S&P report outlines approach used to rate Sukuk

An unprecedented surge in sukuk issuance during the past three years has provided issuers with an alternative way to structure their funding.

We estimate sukuk outstanding worldwide to be in excess of $80 billion at June 30, 2007. Over two-thirds are unlisted, over-the-counter instruments, with the remainder listed. The number and size of listed sukuk are increasing fast, the largest being that issued by Dubai-based Nakheel Group in early 2007 for $3.52 billion, listed in London and Dubai.

As of Sept. 17, 2007, we rated $12 billion in sukuk outstanding listed on the world's markets, and we believe the volume of rated sukuk is set to rise due to the rapid development of this type of financing.

We understand that in structuring sukuk, parties endeavour to ensure that:

Rights and obligations of both the issuer and investors are clear and transparent, in compliance with the principle of Islamic finance that bans "gharar" (uncertainty);

Income from securities is related to the purpose of the funding, and does not simply comprise interest payments--abiding by the principle that bans "riba" (usury or interest); and

Securities issued are backed by yields derived from identified tangible underlying assets, according to the principle that all financial transactions must be asset backed, or at least asset based.

In light of these principles, sukuk lie on a continuum ranging from the lowest profit-sharing structures (typically guaranteed sukuk with a predetermined rate of profit ranking pari passu with the obligor's other obligations) to the highest profit-sharing structures (nonguaranteed sukuk behaving like ABS and issued by pass-through or pay-through vehicles.) In this report, we identify three broad categories of sukuk:

Sukuk with full credit-enhancement mechanisms;

Sukuk with no credit-enhancement mechanisms; and

Sukuk with partial credit-enhancement mechanisms.

For each sukuk category, we describe our ratings approach in detail and provide useful examples.