commercial assets in which the proceeds of a Sukuk issue can be invested).
Speculation, betting and gambling (maisir) including the speculative trade or exchange of
money for debt without an underlying asset transfer.
Preventable uncertainty (gharar) such as that related to derivative instruments, forwards
and futures.
Trading in ‘indebtedness’ at any price other than the face value.
Islamic Finance itself is not a recent phenomenon but has developed over many hundreds of
years. Over that time a variety of different contractual instruments have become well
established as common ways of financing, and been given the green light by Islamic scholars
tasked with developing Islamic jurisprudence and interpreting the principles laid down in
(most importantly) the Qu’ran. Traditionally these instruments have formed the basis for
commercial banking, although as we will see later they are now being used as the basis for
many Sukuk and hence are being translated into the investment banking arena.
Before delving into the anatomy of Sukuk we briefly touch on some of the most common
contracts in Islamic Finance, which form the building blocks of Sukuk. Given the Shari’ah
restrictions on the trading of indebtedness, we have divided the contracts into two groups:
those which can tradable at a market price and those that can only be transferred at face
value. Naturally the ones in the former group are the most important for Sukuk, although the
ones in the latter do occur within some Sukuk – hence their inclusion here.
Contracts which can be transferred at a negotiated price
Ijara – an ijara is essentially a lease contract whereby assets (or the usufruct of an asset) is
leased out with the lessor retaining all the rights and responsibilities that go with ownership.
Ijara represents the typical Islamic mortgage structure. As Ijara bonds represent ownership in
well defined securities they can be freely traded in the secondary market at a market price.
Mudaraba – a mudaraba can be thought of as an asset management agreement whereby

one party provides finance to another party and the second party (known as the mudarib)
invests the capital according to some pre-agreed business plan. The profit of the business is
distributed according to a pre-determined ratio, but any financial loss is incurred only by the
finance providers.
Musharaka – a musharaka agreement is somewhat similar to that of a mudaraba, but in this

case both parties provide capital (or assets) and both may be involved in the management of
the assets. Essentially a musharaka is a joint-venture. As with the mudaraba, the profit of the
business is distributed according to a pre-determined ratio, however, in a musharaka the loss
is distributed in proportion to each partners share of the capital.
Deutsche Bank AG/London Page 3

Contracts only transferable at face value
Murabaha – the most common instrument in Islamic Finance, the murabaha is essentially a
tool for financing the purchase of specific assets. Under the contract the counterparty
providing the financing purchases the required assets and sells them to the buyer at a pre-
agreed marked-up price. The payment can be settled in instalments or as a lump sum within
an agreed period.
Istisna’a – a contract which exchanges an upfront payment for the future delivery of an
asset. An istisna’a contract requires that the asset is made to order. Full payment need not
necessarily be made in advance and can be phased. This is the most common form of
financing for construction projects.
As an indication of the relative importance of these various forms of Islamic Finance

instruments, Figure 1 below illustrates the composition of the assets of the Dubai Islamic
Bank (the world’s third largest Islamic bank) as of the end of 2006.
Figure 1: Composition of Dubai Investment Bank’s Islamic Assets
Sukuk:
1.6bn
14.3%
Mudaraba:
Murabaha:
0.8bn
4.9bn
7.6%
44.9%
Musharaka:
0.8bn
7.0%
Istisna’a:
Ijara: 1.6bn 1.2bn
15.0% 11.1%
Source: Dubai Islamic Bank Consolidated Financial Statements 31 Dec 2006
Sukuk as a vehicle for Shari’ah compliant financing and

investment
Sukuk2 are effectively ‘Trust Certificates’ which employ the principals of Islamic Finance in
order to provide a Shari’ah compliant, tradable security, the financial characteristics of which
appear to the holder to be very similar to those of a conventional bond. At the heart of the
majority of Sukuk are one or more of the traditional instruments described above, particularly
those that can trade at a negotiated/market price. Hence, the most common Sukuk are based
on ijara, mudaraba or musharaka.
In order for a Sukuk to be considered Shari’ah compliant the issuer will apply to a Shari’ah
board of Islamic scholars. If the board considers the Sukuk to be Shari’ah compliant it issues
a pronouncement (a fatwa) to certify its decision. This fatwa is similar to a legal opinion in
that it is (generally) not legally binding and other scholars may disagree with the decision. For
this reason, many Sukuk issuers (particularly those within the GCC) will work with a small
group of Shari’ah scholars who are very familiar with Sukuk and whose judgements are
widely respected in the field of Islamic jurisprudence. One scholar in particular stands out in
this regard – Dr Hussein Hamid Hassan. Dr Hassan chairs a number of Shari’ah boards and
has been responsible for issuing fatwas for the majority of international Sukuk.
2
The most accurate English translation of the Arabic word Sukuk is ‘participation’. In Arabic, Sukuk is actually the plural
form of sakk which itself is the origin of the European word cheque.

While a basic understanding of the general structures of Sukuk can help to make Sukuk
documentation somewhat more intelligible, for the most part the exact nature of the
underlying structure is not generally of importance to the Sukuk holder and secondary to the
cash flow characteristics of the Sukuk (from the perspective of the holder) are described by:
the periodic distribution amount (often expressed as Libor-plus amount, paid on a semi-
annual basis) – analogous to a bond coupon.
the scheduled dissolution/redemption date – analogous to the maturity date of a bond.
However, from a risk perspective, the exact nature of the Sukuk can have a bearing on credit
risk, legal risk and liquidity risk, all of which will be discussed subsequently.
Sukuk-al-ijara
Sukuk based on ijara (sale and leaseback) agreement are formally known as Sukuk-al-ijara.
Figure 2 below illustrates the typical structure of a Sukuk-al-ijara. In this structure the issuer of
the Sukuk – often a SPV – uses the proceeds of the issue to purchase the specific assets
from the originator. It then leases them back to the originator (or often to an affiliate of the
originator). The lease payments made by the originator are then passed on to the Sukuk
holders as periodic distributions. At the end of the specified term, the originator repurchases
the assets from the issuer, with the repurchase proceeds being passed on by the issuer to
the Sukuk holders, in effect redeeming the Sukuk.
Figure 2: Typical structure of Sukuk-al-ijara
Issue proceeds (2)

Originator
(as seller) Title to assets (2)
Lease agreement (3) Issue proceeds (1)

Originator Periodic distribution (4) Sukuk
Issuer
(as lessee) Periodic rentals (4) Repurchase proceeds (6) Holders
Originator Title to assets (5)

(as obligor)
Repurchase proceeds (5)
1. The issuer - usually an SPV - issues sukuk to sukuk holders in exchange for proceeds.
2. The issuer purchases title to assets from the originator
3. The Originator enters into a lease agreement with the issuer to lease the assets
4. The originator makes periodic rental payments on the lease to the issuer which the issuer passes on to the sukuk holders.
5. At maturity (or upon a dissolution event ) the issuer sells the assets back to the originator (purchase undertaking )
6. The issuer passes the proceeds on to the sukuk holders and the SPV is dissolved.
Source: Deutsche Bank
The rental payments on the lease agreement (i.e. the periodic distribution received by the
Sukuk holders) are generally structured as semi-annual payments often with a rate
determined by LIBOR plus a specified margin.
The repurchase of the assets by the originator from, in effect, the Sukuk holders, is governed
by a purchase undertaking which is invoked at the scheduled dissolution date (i.e. the
maturity date) or on the occurrence of a dissolution event. Such dissolution events generally
include many of the clauses which are analogous to events of default on a conventional
bond. As a result of the purchase undertaking, such events effectively result in an
acceleration of the Sukuk, much like a conventional bond and would convert the trust
certificates into a debt claim on the originator.

The underlying assets which are so essential to a Sukuk-al-ijara transaction are often land
parcels, but can also be specific buildings or other property, or even simply the rights to use
the property (a more recent development). The size of the Sukuk is restricted to the value of
the assets being transferred from the originator to the special purpose vehicle, and once the
assets have been used they cannot be used for another purpose until the Sukuk has matured
– this implies some loss of flexibility on the amount of paper that can be issued by an
individual borrower, though in practice this has not yet posed serious constraints. It is worth
noting that Sukuk involving assets in Saudi Arabia generally employ two SPVs, one
incorporated in Saudi Arabia, the other offshore. This arrangement arises because Saudi law
forbids the foreign ownership of assets located in Saudi Arabia.
Sukuk-al-musharaka and Sukuk-al-mudaraba

Sukuk based on musharaka or mudaraba agreements are very similar in structure, both
entailing an agreement with a business plan with profit-sharing terms. Figure 3 illustrates the
typical structure of a Sukuk-al-mudaraba. In this structure the SPV (the issuer of the Sukuk)
acts as raab al-maal and enters into a mudaraba agreement with the originator (acting as the
mudareb). The specific nature of the agreement varies from Sukuk to Sukuk, but generally it
will entail the mudareb investing the proceeds provided by the SPV (obtained from the issue
of the Sukuk) according to some agreed business plan. The profits-sharing terms of the
agreement are often heavily weighted in favour of the SPV (often 99% to 1%). However, if
the resultant share of the profits exceeds the periodic distribution amount specified in the
Sukuk terms, the issuer foregoes the excess. Alternatively, if the share of profits is less than
the periodic distribution amount, the mudareb is committed to fund the short-fall by
extending financing to the issuer.
Figure 3: Typical structure of Sukuk-al-mudaraba
Issue proceeds (2)

Originator Mudaraba agreement
(as mudareb)
Periodic distribution (3)
Issue proceeds (1)
Issuer's interest in Issuer Periodic distribution (3) Sukuk
mudaraba assets (4) (as raab al-maal) Purchase proceeds (5) Holders
Originator
(as obligor) Proceeds of purchase undertaking (4)
1. The issuer - usually an SPV - issues sukuk to sukuk holders in exchange for proceeds.
2. The issuer enters into a mudaraba agreement with the originator (acting as the 'mudareb')
Typical mudaraba agreement
The mudareb invests the proceeds in accordance with the agreed business plan.
The profit generated by the business plan is shared between the issuer and the mudareb according to a pre-agreed schedule
If the issuer's profit share exceeds the amount required for the periodic distribution, the mudareb retains the difference.
If the issuer's profit share falls short of the amount required for the periodic distribution, the mudareb supplements the difference.
3. The mudareb makes periodic payments to the issuer which are passed on to the sukuk holders.
4. The orginator (as obligor) purchases all of the issuer's ownership interest in the mudaraba assets
5. The issuer passes the proceeds on to the sukuk holders and the SPV is dissolved.
As with Sukuk-al-ijara, the redemption of the notes is achieved by means of a purchase

undertaking by the obligor. However, in the case of a Sukuk-al-mudaraba, the obligor
purchases the issuer’s ownership interest in the mudaraba assets (rather than purchasing
assets owned by the issuer). The purchase price for the purchase undertaking is equal to the
aggregate principal amount of the certificates outstanding. The issuer then passes the
proceeds of this purchase on to the Sukuk holders, effectively redeeming the Sukuk.

The primary difference between Sukuk-al-mudaraba (described above) and Sukuk-al-

musharaka are that the joint venture embedded in the latter entails the originator providing a
share of the capital (and/or assets), in addition to the finance provided by the issuer
(ultimately by the Sukuk investors), rather than simply providing the management expertise.
Compared to ijara structures, both these Sukuk variants permit greater flexibility in the cash
to be raised relative to the magnitude of asset transfer, as the amount of cash to be raised
does not need to correspond to the assets available for transfer into the
mudaraba/musharaka.
Other structures of Sukuk

Although the majority of internationally traded Sukuk are based upon ijara, mudaraba or
musharaka, other forms of structure exist. As discussed above, murabaha and istisna’a
contracts are two of the most common forms of Islamic finance agreements; however,
Shari’ah forbids such contracts to be traded at any price other than face value, Sukuk based
upon them would have limited liquidity. This constraint has led to two additional forms of
Sukuk which include a proportion of murabaha and/or istisna’a contracts (among other
Shari’ah compliant assets).
Hybrid Sukuk. Several construction projects in the GCC have included ijara-istina’a Sukuk
for a portion of their financing. These Sukuk include both ijara agreements and istina’a
agreements within them. For instance, the Durrat 2010 Sukuk 3 includes a series of
istina’a contracts for various construction projects which when complete are leased back
under the master ijara agreement. Such Sukuk are tradable if the majority of the
underlying assets (which can vary over the life of the Sukuk) are ijara.
Sukuk-al-wakala. Essentially a Shari’ah compliant investment management vehicle which
allows a variety of assets to be pooled together. Provided at least 51% of the assets are
tradable – such as ijara contracts – the Sukuk itself can be traded at a negotiable price. In
essence, any variation in the price of the Sukuk is considered to be a variation in the
value of the ijara contracts, while the other contracts in the pool remain at face value.
In the Malaysian domestic market, Sukuk based on cost-plus-sales, known as Sukuk-al-

murabaha or Bai Bithaman Ajil (BBA) have dominated, although such structures are rare in the
international Sukuk market as few Middle Eastern Shari’ah scholars consider them to be fully
Shari’ah compliant.
Convertible Sukuk
Some of the larger, more recently issued Sukuk are also convertible into equity, although the
underlying structures of the securities are still based on ijara, mudaraba or musharaka. Two
main types of convertible Sukuk have been issued: conventional convertibles (giving the
Sukuk holder the right to exchange their Sukuk for a pre-determined amount of a pre-existing
stock) and pre-QPO4 Sukuk which give the holders the right to participate – sometimes at a
discount -- in an public offering of a company’s stock (if one is offered during the life of the
Sukuk). Convertible Sukuk have helped to broaden the potential investor base for Sukuk and
the largest Sukuk issues have all been convertible. Even though only seven convertible Sukuk
have been issued, they represent USD 11.8bn of the USD 27.8bn of international Sukuk that
have been issued to date.
3
For the financing of the reclamation and initial stage development of ‘Durrat Al Bahrain’ – the Kingdom of Bahrain’s
largest residential development project.
4
Qualifying Public Offering.

A brief history of the development of the Sukuk market

The first Sukuk were issued in Malaysia during the 1990s, although these were denominated
in Malaysian ringgit and were targeted toward domestic investors. A key catalyst behind the
growth of the domestic Sukuk market in Malaysia was the establishment in 1996 of the
Shari’ah Advisory Council (SAC) of the Malaysia Securities Commission. The SAC was given
the mandate to ensure that the running of the Islamic capital market complies with Shari’ah
principals. The SAC created explicit guidelines for the issuance of Shari’ah compliant
securities and by so doing, provided a clear benchmark view on the compliance of certain
structures, thus helping to generate a degree of uniformity in the Sukuk offered.
By 2002, over USD 5bn equivalent of Sukuk was being issued annually in Malaysia, via
around 100 separate offerings. However, the market was of little interest to Islamic investors
outside of Malaysia for two reasons. First, the fact that all the issues were denominated in
ringgit and traded only on the domestic Malaysian market. Second, and perhaps more
importantly, there was a widespread view among Islamic scholars that the interpretation of
Shari’ah adopted by the SAC was too liberal and that the majority of the securities that had
been certified as Shari’ah compliant by the SAC were not considered Shari’ah compliant by
the wider community of Islamic scholars. In particular, SAC permitted Sukuk to be based
upon murabaha, while Shari’ah scholars in more conservative jurisdictions explicitly prohibit
the trading of murabaha debt.
In September 2001, the government of Bahrain became the first issuer of USD-denominated
Sukuk with its USD100mm five-year issue. However, as with the Sukuk issued in the
Malaysian market, these Sukuk were intended for domestic investors. Nevertheless, being
the first Sukuk out of the GCC and also being based on an ijara structure, this Sukuk
represented an important stepping-stone towards the creation of an international Sukuk
market.
The first true international Sukuk issue was issued by Guthrie (a Malaysian plantation firm) in
December 2001. This was also an ijara-based Sukuk but unlike the Bahrain Sukuk was issued
as a global certificate under New York law. Appropriately, the SPV was named ‘First Global
Sukuk Inc.’ Two tranches were issued simultaneously a USD50mm three-year and a
USD100mm five-year certificate.
Figure 4: All Sukuk Issuance Figure 5: International Sukuk Issuance
Amount Issued, US$bn Amount Issued, US$bn

Total number of deals adjacent to bars Total number of deals adjacent to bars
30 14
Asia 915 Asia
25 12
Middle East Middle East 14 17
713
Other 10 Other
20
455
469
8
15
6
10 217
579 142 4
352 3 6 10
5 36 22 2
1 1 10
0 0
1995 1997 1999 2001 2003 2005 07 1995 1997 1999 2001 2003 2005 07
YTD YTD
Source: Bloomberg, Deutsche Bank Source: Bloomberg, Deutsche Bank
Following the Guthrie Sukuk, the first sovereign Sukuk – Malaysia’s 5-year global Sukuk – was
issued in July 2002. Good demand for the deal saw it upsized from the originally planned
USD350mm to USD600mm. With 50% placed with investors in the Middle East, 30% to
Asia, 16% to Europe and 4% to the US, the deal was clearly international. Despite the
success of this deal, it was another year before the first Sukuk was launched in the GCC – the

Islamic Development Bank’s USD400mm 5-year Sukuk-al-wakala 5 . This was followed in

October 2003 by a seven-year sovereign Sukuk from Qatar of USD700mm.
After the sporadic issuance of the first three years of the international Sukuk market, 2004-05
witnessed a marked increase in number of deals (six in 2004 and 10 in 2005), although the
size of individual deals remained small. The highlight deals of the period were a USD1bn five-
year Sukuk-al-ijara from the Government of Dubai, a USD600mm five-year Sukuk-al-ijara from
the Islamic Republic of Pakistan and the first musharaka-based international Sukuk, a
USD200mm five-year deal from the Dubai Metals and Commodities Centre (the ‘Gold
Sukuk’). Also in 2004 was the first Sukuk issue from a non-Muslim country; the German State
of Saxony-Anhalt issued a EUR100mm five-year Sukuk-al-ijara.
In 2006 the Sukuk new issue market shifted gear with the first convertible Sukuk (under a
Musharaka structure), a massive USD3.5bn by DP World for the acquisition of P&O. This was
followed by several more jumbo convertible Sukuk and smaller non-convertible Sukuk.
During 2006, Sukuk-al-musharaka became the dominant form, with Sukuk-al-ijara issues
declining in frequency. This was partly a reflection of a shift toward using Sukuk for the
financing of specific development projects and away from raising general capital using assets
as collateral. However, perhaps more importantly, Sukuk-al-musharaka (and Sukuk-al-
mudaraba) are generally considered closer to the spirit of Shari’ah than Sukuk-al-ijara and
hence are more likely to be acceptable to Shari’ah boards.
Figure 6: International Sukuk by Type

Amount Issued, US$bn Number of deals
12 16
Murubaha Murubaha
14
10 Hybrid Hybrid
Wakala 12
Wakala
8
Musharaka 10 Musharaka
6 Mudarabah 8 Mudarabah
Ijara Ijara
6
4
4
2
2
0 0
2001 2002 2003 2004 2005 2006 07 YTD 2001 2002 2003 2004 2005 2006 07 YTD
Source: Individual Sukuk Prospectuses, Deutsche Bank Source: Individual Sukuk Prospectuses, Deutsche Bank
Malaysia is still the dominant source of Sukuk issuance 6 , although this remains primarily
domestic issuance. As Figure 7 shows, Sukuk issuance within Asia has been overwhelmingly
on the domestic market, while in the Middle East international Sukuk have dominated.
Malaysia (along with Bahrain and Qatar) was one of the pioneers of the international Sukuk
market; however, the UAE has become the dominant source of issuance. Of the USD 28bn
issued to-date, more than USD 17bn has come from the UAE. Indeed, the five largest
international Sukuk (and eight of the top 10) have all come from UAE issuers. Within the UAE,
Dubai has been the primary source, with six of the top eight Sukuk originating from this
emirate.
5
The Sukuk assets comprised ijara, murabaha and istisna’a contracts. At closing, 65.8% of the assets were in the form
of ijara contracts.
6
More than 75% of the USD 129bn of Sukuk issued have been from Malaysian issuers.

Figure 7: International Sukuk dominate Figure 8: International Sukuk issuance by

in the Middle East, unlike in Asia country of origin
Amount Outstanding, US$bn Malaysia
Proportions by USD Saudi
60 11% Bahrain
amounts Arabia
Domestic 7%
9%
50 International
Kuwait
40
3%
30 Qatar
5%
20 Pakistan
2%
10 USA
1%
0 UAE Germany
62% 0%
Asia Middle East
Source: Bloomberg, Deutsche Bank, as at mid-August 2007 Source: Bloomberg, Deutsche Bank, as at mid-August 2007
Expectations for market development

As is often the case with a young, rapidly growing market, forecasts of the potential size of
the Sukuk market vary widely7. In order to gauge the potential growth of the market, below
we discuss the potential supply and demand of Sukuk from the perspective of both issuers
and investors. However, before we begin, it is important to reiterate that Sukuk need not be
issued solely by Islamic entities and need not be invested in solely by investors concerned by
their Shari’ah compliant nature. As a result, the potential supply of and demand for Sukuk
goes well beyond the Islamic world. Indeed, large proportions of recent international Sukuk
have been placed with European (and to a lesser degree) US-based investors and certainly
among some institutional investors for whom the Shari’ah aspects of the instruments is not a
key factor in their investment decision8. Similarly, there have been – to date – two Sukuk
issued from non-Islamic countries (one by the German State of Saxony-Anhalt and the other
by a Texan oil and gas exploration and production firm), but this is expected to expand
considerably. Both the UK and Japanese governments have proposed issuing Sukuk.
Furthermore, French renewable energy company Velcan Energy has recently announced
plans to issue EUR200mm in Sukuk to finance a hydroelectric dam project in India.
Turning to our assessment of the potential supply and demand from within the Islamic world,
the bottom line is that on a 5 year horizon, the potential demand for Sukuk is likely to far
outstrip available supply.
Estimating potential demand for Sukuk

In trying to gauge the growth potential of Sukuk as an asset class, it is useful to start from the
level of financial penetration Shari’ah compliant products currently have in both Islamic and
non-Islamic countries.
The first observation in this regard is that Shari’ah compliant assets (Sukuk as well as more
traditional bank finance products) generally do not exceed more than a 20% penetration rate
7
A. Jobst (“The Prospects of Islamic Securitization”, forthcoming) cites market reports estimating corporate and
government issuance of USD30bn over the next 3 years. I.A. Alvi (ISFM) estimates that the stock of Sukuk would
double from USD25bn in 2006 to USD50bn in 2008. S&P in October 2006 estimated the stock of rated (listed) Sukuks to
double from USD10bn to USD20bn by 2010. The Gulf Daily News (May 27, 2007) cites an estimate of USD100bn in
Sukuk issuance in the next 5 years.
8
The motivation for such investors to purchase Sukuk lie instead in portfolio diversification, access to Middle Eastern
credit exposure, access to Middle Eastern equity markets (in the case of the convertible Sukuk) and, in most cases,
relatively attractive valuations compared to similarly rated traditional bonds.

even in Islamic countries, implying the coexistence of Shari’ah compliant products and
conventional finance in most countries.9
The total stock of Sukuk (domestic and international) amounts to just 3½% of the
collective GDP of the 57 member countries of the Organization of the Islamic conference
(OIC)10.
S&P, for instance, estimates total Shari’ah compliant assets at USD400bn, which would
be roughly equivalent to 18½% of OIC broad money and roughly 10% of their GDP. S&P
also estimates Islamic banking assets to comprise roughly 20% of total in the Gulf.11
The Dubai International Financial Centre (DFIC) estimates the current market for Islamic
financial products at USD260bn worldwide and forecasts it to grow 12-15% annually. It
estimates current market penetration at 20% of the Arab population, though predicts
that number to rise drastically to 50-60% of total savings held within the next decade.
However, the share of Sukuk bond issues in total securitized debt appears to be rising much
faster than financial penetration in banking system assets.
In Bahrain, one of the countries most actively promoting Sukuk issuance, Islamic assets
still only comprise around 15% of total banking system assets and less than 10% of non-
bank financial assets. However, Sukuk issuance already comprises 75% of total
outstanding international bond debt.
In Malaysia, which has perhaps the most developed Islamic bond market, Sukuk now
comprise a little under 50% of all outstanding domestic and international bonded debt
and around three out of every four new corporate bonds being issued is a Sukuk. Islamic
banking system assets, however, are still only around 12% of total banking system
assets. The government aims to bring this share to 20% by 2010 under its Financial
Sector Master Plan.
This coexistence of Shari’ah compliant products and conventional finance is important in that
it underscores that the true magnitude of potential demand for Sukuk in Islamic countries is
likely as much a function of how much domestic money crosses over from conventional
finance products into Shari’ah compliant products, as it is a function of tapping into new
pools of currently idle, non-financially intermediated, resources that find themselves lacking
Shari’ah compliant investment products. For instance, we estimate end-2006 total net foreign
assets in the GCC countries at USD850bn12, up from USD280bn in 2000, and project these to
rise to USD1025bn by end-2008 based on our current oil price baseline. Clearly the bulk of
GCC NFA assets is currently not invested in Sukuk, and the projected NFA increase for this
group of six countries alone far outstrips any estimate for Sukuk growth in the next two
years, but it also suggests there is a potential wall of (oil) money that could cross-over and
provide sustained demand for Sukuk for many years to come.
9
At the two extremes of the spectrum are Saudi Arabia (its retail banking sector is 90% Shariah compliant) and Oman,
where the Sultanate has so far not permitted Islamic banking.
10
Using membership of the Organization of the Islamic Conference or the Islamic Development Bank has some intuitive
appeal as these countries are, with some minor imprecision, self-identified Muslim states and have legal systems that
are at least partially influenced by Shariah principles. The 57 OIC member states have a combined population of 1.4
billion, of which roughly 1.1 billion are Muslim (based on 2004 UN/WB censuses). This is close to the global estimate of
the number of Muslims of roughly 1.5 billion. Countries with large Muslim populations that are not members of the OIC
are India (over a 100 million), and Ethiopia (17 million).
11
See “Islamic Banks in Malaysia Less Profitable than Gulf Counterparts”, Standard & Poor’s (July 5, 2006).
12
NFA statistics are by definition compiled on a residency basis and, as such, would exclude any investment by, for
example, the Abu Dhabi Investment Authority into Sukuk’s issued by a UAE entity. The purchase of a Sukuk by any
other country would, however, be included.

Figure 9: Potential demand for Shari’ah assets is huge, and stems not just from
Muslim majority countries.
Population GDP (USD bn) Int'l Debt Stock (USD bn)
Scaled by %
Total Muslim % M3/GDP Total Muslim pop. Total Sukuk
Indonesia 201.2 88.2 42.0 364 321 19 -
Pakistan 164.7 97.0 46.4 129 125 2 0.6
Bangladesh 150.4 83.0 54.7 65 54 - -
India 838.6 12.1 73.8 887 107 27 -
Turkey 71.2 99.8 54.6 392 392 48 -
Nigeria 135.0 50.0 20.7 115 58 1 -
Iran 60.1 99.6 36.9 212 212 2 -
Egypt 48.2 94.1 101.6 107 101 5 -
Morocco 33.8 98.7 114.4 57 57 1 -
Algeria 33.3 99.0 55.1 114 113 - -
Saudi Arabia 27.6 100.0 50.7 349 349 3 1.5
Malaysia 17.5 58.6 133.2 151 88 33 2.2
UAE 4.4 96.0 64.6 168 162 39 17.1
US 301.1 1.0 75.3 13,245 132 4714 0.2

EU 493.0 3.5 76.5 14,527 509 11385 0.1
Source: UN/WB censuses 2004, CIA factbook, Haver, Bloomberg, BIS, IMF, DB Global Market Research
Estimating potential supply of Sukuk

From a supply perspective, the bulk of issuance is likely to continue to originate from Islamic
rather than non-Islamic countries, even if here too there will be a difficult to estimate cross-
over component. And the bulk of that supply is likely to originate from the corporate rather
than the government or financial sector, at least in the Middle East:
The lack of potential supply from governments is intuitively premised on their current
fiscal positions. Approximately half the countries in the Middle East are oil exporters and
run fiscal surpluses, implying limited borrowing requirements 13 . Of total international
issuance out of the Middle East since 2002, only 7.2% was issued by sovereigns (15.4%
if domestic Sukuk issuance is included as well). That said, many oil exporters are
embarking on multi-year investment programs often financed through public-private
partnerships or state-owned enterprises (see below). And there are also a number of
large non-oil exporting countries with significant Muslim populations and sizeable
international debt stocks that have yet to issue Sukuk (Figure 9).
Banks in the Middle East, for their part, tend to be flush with liquidity, in part because of
a lack of Shari’ah compliant investment products on the asset side of their balance
sheets to absorb the non-remunerated Shari’ah compliant deposits. This implies that
while banks are likely to be an important source of future demand, the incentive to issue
Sukuk themselves is relatively low.
There is, however, an enormous pipeline of potential corporate issuance (which will tend
to include quasi public investment and issuance by state-controlled enterprises). The IMF
in its September 2006 Regional Economic Outlook for the Middle East estimated GCC
investment plans for 2006-2010 at USD700bn, split roughly equally into the oil and gas
sector (funded mainly by national oil companies), infrastructure (funded by public-private
partnerships) and real estate (financed principally by the private sector). In a more recent
report the IMF seemed to have scaled down these estimates somewhat, but still put
GCC infrastructure investment needs for the next two to three years at USD50bn (a
13
In its latest Regional Economic Outlook on the Middle East and Asia, the IMF classifies 14 out of 30 countries in the
region as oil exporters; only two of which, Iraq and Syria, have fiscal deficits (almost all countries in the region are
members of the Organization of the Islamic Conference). The average fiscal surplus in the Middle East and North Africa
for 2007 is estimated at +4.7%, among oil exporters as a group +8.9%GDP and among the GCC +16% of GDP.

subset of the aforementioned total Middle East need). The Governor of the Central Bank
of Malaysia has consistently cited a USD1trillion infrastructure investment need for Asia
in the next five years, and a similar USD500bn need for the Middle East.14
In our view, if we assume that only 10% of the region’s investment needs will be met by
international Sukuk issuance this would still imply a doubling of the existing international
Sukuk stock within two years, reaching close to USD100bn by 2010. Indeed, the recent shift
in Sukuk offerings from Ijara structures toward Musharaka/Mudaraba issuance is in part
explained by the need to satisfy the expansion demands of some of the leading
infrastructure, utility and investment companies in the region. So we are starting to see the
tip of the investment iceberg. The sleeping giant in all this, and likely a key determinant as to
whether the current pace of Sukuk expansion can be sustained, is Saudi Arabia, which is
purported to be embarking on a USD250bn investment program of its own, and has plans to
displace Dubai as the region’s financial centre in the medium term. To date, however, Saudi
Arabia has only issued three international Sukuk in the amount of USD1.5bn.
Factors likely to affect the pace of growth of the asset class

Sukuk constitute an expansion of the EM asset class and provide a unique opportunity to gain
exposure to the previously difficult to access Middle Eastern region and to diversify
portfolios. However, how fast and furious the growth of the Sukuk asset class will be is likely
to depend on the ability to continue expanding the investor base, to improve liquidity and
transparency, to create a more unified regulatory framework, and to move to some
standardization in the structures being used (at present each transaction is different). We
identify the following 10 factors (in no particular order) as key determinants of future Sukuk
asset class growth:
1. Ability to reduce Shari’ah interpretation risk. Islamic jurisprudence lacks homogenous
interpretation, both within and across countries, leading to divergent rulings on the
religious compliance and eligibility of certain assets and transaction structures for
securitization. This has effectively led to a segmentation between the Malaysian and
Middle East Sukuk market, and poses a potential risk for market fragmentation moving
forward. The central bank governors from both Bahrain and Malaysia have in a number of
speeches called for a harmonization of Shari’ah judgments.
2. Greater standardization and regulatory alignment. Recent efforts at standard setting
have helped alleviate some of the legal uncertainty that surrounds Islamic jurisprudence
and the lack of market practice. For instance the Accounting and Auditing Organization
for Islamic Financial Institutions (AAOIFI) runs a Shari’ah board of 17 religious scholars
whose role is, inter alia, to unify the various opinions issued by religious scholars on
behalf of individual institutions. However, only eight countries have so far adopted
AAOIFI standards as mandatory. In addition, in 2002, the Islamic Financial Services Board
(IFSB) was inaugurated in Malaysia, comprising 88 member countries, serving as an
international standard setting body of regulatory and supervisory agencies and to
develop new, or adapt existing, international finance standards consistent with Shari’ah
principles and harmonization of practices within the Islamic finance service industry.
Other important bodies are the Islamic International Rating Agency (IIRA) and the General
Council for Islamic Banking and Finance Institutions (GCIBFI).
3. Liquidity. So far, the dominant tendency by most investors is still to treat Sukuk as buy
and hold investments inhibiting both secondary market liquidity and price discovery. This
is attributable to a lack of alternative Shari’ah compliant investment products (e.g. for
insurance companies, banks and large institutional investors dominated by government
controlled funds), the still limited amount of issuance so far, the shortage of paper
14
See speech by Zeti Akhtar Aziz, “Potential Role of Islamic Finance in Strengthening the New Silk Road” (March 28,
2007).

available for trading, and small issue size (with a few notable exceptions). Also, in some
markets the local institutional investor base is still underdeveloped and financial systems
remain heavily bank centric. Thus, while the pace of primary market issuance has been
impressive, an improvement in secondary market liquidity is likely needed to open the
Sukuk market up to a wider base of non-Islamic asset managers.
4. Transparency & ratings. One factor that is likely to significantly enhance secondary
market liquidity is an increase in the number of credit rated Sukuk. This has the dual
benefit of generating research assessing the originator’s credit risk and providing pricing
guidance. We have seen a marked increase in hedge fund demand for Sukuk in recent
months as several of the new issuers obtained credit ratings.
5. Lack of alternatives. The flurry in Sukuk issuance in recent years, and the strong
demand from non-Islamic investors, would likely not have been as pronounced had it not
been for the significant yield compression in EM external debt. Similarly, demand from
Islamic investors would likely not have been as strong if regional equity markets had not
slumped (see Figure 10).
Figure 10: The surge in middle-eastern Sukuk issuance coincided with the turn in the
Saudi stock market
Sukuk issuance from Middle-Eastern entities, Saudi Stock Index
USD bn (Tadawul All Share)
25 12
10
20
2007 8
15
YTD
6
10
4
5
2
0 0
2000 2001 2002 2003 2004 2005 2006 2007
6. Changes in tax treatment. Withholding taxes, characterization of income (e.g. whether

a stream of payments within a Sukuk represents interest, principal or dividend) and the
categorization of the transaction itself (loan, equity investment or asset sale) are
common tax issues that arise in Sukuk sales. The UK government recently announced
draft legislation that will give companies issuing Sharia compliant bonds the same tax
relief as those issuing conventional bonds by allowing them to offset the coupon
payments on the securities against the companies profits for tax purposes.15 Moving
forward, similar regulatory/tax changes could remove comparable roadblocks in other
jurisdictions.
7. Market externalities. Greater demand for Sukuk is likely to go hand in hand with capital
market development (particularly the Islamic insurance industry, Takaful).
8. Competition. Several Islamic countries (Bahrain, Malaysia and the UAE) are vying to
become a regional center of Islamic finance and there is also competition from advanced
economy exchanges such as the Third Market (Vienna) and of course London. This
15
Earlier the government had also lifted the double stamp duty on Islamic residential mortgages and commercial
property loans. In the past these loans were subject to two charges as an Islamic loan involved a bank buying a
property, then selling it back to an individual or business for a higher price/fee.

competition is likely to encourage innovation, greater transparency and liquidity. The

Dubai International Financial Center, for instance, is actively trying to shore up local
supply and consolidate secondary market trading (the Dubai International Financial
Exchange, DFiX, currently boasts the highest market value of Sukuk listed across the
globe). Malaysia last year liberalized restrictions to issue foreign currency denominated
financial instruments in Malaysia. Cross-listing of bonds across exchanges is also likely to
be an important factor.
9. Government benchmarks, in order to set successful precedents for Shari’ah compliant
structures, solve possible first mover problems (in new markets) and provide a pricing
benchmark for corporates.
10. Limited quality assets available for Ijara securitization. Shari’ah requires that all
financing is raised for trading in, or construction of, identifiable assets, which implies that
there is a stronger constraint on issuance size (e.g. upsizing of the deal) than in
conventional debt issuance.
Against these ten factors which could help promote the growth of the asset class, is one key
factor which could act as a limiter:
Oil prices. One of the reasons Sukuk issuance has taken off is the sharp increase in
liquidity in many Islamic countries that are oil exporters. A sharp reversal in oil prices
would potentially affect the level of demand.
Credit Risk – how rating agencies approach Sukuk

One of the principal catalysts for the development of the Sukuk market is likely to be the
extension of rating coverage to Sukuk issues – thus far only around a third of internationally
issued Sukuk has been rated. In view of the added complexity of Sukuk structures and the
legal uncertainty produced by the co-existence of commercial law and Shari’ah law, we
briefly review the approach to Sukuk ratings by the three main rating agencies16.
Figure 11: New Sukuk are increasingly Figure 12: ...but the majority of the
being rated... market remains unrated
Amount of International Sukuk Issued, Proportions by
US$bn number of deals
12
10 All issues Rated, 18

Rated
8
4 Unrated, 31
2
0
2001 2002 2003 2004 2005 2006 2007
Source: Bloomberg, Deutsche Bank Source: Bloomberg, Deutsche Bank, as at mid-August 2007
All three rating agencies have stated that their current rating methodologies and rating scales
can accommodate Islamic debt instruments. In the vast majority of cases so far, the rating
agencies have treated Sukuk as unsecured rather than secured credit instruments, with the
rating reflecting the originator’s credit risk rather than that of the underlying Sukuk assets.
This can be largely attributed to the purchase undertaking, which fundamentally alters the
16
This section is based on the following documents: (1) “Fitch’s Approach to Sukuk” (Fitch, March 2007); (2)
“Demystifying Corporate Sukuk” (Fitch, March 2007); (3) “Shari’ah and Sukuk: A Moody’s Primer” (Moody’s, April
2006); (4) “Islamic Finance Outlook 2006” (and collection of articles therein; Standard & Poor’s, September 2006); (5)
“The Islamic Financial Industry Comes of Age” (Standard & Poor’s, October 2006).

credit risk dynamics of the Sukuk structure. More to the point, rating agencies have pointed
out that:
Sukuk are often not true securitizations as the investors do not have recourse to the
underlying assets in the event of default. Rather, default would accelerate the purchase
undertaking and, if not fulfilled, would trigger a claim on the originator. This claim would
be pursued through the commercial court and Sukuk holders would rank as senior
unsecured creditors of the originator, similar to the situation in a conventional bond
default.
Investors’ risk to the underlying assets is contractually limited and the true credit risk
ultimately relates to the originator. For instance, the Sukuk payment stream may be
independent of the performance of the underlying asset. In many cases the originator
provides a liquidity facility to ensure payments to creditors equal the contractual periodic
distributions due on the Sukuk, hence eliminating any volatility in the cash flows deriving
from the assets. In addition, because the purchase undertakings take place at a pre-
agreed price, the investor is shielded from any valuation risk on the underlying assets.
The fact that credit risk has tended to relate to the originator and not the underlying asset
performance has meant that, in practice, long-term ratings of Sukuk do not exceed the
originator’s/issuer’s rating. They could, however, have a lower rating if there are additional
risk factors specific to the Sukuk.
Only in a minority of cases have rating agencies treated Sukuk as asset-backed

securitizations, which in those instances can lead to a higher rating than the unsecured rating
of the borrower. For this to be the case, Sukuk holders would need to hold beneficial title
over the assets and be able to realize ownership over the assets. This will tend to require (i) a
true sale of the assets to the SPV, i.e. the collateral needs to legally belong to the SPV with
no prior liens, mortgage, security or other encumbrances and; (ii) bankruptcy remoteness for
the SPV, i.e. if the originator goes bankrupt the underlying collateral would be protected
within the SPV from a “claw back” (reclaim) by an administrator of the insolvent estate. As
recently as March 2007, Fitch noted that none of the transactions it had reviewed satisfied
these requirements.
Ratings assigned to Sukuk do not imply confirmation that they are Shari’ah compliant, nor do
they require Sukuk to be compliant to be rated17. The rating agencies also do not opine on the
validity of a Shari’ah board’s recommendation or decision, and it is recognized that other
Shari’ah scholars may disagree with the originator’s Shari’ah board 18 . Such instances of
disagreement are generally not expected by the rating agencies to affect the legal
enforceability of the Sukuk (though they may affect demand for, and liquidity in, the Sukuk
but that is separate from the assessment of credit risk). Internationally issued Sukuk are
generally governed by English or NY law – similar to a normal bond – but like a normal bond
enforcement of a claim would likely be subject to review of the courts where the originator is
domiciled. These courts would generally act in accordance with commercial law. To the
extent the local courts are influenced by Shari’ah law this adds uncertainty to any judgment
and may complicate recovery, but uncertainty relating to the legal enforceability of a claim,
and risks related to local courts, are also present under commercial law and would be
embedded in an issuer’s rating.
17
S&P, however, notes that all Sukuk it has rated are structured with the approval of a Shari’ah board.
18
If Shari’ah non-compliance is included in the documentation as a dissolution event, the rating agency may perform
liquidity analysis to ensure the originator has sufficient available resources for the purchase undertaking, if the event
were to occur. Generally, dissolution events in Sukuk documentation are similar to events of default in conventional
bond prospectuses.

Sukuk Pricing and Secondary Market Behaviour

The increasing number of Sukuk that have been assigned ratings by the international credit
rating agencies has certainly been an important factor in helping to broaden the appeal of the
asset class among international investors. In addition to providing specific research on the
issues, the provision of a rating provides a means of comparing the pricing of such Sukuk
with comparably rated traditional corporate bonds. In Figure 13 we illustrate the rated Sukuk
that have been issued over the past year, along with the average level of the spread of
similarly rated US corporates as observed at the time of the relevant Sukuk issuance. It
should be noted that there is a wide range of spreads within each rating cohort in the US
corporate universe, hence the relative spread of any individual Sukuk to the average of
similarly rated US corporates should not be taken as a clear indication of richness or
cheapness. Nevertheless, the fact that the Sukuk have priced consistently wide to US
corporates is perhaps indicative of a structural factor in the pricing of the asset class. Namely,
that Sukuk are cheap to comparable credits in the US. Such cheapness would certainly
explain the significant appetite for recent Sukuk from international institutional investors, but
it could also be argued that some cheapness is justified given the additional complexity of
Sukuk documentation, even if – ultimately – the economics of the instrument from the
perspective of the holder are virtually identical to those of a traditional bond.
Figure 13: Recent rated Sukuk have been consistently priced wide of comparably
rated US corporates at issue
Spread over Issue Spread Spread of US Corps of equivalent rating and tenor
US Libor Curve, bp
(BBB-/-/-)
GFHSUK
140
(BBB+/A3/BBB+)
(BBB+/Baa1/-)
(BBB-/-/-)
TABRED
GOBLT
MAYMK
120
100
(BBB/-/-)
SIB
DPWORL
(A+/A1/-)
80
(A+/A1/-)
DIFCDU
(-/A2/A+)
ADIB
60
(A/A1/-)
EIBSUK
DIBUH
(A/A1/-)
40
20
0
Jul 06 Oct 06 Jan 07 Apr 07 Jul 07
The development of an active secondary market has substantially lagged the primary market,
although the first half of 2007 has seen a significant increase in turnover. Figure 14 lists the
current most traded Sukuk with an indication of their approximate relative liquidity.
Of the five most actively traded Sukuk, two are pure fixed-income Sukuk, while the other
three are equity linked.
Pure fixed-income Sukuk

DP World 17 sees the most diversified interest with frequent trades by
Asian/US/European as well as ME money managers. A normal ticket size would be USD
5mm, although trades up to USD 25mm have been done. An average day would see
about USD15-20mm of DP World 17s trade.
DIFCDU was extremely popular soon after issuance with trades of USD 25mm
commonplace. The average ticket size has now fallen to USD 5mm. An average day
would see about USD10-15mm of DIFCDU trade.

Equity-linked Sukuk
ALDAR is by far the most active sukuk in terms of frequency of trades on a given day,
due to the fact that the equity conversion is well in-the-money and hence pricing is
governed entirely by the underlying stock – which is itself active. The average ticket size
is around USD 5mm. On a quiet day daily volume would be around USD 10-20mm, but
this can go up to USD 60mm on a day in which the underlying stock is volatile.
Nakheel is fairly active and popular with hedge funds in particular. Typical trade size
would be USD 10mm, but can be up to USD 50mm. An average day would see around
USD 20-25mm trade in the market.
PCFC is event-driven thanks to the proximity of its maturity (Jan 2008) and the
implications of an IPO prior to then (see Appendix A for details). Average trade size is
around USD 5mm. However, trading activity is rather infrequent. A quiet week could see
USD 5-10mm trade, whilst an event-driven week (IPO speculation) could see USD 70-
100mm trade in the market.
DB’s Emerging Market interactive pricing and analysis platform – QuantEM – now includes
the most liquid Sukuk with daily prices, yields and spreads along with historical data.
QuantEM is available to DB clients at http://gm.db.com/quantem. See Figure 15 (on page 21)
for an illustration of the QuantEM sukuk screen.
Figure 14: Summary of current most liquid Sukuk

Amount Issued Rating
Liquidity Ticker Originator Issue Date Original Tenor Maturity Coupon (USD mm) Structure Equity LInked S&P Moody's Fitch
Excellent
DPWORL DP WORLD SUKUK Jul 07 10 Jul 17 6.25 1,500 Mudarabah A+ A1
DIFCDU DUBAI SUKUK Jun 07 5 Jun 12 L+37.5 1,250 Mudarabah A+ A1
ALDAR ALDAR FUNDING Mar 07 5 Nov 11 5.767 2,530 Mudarabah Y
NAKHL NAKHEEL DEVELOP Dec 06 3 Dec 09 Complex* 3,520 Ijara Y
PCFC PCFC DEVT FZCO Jan 06 2 Jan 08 Complex* 3,500 Musharaka Y
Good
DARARK DAAR INT SUKUK Mar 07 3 Mar 10 L+200 600 Ijara
AABAR AABAR SUKUK LTD Jun 06 4 Jun 10 6.894 460 Mudarabah Y
EMIRAT WINGS FZCO Jun 05 7 Jun 12 L+75 550 Musharaka
PKSTAN PAKISTAN INT Jan 05 5 Jan 10 L+220 600 Ijara B+ B1
DGSI DUBAI GLOBAL Nov 04 5 Nov 09 L+45 1,000 Ijara
Ok
EIBSUK EIB SUKUK LTD Jun 07 5 Jun 12 L+30 350 Musharaka A A1e
IIGF IIG FUNDING LTD Jun 07 5 Jul 12 6.75 200 Mudarabah Y
GOBLT GOLDEN BELT May 07 5 May 12 L+85 650 Ijara BBB+ Baa1
DIBUH DUBAI ISLAMIC BA Mar 07 5 Mar 12 L+33 750 Musharaka A A1
Poor
ADIB ABU DHABI ISLAMI Dec 06 5 Dec 11 L+40 800 Musharaka A2 A
SIB SIB SUKUK CO LTD Oct 06 5 Oct 11 L+65 225 Ijara BBB
TABRED TABREED 06 FIN C Jul 06 5 Jul 11 L+125 200 Hybrid BBB-
QATAR QATAR GL SUKUK Oct 03 7 Oct 10 L+40 700 Ijara AA-
Source: Deutsche Bank, ratings agencies, company data

Appendix A – Equity-linked
Sukuk
As has previously been mentioned, the introduction of Sukuk with convertible features was a
key catalyst for the asset class, bringing in new investors and allowing for larger issue sizes.
Since these Sukuk are among the most actively traded Sukuk and also given that they have
rather more complex terms than the majority of Sukuk, it is worth briefly reviewing the
different types.
The equity-linked Sukuk can be divided into two groups: true ‘convertible’ Sukuk and Sukuk
bearing pre-QPO subscription rights.
Pre-QPO Sukuk
Pre-QPO Sukuk include QPO subscription rights which give the Sukuk holder the right to
participate in any Qualifying Public Offering of the obligor (and generally also associated
companies).
PCFC 2008
The 2Y Sukuk issued by the Dubai Ports, Customs and Free Zone Corporation is a zero-
coupon issue which may be redeemed in part through the issue of PCFC shares on the
occurrence of one (or more) QPOs.
In the event that there is no QPO during the life of the Sukuk, the accumulated annual
return is 10.125%. Holders will receive the principal amount, plus this higher
accumulated return, in cash. For a USD100 face amount of Sukuk, this equates to a
redemption amount of USD120.25
In the event of a QPO, holders will receive an accumulated annual return of 7.125% up
to the date of the QPO. The principal amount of the notes, plus the accumulated return,
will be dispersed 70% in cash, 30% in QPO shares (at the QPO price). 50% of the
shares are delivered on the QPO redemption date, the remaining 50% being delivered
after a ‘lock-up’ period of three months. The size of the QPO may be less than would be
required to redeem the entire Sukuk, in which case the redemption is conducted on a
pro-rata basis. The terms allow for the Sukuk to be redeemed in parts via a sequence of
separate QPOs.
Nakheel 2009
The 3Y Sukuk issued by the Nakheel Development Corporation in December 2006 are
somewhat simpler in that they carry pre-QPO subscription rights, giving the Sukuk holder the
right to participate in any QPO at a discount to the QPO price of 5%. The yield on the Sukuk
is 6.345%, although only half of this is paid on a periodic basis (semi-annually) during the life
of the Sukuk. At final redemption (which will be in December 2009 regardless of whether a
QPO occurs or not) the remaining half of the yield is paid. For a USD100 face amount of
Sukuk, this equates to a redemption amount of USD109.5175 (100 plus 3.1725% for three
years).
As with PCFC, the yield on the Nakheel Sukuk is reduced in the event that a QPO occurs.
In the event that there is no QPO during the life of the Sukuk, an additional 2% of the
face amount is paid to Sukuk holders.

If a QPO does occur, Sukuk holders have the right to participate in the QPO at a discount
of 5%. The amount of QPO shares available to Sukuk holders at any QPO depends on
the total size of that QPO (up to 30% will be available to Sukuk holders) and only up to
25% of the face amount of the Sukuk. In the event that less than the full 25% of QPO
subscription rights are attributed during the life of the Sukuk, an additional payment is
made to Sukuk holders on a sliding scale from 2% to zero depending on the proportion
of rights attributed (between zero and 25%). As with PCFC, the QPO shares are also
subject to a lock-up period: 34% are delivered immediately, 33% after one month and
the final 33% two months after the QPO.
For the purposes of valuing the pre-QPO Sukuk, it is simplest to consider two alternative
cashflow streams for each – one assuming no QPO takes place, the other assuming a full
QPO occurs. Within QuantEM we display the yields and spreads corresponding to these two
alternatives given the current price of each Sukuk. In the QPO case we conservatively
assume that there is no incremental value in the QPO shares and we also ignore the QPO
discount in the case of Nakheel.
At current prices, the spread over the US libor curve for PCFC-08 (mid price 115.625) is
+345bp assuming no QPO, but is -797bp assuming a QPO takes place. With less than six
months until maturity, the pricing of this Sukuk is highly sensitive to whether a QPO takes
place or not. Certainly the market current appears to attach a high probability to there not
being a QPO.
Convertible Sukuk
At the time of writing, five true convertible Sukuk had been issued. Two of these are among
the most actively traded international Sukuk.
AABAR 2010
Exchangeable at anytime between June 28, 2008 and the scheduled redemption.
Converts to 917.8522 shares. Current share price is AED 3.59, implying a parity of USD
89.71. The current price of the Sukuk is 106.50 (mid), which equates to a libor-spread of -
57bp.
Even though the exchange is currently out-of-the money, the fact that the Sukuk is
trading with a negative spread over the US libor curve suggests that a small value is
being attached to the exchange option.
ALDAR 2011
Exchangeable at anytime between September 10, 2007 and 25 day prior to scheduled
redemption.
Exchange for 645.161 shares. Current share price is AED 6.63, implying a current parity
of USD116.46. This equates to a libor spread on the Sukuk of -342bp.
The exchange is substantially in-the-money and as a result the price of the Sukuk is
governed entirely by the price of the underlying stock.

30 August 2007
Figure 15: DB’s Emerging Market Pricing Platform – QuantEM – provides data and analysis on the most liquid Sukuk
http://gm.db.com/quantem
Bond Market Guide

Page 21
o
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GRCM2007PROD011186

Deustsche Bank Introduction To Sukuks

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Deustsche Bank Introduction To Sukuks

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GEMS: Middle East

Bond Market Guide Primer

Introduction to Sukuk Introduction ........................................................ Page 2

Shari’ah concepts in Islamic Finance ................. Page 3

Sukuk Market Size

Deutsche Bank AG/London

It is somewhat misleading to think of Sukuk as being designed specifically for Muslim

Page 2 Deutsche Bank AG/London

Shari’ah concepts in Islamic Finance

Aside from the prohibition of riba, Islamic finance also prohibits:

Contracts which can be transferred at a negotiated price

Mudaraba – a mudaraba can be thought of as an asset management agreement whereby

Musharaka – a musharaka agreement is somewhat similar to that of a mudaraba, but in this

Deutsche Bank AG/London Page 3

Contracts only transferable at face value

As an indication of the relative importance of these various forms of Islamic Finance

Figure 1: Composition of Dubai Investment Bank’s Islamic Assets

Source: Dubai Islamic Bank Consolidated Financial Statements 31 Dec 2006

Sukuk as a vehicle for Shari’ah compliant financing and

Page 4 Deutsche Bank AG/London

Figure 2: Typical structure of Sukuk-al-ijara

Issue proceeds (2)

Lease agreement (3) Issue proceeds (1)

Originator Title to assets (5)

Source: Deutsche Bank

Deutsche Bank AG/London Page 5

Sukuk-al-musharaka and Sukuk-al-mudaraba

Figure 3: Typical structure of Sukuk-al-mudaraba

Issue proceeds (2)

Source: Deutsche Bank

As with Sukuk-al-ijara, the redemption of the notes is achieved by means of a purchase

Page 6 Deutsche Bank AG/London

The primary difference between Sukuk-al-mudaraba (described above) and Sukuk-al-

Other structures of Sukuk

In the Malaysian domestic market, Sukuk based on cost-plus-sales, known as Sukuk-al-

Deutsche Bank AG/London Page 7

A brief history of the development of the Sukuk market

Figure 4: All Sukuk Issuance Figure 5: International Sukuk Issuance

Amount Issued, US$bn Amount Issued, US$bn

Page 8 Deutsche Bank AG/London

Islamic Development Bank’s USD400mm 5-year Sukuk-al-wakala 5 . This was followed in

Figure 6: International Sukuk by Type

Deutsche Bank AG/London Page 9

Figure 7: International Sukuk dominate Figure 8: International Sukuk issuance by

Expectations for market development

Estimating potential demand for Sukuk

Page 10 Deutsche Bank AG/London

Deutsche Bank AG/London Page 11

US 301.1 1.0 75.3 13,245 132 4714 0.2

Estimating potential supply of Sukuk

Page 12 Deutsche Bank AG/London

Factors likely to affect the pace of growth of the asset class

Deutsche Bank AG/London Page 13

 6. Changes in tax treatment. Withholding taxes, characterization of income (e.g. whether

Page 14 Deutsche Bank AG/London

competition is likely to encourage innovation, greater transparency and liquidity. The

Credit Risk – how rating agencies approach Sukuk

10 All issues Rated, 18

Deutsche Bank AG/London Page 15

Only in a minority of cases have rating agencies treated Sukuk as asset-backed

Page 16 Deutsche Bank AG/London

Sukuk Pricing and Secondary Market Behaviour

6. Changes in tax treatment. Withholding taxes, characterization of income (e.g. whether