11-03

Rating Methodology and Evaluating

the Issuer of Sukuk

Slim MSEDDI and Nader NAIFAR

1
2012
 Rating Methodology and
Evaluating the Issuer of Sukuk

Slim MSEDDI and Nader NAIFAR

Department of Finance and Investment, College of Economics and
Administrative Sciences, Al-Imam Muhammad Ibn Saud Islamic University,
Riyadh, Saudi Arabia, Email: naneifar@imamu.edu.sa

The paper was financially supported by Research Grant

Program of SABIC chair for Islamic Financial Markets Studies at
Imam University, Riyadh, Saudi Arabia (Grant No. 11-02)

2012

1
 Rating Methodology and Evaluating the Issuer of Sukuk
Abstract:
Islamic financial institutions have recently extended their activities in
capital markets. Actually, sukuk is one of the most important tools of Islamic
capital market; it plays a significant role in mobilizing resources. Given the
preferences of investors who demand that the money is repaid, managed in
compliance with Shari'ah and generates an acceptable rate of return. The main
objective of this paper is to develop and evaluate an appropriate rating
methodology for the issuers of sukuk. First, this research begins by studying the
differences between sukuk and conventional bonds. The key idea is to detect
the real factors that affect rating decision for issuer of sukuk. Second, referring
to the structure of sukuk and the international agencies of rating (i.e. Moody's,
Standard and Poor's, Fitch, MARC -Malaysian Rating Corporation- and Islamic
International Rating Agency of Bahrain) and using the literature based on the
previous research in rating for the issuers of conventional bonds (financial and
operational risks) and fiduciary rating (systems failure risk, governance and
quality of management), This study proposes an integrated methodology that
combines sukuk rating and fiduciary rating that analysis the firm ability to repay
its debt, managed compliant with Shari'ah (Islamic laws) and provides
acceptable performance compared to the market. This study investigates all
factors influencing the issuer of sukuk and offers a suitable rating methodology.
Our research will have practical implications: it provides a new rating
methodology suitable for the issuer of sukuk that can be used by investors,
financial institutions and financial market.
Key words: Rating factors, Islamic finance, Sukuk, Business risk, Financial risk,
Default risk, Risk sharing, Fiduciary Rating.
2
 Rating Methodology and Evaluating the Issuer of Sukuk

Introduction
Sukuk (as investment certificates that comply with Islam's Shari'ah
legal code) is one of the fastest growing segments in the financial markets
(Beck, Demirguç-Kunt, and Merrouche, 2010). Sukuk, as instrument Shari'ah
compliant and suitable for Muslim investors, are issued in Islamic and non-
Islamic countries in Japan, China, USA, France, Britain and Germany. The first
issuance of sukuk may be dated in 1990 in Malaysia. The issuance of sukuk
rose from US$7.2 billion in 2004 to US$39 billion in 2007, with a global
outstanding volume exceeding $90 billion (Jobst, Kunzel, Mills and Sy, 2008).
In 2010 Sukuk issuances hit a record of US$47.78 billion (IFIS: Islamic Finance
Information Service, 2010), with a global outstanding volume exceeding $197
billion. Against this positive growth, renewed confidence of investors and
issuers is evident. The number of sukuk rose from 87 in 2005 to 730 in 2010.
According to Dow Jones Islamic Markets Indices, the Sukuk Index gained 9.1%
in 2010 finishing at 125.32 points. Until December 31th 2010, 45% of the total
sukuk issued in the international market and 23% of the total sukuk issued in
the domestic market have been Ijarah-based (IIFM, 2011). Sukuk Al Murabaha
and sukuk Al Musharaka represent 30% and 26%, respectively. Despite the
restricted place in the global financial system, there is growing demand for
Islamic finance, principally for sukuk market (15% per year over the past three
years and 10% over the past decade). Two major reasons can explain this
growth. The first, a strong demand from Muslims seeking financial Shari'ah, the

3
second, a significant need for investment by investors from the Gulf, where
surplus oil-exporting countries, or US$1,500 billion, have doubled over the
previous decade. AAOIFI defined Sukuk as "Certificates of equal value
representing undivided shares in ownership of tangible assets, usufructs and
services or (in the ownership of) the assets of particular projects or special
investment activity"1. Unlike conventional bonds that promise to pay back the
principal and interest, Sukuk is Shari'ah compliant and accordingly, returns are
paid to investors in line with their proportional ownership in the underlying
asset. Sukuk are not supposed to be bonds, but like equity or profit-sharing
instruments. Woodruff (2007) suggests, however, that Sukuk is not the same
thing as an equity stake or share of the company, in as much as a share is an
ownership claim on the company itself, with no maturity date, while Sukuk are
a claim on a well-defined, specific asset. Interest, though, is forbidden in Islam,
so traditionally; a sukuk raises capital by leasing a tangible asset, such as real
estate. The sukuk investor purchases a proportional ownership of that asset,
and earns profit off the leasing arrangement.
In practice, however, most sukuk in the modern Islamic financial
market were not Shari'ah compliant, as the investors expected to get the
nominal value of their capital returned on maturity, avoiding exposure to
market risk. Usmani (2007) and The Accounting and Auditing Organization for
Islamic Financial Institutions (AAOIFI) believe that many sukuk are
indistinguishable from conventional debt financing. Unfortunately, sukuk are
structured not only on tangible assets, but also on debts, businesses, and
investments, so many accept the need for rating a sukuk similarly as a
conventional bond. International rating agencies considered two types of

1
Page 298 of AAOIFI’s Shari’ah Standards for Financial Institutions 2004-5
4
sukuk: asset-based sukuk and asset-backed sukuk. The main difference
between asset-based sukuk and asset-backed sukuk lies in the ownership and
sale of the assets.
Asset-based sukuk permit the insertion of the tangible asset which may
not be legally admitted to be owned outright by the sukuk holders. Asset-
backed sukuk permits the sukuk holder a share of the real asset or business
venture, and a share of the risk appropriate with the "true sale" ownership of
the asset. In this case, sukuk securitization is planned around the sukuk holders'
legal ownership of assets, which forms the only source of return and principal
payments. Certainly, ratings for sukuk will increase transparency and add to
efficiency in the market. Many international and domestic agencies are
interested to rating sukuk. The three major international ones usually referred
to are, Moody's, Standard and Poor's, and Fitch. According to Zaidi (2008),
domestic rating agencies' knowledge services to their domestic markets and
have earned credibility and respect of the users for their ratings, research and
assessment services, which reduces the need to go to the global rating agencies.
Domestic rating agencies focus on local markets and offer an alternative to the
global rating agencies.
Islamic investors are always looking for investment opportunities,
management process, corporate governance (disclosure of relevant
information's and transparency) and Asset Manager Quality in accordance with
the Shari'ah. Recently, many investors are interested to fiduciary rating as an
indication of the structural and performance risks that investors must consider
when entrusting funds to specific investment managers. The investors seek to
maximize the probability of making profitable investments and acceptable rate
of return compliant with Shari'ah.

5
 The present paper proposes an integrated approach that combines two
dimensions credit risk and fiduciary risks. The paper starts with definition of
sukuk, the difference between sukuk and conventional bonds, structures sukuk
and types of sukuk. After giving an overview of the importance of rating sukuk,
we then present our own methodology for rating sukuk while exploring the
differences in methodologies across sukuk rating agencies (mainly Standard
and poor's, Moody's and Fitch). The remainder of the paper covers an essay to
rating sukuk with fiduciary risk. We close with a conclusion.
1- An overview of sukuk
In this section we present the main differences between sukuk and
conventional bonds, sukuk structures and then the types of sukuk.
1.1. The difference between sukuk and conventional bonds
Conventional bonds are defined by Hymas2 (2009) as instruments for
which "there must be precise dates on which interest and principal repayment
flow to the investor, in default of which an operating company is put into
bankruptcy". Bonds are pure contractual debt obligations of a lender to a
borrower that used to finance any activity and whose value rests on the
creditworthiness of the issuer. In contrast, sukuk, trust certificates, represent an
ownership interest in existing, well-defined (specific) assets or a pool of assets,
service, or project capable of being certified by a third party, but not like share
as an ownership claim on the whole of the company. Sukuk are similar in
structure to conventional bonds but allow sovereign and corporate entities to
raise funds in capital markets in conformance with Shari'ah principles,
Godlewski, Turk-Ariss and Weill (2011). The subject matter of securitization in

2
James Hymas, Bond Characteristics, Canadian Money saver, February, 2009.
6
a sukuk is neither an obligation/indebtedness nor a receivable. The return to
investor is not fixed or guaranteed but is subject to the performance of
underlying asset. Sukuk can be assimilated both bond and stock-like features
issued to finance assets. Like bonds, sukuk have a maturity date and holders are
entitled to a regular stream of income over the life of the sukuk along with a
final market value payment at maturity. However, like shares stocks in the
sense that they represent ownership claims and that the return on both
investments is not guaranteed. So, in the secondary market, sukuk prices can
vary both with the credit-worthiness of the issuer and the market value of the
underlying asset.
Woodruff (2007) presents the difference between conventional bonds
and sukuk:
- The sale of financial instruments in the secondary market represents
the sale of a debt obligation in the case of conventional bonds and the
sale of a right of use of an asset for sukuk.
- The second difference is the tax treatment, under several tax systems,
sukuk rental payments are not deductible before tax in the same way
as conventional bonds interest payments. A sukuk transaction is one
whereby investors finance the purchase of an asset by means of profit-
sharing financing. The payments to investors should come from after-
tax profits.
- Sukuk, like conventional bonds, are easily marketable and transferable
in the secondary market. The secondary market of sukuk is not as
liquid as the normal conventional bonds market because the strategy
of buy-and-hold for many investors and types of sukuk, asset-based
securities or asset-backed secured claims.

7
 The AAOIFI Standard (2003) distinguishes sukuk from stocks, bonds,
and from the conventional process of securitization as well. Sukuk are, not debt
certificates with a financial claim to cash flow, but similar to a trust certificate
with proportional or undivided interest in an asset or a pool of assets. The
AAOIFI suppose that the right to a proportionate share of cash flow is derived
from ownership interest that carries risks and benefits. Wilson (2008) noted
that the return is usually benchmarked to the LIBOR in sukuk pricing is not
preferable as argued by Islamic scholars as well. He argues that financiers want
the investors to regard the sukuk as similar to their equivalent conventional
asset classes, as this simplifies risk assessment. He suggested that corporate
sukuk could be benchmarked against indicators relating to the performance of
the companies being financed. However, he proposed that the use of dividend
or profit indicators could be entirely appropriate, which could be the basis for a
new type of sukuk based on a Musharakah partnership structure.
1.2. Sukuk structures
As with conventional debt securities sukuk are issued for a fixed time
period rather than in perpetuity as in the case of equity. According to the
Islamic laws, sukuk must be backed by a real asset (a piece of land, a building or
an equipment), and therefore when sukuk are bought and sold the purchaser
and seller are dealing indirectly in a real asset, and not simply trading paper.
Sukuk can be structured in a variety of ways. The Accounting and Auditing
Organization for Islamic Financial Institutions (AAOIFI) has developed 14
prototypical sukuk (with different risk and return characteristics) in its
investment Sukuk standards, where some of these sukuk are tradable in the
second market and others are non-tradable based on the type and
characteristics of the issued Sukuk.

8
 Sukuk can be structured alongside different techniques3. Following the
period between 1st January 2001 to 31st December 20104, the widely used
sukuk structures are Murabaha (cost plus sales) that represent 30% of the
global issuance in domestic sukuk market but only 2% in the international
market (these sukuk have no secondary market). The 2nd are Musharaka sukuk
- financing a business activity on the basis of partnership contracts- that
represent 26% of domestic sukuk market and 19% of international sukuk
market. The 3rd are sukuk Al-Ijarah that represent ownership of equal shares in
a rented property or usufruct of the property. In the international sukuk market
and in the domestic sukuk market, the sukuk Al-Ijarah represent 45% and 23%,
respectively. There are others types of sukuk: i.e. Salaam Sukuk (future
delivery), Istisna sukuk (manufacturing), sukuk al-Mudarabah (financing),
Sukuk al-Muzara'ha (sharecropping), Sukuk al-Musaqah (Irrigation), sukuk Al-
Mugharasah (agriculture) and hybrid sukuk (combination of some of these
types).
Many critics are addressed to sukuk structures. According to Moody's
report (Howladar, 2009), a lot of sukuk structures applied have been effectively
reduced to a form that is identical to conventional unsecured bond. According
to Mohammad Taqi Usmani (President of the AAOIFI Shari'ah Council), current
practices of issuing Sukuk replicate the structure of conventional bonds in
terms of lack of ownership, right to a fixed return, and the guarantee of

3 For more details about sukuk types see Wilson (2008), El-Quqa, Hasan, Rout and Joubaili
(2008), Shaikh and Shan (2010) and IIFM Sukuk Report 1st Edition (2010).
4
Ijlal Ahmed Alvi (International Finance Islamic Market), 2011, "Overview & Trends in the
Global Sukuk Market", Annual Shari'a Conference, 30-31 May, Manama, Kingdom of
Bahrain.
9
repayment of principal. Usmani (2007) think that most sukuk (he estimated
that 85%) were not shariah-compliant. Yean (2009) suggests that most asset-
based sukuk may have the form of asset-backed sukuk, but not in substance.
1.3. Asset-based sukuk versus Asset-Backed sukuk
Shari'ah principles must be applied when structuring Shari'ah-
compliant financial products, including sukuk. These principles include the
avoidance of riba (surplus value without counterpart: interest), Maysir (the
contract indicates that the ownership of a good depends on the occurrence of a
predetermined, uncertain event in the future) gharar (speculation transactions),
unjust enrichment and prohibited activities or investments (such as gambling
and alcohol related investments). Similarly, Shari'ah principles, must also be
applied when sukuk default and liquidation situations arise. The originator
transfers certain of its assets to a special purpose vehicle (SPV). The SPVs
become the issuers/trustees of sukuk. The SPV typically is owned by a purpose
trust. The SPV will issue sukuk or trust certificates to investors (the buyers of
sukuk) and invest the proceeds in assets. The SPV holds the assets in trust for
the benefit of the sukuk holders pursuant to a declaration of trust, using the
income from the assets to make payments to the sukuk holders.
Upon an event of default or at maturity (at the option of trustee under
the purchase undertaking); or the exercise of an optional call (if applicable to
the sukuk), trustee will sell, and originator will buy-back, the assets enabling the
SPV to redeem the outstanding certificates and repay the sukuk holders. In this
regard, the rights of sukuk holders in the event of default will vary depending
on whether the sukuk structure is an “asset-based” or an “asset-backed”
structure, Elmalki and Dennis (2010). Asset -based sukuk represent an
ownership interest in a specific asset so as to identify the proportional profit

10
generated from that asset, Woodruff (2007). He adds that effectively structured
asset-backed securities represent a secured claim on some specific underlying
equipment. However, sukuk are asset-based rather than asset-backed
securities, with the underlying asset being necessarily Shari'ah-compliant in
both nature and use. The key difference between asset-based sukuk and asset-
backed sukuk is the concept of true sale. In terms of risk/return profile, asset-
backed sukuk are closer to an equity position because sukuk holders own the
underlying asset and have no recourse to the originator in the event of a
payment shortfall. Asset-based sukuk are closer to debt because sukuk holders
have recourse to the originator if there is a shortfall in payments. The majority
of sukuk issues, however, are asset based.
In asset-based sukuk, the originator typically transfers only the
beneficial ownership to the special-purpose vehicle (SPV) issuer. According to
the shari'ha principles there must be a transfer of assets to sukuk holders,
however, since investors have no recourse to the assets, the transaction does
not focus on asset risk, but rather on the creditworthiness of the sponsors of the
sukuk, Elmalki and Dennis (2010). If the originator fails to meet their
obligations pursuant to the transaction documents, the certificate holders have
no recourse against any other assets of the issuer, or the trustee, or the right to
cause the sale or other dispersion of any of the trust assets on default, except
during the initial purchase undertaking. Under the transaction documents, the
certificate holders can exercise their rights by issuing notice to the originator
pursuant to its undertaking to repurchase the assets on maturity or default of
the sukuk. The nominal value is effectively guaranteed, in most cases by the
originator, via a purchase undertaking agreement, i.e. a promise to repurchase
the underlying assets at the sukuk maturity. Facing cash flow problems and
financial distress, the certificate holders and the originator can agree to
11
restructure the debt and related obligations (i.e. an agreement to reduce the
principal sums outstanding) under the transaction documents. Ultimately,
asset-based sukuk are based upon the credit of the issuer, guarantor or other
co-obligors, Elmalki and Dennis (2010).
Alternatively, in asset-backed sukuk, there is a true sale, the originator
sells the assets to a special-purpose vehicle (SPV) that holds them and issues
the sukuk and the buyers (sukuk holders) do not have recourse to the originator
if there is a shortfall in payments. A true sale denotes the assets of the issuer will
not be consolidated with the assets of the originator in the event of the
liquidation. Assets are owned by the SPV, returns are derived from assets, and
asset prices may vary over time. Asset-backed sukuk are closer to equity than
debt, represent a minority of sukuk issues, Taqi Usmani (2007). An issue of
contention in recent defaults has been whether the SPV (and thus the sukuk
holders) truly have complete ownership of the assets. This is important since
the originator is in default may not be able to honor the purchase undertaking.
Consequently, in asset-based sukuk, the recourse of the investor is to the
creditworthiness of the ultimate obligor, but if sukuk are backed, the recourse
of the investors is to the asset-issuing vehicle and the sukuk investors bear any
losses in case of impairment of the sukuk. In the last case, legal title to the
underlying assets will typically represent a true sale from the originator to the
issuer SPV. The principles of true sale, fundamental to a securitization, must be
present in an asset-backed sukuk. The AAOIFI has stated that for “sukuk, to be
tradable, (they) must be owned by sukuk holders, with all the rights and
obligations of ownership in real assets”5. The AAOIFI has recently approved

5
AAOIFI, Shari'ah Board Statement, Bahrain (February 13 and 14, 2008), p. 1.
www.aaoifi.com/sharia-board.html
12
new guidelines that will require investors to become the legal, rather than
nominal, owners of sukuk assets. In addition, Shari'ah boards are to review all
relevant contracts related to financing with sukuk to ensure complete
compliance with Shari'ah principles and supervise that realization and
operation complies with Shari'ah. According to AAOIFI, sukuk must be like
equity that cannot represent a debt owed to the holder. While, asset-backed
sukuk are more suitable with the principle of granting the investor an
ownership share of the asset, asset-based sukuk may be more consistent where
legal title to assets is complicated to transfer to sukuk holders (i.e. restrictions
on foreign ownership and sovereign owned assets).
2- Role of rating and outline of sukuk rating by Standard and
Poor's, Moody's and Fitch
2.1. The role of rating in sukuk
The role of rating agencies is to provide an independent opinion (that
contributes to reduce information asymmetry), objective and prospective on
the risk of financing a borrower. This rating provides reliable and objective
information to foreign investors to make more relevant decisions. Zaidi6 (2008)
defined rating as an independent, objective opinion regarding the relative
capacity to meet financial obligations, including Islamic returns. A strong
consensus exists on the capacity rating agency to vehicle additional information
to the market investors. The rating agency provides for economic agents a
signal on the probability of default of the counterparty. Thus, rating of
companies provides an assessment of the probability of default of the

6
Jamal Abbas Zaidi, 2008, Islamic International Rating Agency, Workshop on Financial
Institutions Analysis.
13
institution. This type of information contributes to market efficiency. This is
especially crucial in an emerging country, where the regulatory environment
and institutional framework can create incentives for excess risk, it is necessary
to balance market efficiency as possible.
Credit rating agencies are specialized in assessing the credit worthiness
of a corporation or security. They accomplish a double role of certification
(granting ratings to potential security issues) and diffusion of information
(distributing rating reports to investors). Many benefits provided by rating:
firms can access markets at low cost (low cost information) and so helps to
allocate capital efficiency across sectors, enhance the transparency and the
ability of the borrower/issuer to access the financial markets, and increases
investor confidence and guide them. More precisely, considering investor
perspectives, rating permits to safeguard their interest, channelizes savings into
the capital market and provides signals to the investors. For issue perspective,
rating facilitates the access of investors and helps it to establish credibility
among investors. Pogue and Sodofsky (1969) examined the information
content of ratings and the process by which ratings are determined for different
types of financial obligations and borrowers. The investor has access to a lot of
information about a company's credit risk from several points of view.
2.2. Rating sukuk by national and international agencies of rating
Rating agencies play a critical role in assessing the creditworthiness of
corporation. Standard and Poor's, Moody's, Fitch, MARC (Malaysian Rating
Corporation) and Islamic International Rating Agency (Bahrain) are the
principal agencies that have experience to rating sukuk. The methodology used
by rating agencies differs for each one. We present an overview to rating sukuk
by the agencies cited above.

14
  Standard and Poor's sukuk rating methodology
The ratings of Standard and Poor's are an opinion about the ability and
willingness of an issuer to meet financial obligations in a timely manner,
without commenting on Shari'ah compliance. Standard and Poor's considers
that sukuk lie on continuum from the lowest profit-sharing structures (typically
guaranteed sukuk with a predetermined rate of return) to the highest profit-
sharing structures (non guaranteed sukuk like Asset-Backed Securities (ABS)).
According to S&P, sukuk are generic for notes, certificates or bonds (and not
equity). Sukuk are considered as debt instruments compliant with Shari'ah
(Islamic Law). The methodology of rating sukuk used by S&P is similar to that of
a conventional bond. It applies the same definition of default to sukuk as it does
to conventional bonds. It distinguishes between three types of sukuk7:
a- Sukuk with full credit enhancement mechanisms:
These are sukuk that receive an irrevocable third-party guarantee,
usually by a parent or original owner of the underlying collateral. The guarantor
provides shariah-compliant shortfall amounts in case the issuing vehicle
(usually a special-purpose entity) cannot make payment. The ratings on this
type of sukuk are largely dependent on the creditworthiness of the guarantor
(the sponsor/obligor's). The guarantee covers not only the principal amount of
the sukuk payable at the maturity date or in the case of predefined default
events, but also the periodic payments (coupons) from the SPE to sukuk
holders.
b- Sukuk with no credit-enhancement mechanisms:

7
Hassoune, 2007, Standard and Poor's approach to rating sukuk, Standard and poor's rating
direct.
15
 This structure resembles an Asset-Backed Security (ABS) or pure Asset-
Backed Sukuk. The pool of underlying assets is the sole basis for the coupon
and principal payment. The ratings on these sukuk are largely based on the
ability of the underlying assets to generate sufficient cash to meet, in a timely
manner, the SPVs obligations.
All rating agencies exercise due diligence before the rating is given. For this type
of Sukuk, S&P's ratings are based on the performance of the underlying assets
under different stress scenarios along with the expected value of these assets at
maturity. For these types of sukuk, the rating methodology does not differ from
that applicable to classic securitization transactions. The quality of cash flows
extracted from the underlying assets and the nature of the structure determine
to a large extent the ratings on the various tranches of Sukuk.
c- Sukuk with partial credit-enhancement mechanisms
This structure combines the first two categories, with a third party
guarantee absorbing limited shortfalls from an otherwise asset-backed
transaction. S&P's ratings approach depends on its estimate of the capacity of
the underlying assets to meet the special purpose entity's (SPE) financial
obligations as well as the terms of the guarantee and the creditworthiness of
the guarantor.
 Moody's Sukuk rating methodology
Moody's ratings address credit risk and not legal compliance of an
instrument with Shari'ah. However, Moody's believes that Shari'ah is not
objective fact. Because of the lack of Shari'ah compliance, Moody's use the
English law as reference for contractual obligations. Moody's considered sukuk
as immature asset class.

16
 According to Moody's, sukuk are not a completely new asset class
requiring a new science to analyze, but rather that such securities employ
existing financial engineering techniques to create asset-backed or
securitization structures that are also Shari'ah-compliant, Howladar (2006). He
confirmed that, a detailed analysis of the commercial terms and legal structure
for some sukuk shows that, sukuk performance is not governed by assets at
their core. So the credit risk is really that of the originator (sponsor).
Moody's distinguishes between two board categories of structures:
- Unsecured (Repurchase) Sukuk or asset base sukuk that benefit from
the originator's guarantee. Ratings are mostly dependent on the
riskiness of the sponsor. In this category of sukuk, asset transfer is
essentially in form rather than in substance.
- Asset-Backed Sukuk, for this structure, sukuk do not benefit from the
explicit support of the asset of sponsor. Ratings are primarily
dependent on a risk analysis of the underlying assets. The asset transfer
is effective in substance and not just form, Hassoune (2008).
According to Moody's (Howladar (2006)), in both cases, the Shari'ah
aspect of the sukuk may add a further element of legal complexity. However, to
conduct the credit risk analysis, Moody's applies its conventional methods for
structured and corporate finance. In April, Hassoune (2008), Moody's
establishes rating methodologies applicable to sukuk depending on whether
they are asset based or asset backed. The rating methodology used for
unsecured asset-based sukuk focuses on the creditworthiness of the sponsor
like conventional bonds. In secured asset-backed sukuk, the applicable ratings
approach is analogous to that for securitization transactions, but with some
meeting point on Islamic features.
17
  Fitch sukuk rating methodology
Fitch illustrates typical Sukuk structures and explains their corporate
approach to rating sukuk considered as Islamic bonds, Woodruff (2007). The
greater part of sukuk are asset-based securities that differ in structure from
conventional bonds, are not really differ in terms of cash flow or principal
repayment, and would therefore tend to receive the same issuer default rating
(IDR) as the originator. Fitch criticizes the Malaysian approach to rating sukuk.
As the first country in the whole of the world to issue sukuk, the Shari'ah
scholar of Malaysian uses different interpretations of Shari'ah to those
established in the GCC countries (many transactions would be unsuitable for
the GCC). Fitch is concerned with Ijarah sukuk structures or pooled portfolio
sale and leaseback securitization, as the assets issued are based on identifiable,
isolated securities on the balance sheet of the originator and placed into a
special purpose vehicle (SPV).
According to Fitch (Woodruff, 2007), Islamic finance continues to
evolve and there are important differences in structure between conventional
bonds and sukuk which must be understood. Regardless of these differences,
Fitch believes that its current rating methodologies and rating scales can
continue to accommodate sukuk, i.e. sukuk can be credit enhanced and rated,
just like secured debt, if additional asset encumbrances are wrapped into the
Sukuk issues.
 MARC (Malaysian Rating Corporation) and Islamic International
Rating Agency (Bahrain) sukuk rating methodologies
MARC regards sukuk as certificates of investment. The analytical
components in the rating of a sukuk transaction can be classified in 5
categories: 1) Analysis of the basic structure of the Sukuk: MARC's distinguishes
18
between the application of conventional corporate and project finance rating
methodology or asset-backed Methodology. 2) Assessment of key transaction
parties: MARC considers the roles of key participants in the transaction:
originator/borrower, lessee(s) or obligor(s), guarantor(s), contractor,
servicer/back-up servicer as well as the credit quality of each participant and
ability to perform their roles. 3) Asset and cash flow analysis: This analysis is the
most important driver of the ratings assigned to asset-backed and non recourse
or limited recourse project finance sukuk. 4) Assessment of credit enhancement
and structural protections, such as reserve accounts, payment waterfalls and
collateral value in addition to external credit support; and 5) Legal analysis: the
perfection of legal interest in the underlying assets are important not only in the
context of any securitization but also from the perspective of any secured
financing. We note that the Islamic International Rating Agency of Bahrain have
a comparable methodology to rating sukuk. Recently both agencies have added
the idea for fiduciary rating to their approach to rating sukuk.
3- A new methodology proposed to rating sukuk
In our present methodology, 1) the first question is to see if sukuk are
really different from conventional bonds and so they need a specific rating that
takes in account the factors appropriate to sukuk, than 2) we suggest an
integrated methodology that combines creditworthiness rating and fiduciary
rating.
3.1. Are sukuk really different from conventional bonds?
To answer this question, we compare the practices of the sukuk issues
and what should really be to respect the Islamic principles (the ban of interest
"riba", uncertainty "gharar", speculation "maysir", and unlawful "haram" sectors,
the obligation to share profits and losses and finely the obligation to back any
19
financial transaction with assets). According to Mirakhor (2006), Islamic
finance - understood as achieving maximum risk sharing- diversifies risk and
allows it to be shared widely. The predicted implications are a close relationship
between finance and real economic activities and the rate of return to finance
determined by the real economic activities rather than the reverse. This
system's complete function leads to financial stability, growth of profit and
employment, and, as a result, permits to reduce in poverty.
Unfortunately, many Islamic financial instruments are structured to
replicate the cash flows of conventional bonds and so to compete them. Miller,
Challoner, and Atta (2007) and Wilson (2008) similarly contend that sukuk do
not constitute financial innovation as they are generally structured along
Western rules of securitization. The convergence between Islamic and
conventional finance, principally in the case of sukuk, is gaining momentum as
foreseen by several scholars (Mirakhor, 2006). Using a market-based approach
on Malaysian data, Godlewski, Ariss and Weil (2011) test the hypothesis
whether investors react differently to the announcements of sukuk and
conventional bond issues. Their findings suggest the stock market is neutral to
announcements of conventional bond issues, but reacts negatively to
announcements of sukuk issues. They attribute this result to the excess demand
for Islamic investment certificates and explain the difference in stock market
reactions as an adverse selection mechanism that favors sukuk issuance by
lower-quality debtor companies. In contrast, using value-at-risk framework
(delta-normal approach as well as Monte-Carlo simulation methods), Cakir and
Raei (2007) think that sukuk differ from conventional bonds as they offer
unique risk-reduction benefits when added to a portfolio of fixed income
securities. They find that correlations of Sukuk returns with returns on

20
conventional bonds are much smaller than the correlations of returns on
conventional bonds with each other.
Howladar (2009), believes that most sukuk structures to date have
been asset-based (rather than asset-backed), which equates them to
conventional unsecured bonds. Scholars have raised issues with market sukuk
structures that guarantee the return of capital of the sukuk holders and provide
for credit enhancement purchase guarantees by related companies. Wilson
(2009) discusses the legitimacy of sukuk from a Shari'ah perspective, as the
present structures have been devised by lawyers and investment bankers and
are not Shari'ah based, as the contracts in traditional Islamic jurisprudence
"fiqh" are significantly different. We believe that, during the past decade, many
traditional banks and have decided to convert in whole or in part (a subsidiary)
in Islamic banks. Most of the staff of these banks and financial institutions, have
graduated from universities that teach classical finance, have taken additional
training in Islamic finance considered inadequate, which explains in part the
lack of financial innovation and bad practices. Number of analysts have tried to
develop Islamic financial products homologous to conventional financial
products follows the same logic training cash flows whose appearance comply
with Islamic principles. Islamic financial instrument i.e. sukuk are Shari'ah-
compliant in the sense that they have been approved by the Shari'ah boards of
the institutions undertaking their arrangement, but they have not participate
when structuring financial products.
Mudaraba sukuk (financing) and Ijara sukuk (leasing) are financial
instruments frequently used as ways of financing investment. In structuring
these contracts, the returns are profit shares (if Mudaraba sukuk) or rents (if
Ijara sukuk) were determined by reference to LIBOR (London Interbank Offered

21
Rate) or SIBOR (Singapore Interbank Offered Rate), or SAIBOR (Saudi Arabia
Interbank Offered Rate). Note that SAIBOR and SIBOR follow both the LIBOR.
Recently, many researches are conducted to find a new benchmarking more
related to the reality of economics and Shari'ah-compliant that can replace the
LIBOR for determining sukuk structure. This show, that profit or rent are not
generated by cash flows and risks of an investment, but indexed to interest rate.
Wilson (2009) argued, these structures are used so that the returns to sukuk
investors are competitive with those on comparable conventional bonds and
bills, but this is driven by market considerations and not by Islamic laws. The
returns Islamic investors are supposed to be justified by risk-sharing. Making
investments in Islamic financial instruments i.e. sukuk, this kind of investors
should be different from investing in conventional bonds, is no longer the same
product. Islamic investors, such as sukuk holders, should have less degree of
risk aversion than bondholders. According to Shari'ah, there is no profit without
sharing risk, and we cannot consider an Islamic product for periodic fixed rate
and repurchase of the instrument at the nominal value.
Taqi Usmani (2009), president of the AAOIFI Shari'ah council, believes
that "the issuers of these sukuk have expended a great deal of effort to make
them competitive with the conventional bonds prevalent in today's capital
markets. By endowing these sukuk with the same characteristics of bonds, they
have attempted to facilitate their acceptance in both Islamic and conventional
markets"8. As pragmatic evidence of the deviation of the principles of Islamic
instruments from the Islamic finance, the mechanisms of the issuance of sukuk
have taken similar steps as those of conventional bonds. Islamic banks and

8
Muhammad Taqi Usmani, (2009), Sukuk and their Contemporary Applications, working
paper.
22
other institutions have been recourse to international agencies of rating such as
Standard and Poor's, Moody's and Fitch to appreciate the creditworthiness of
sukuk before issuance, Abdurrahman Yosri (2010)9. These agencies have
attributed a high rating for these instruments on the basis that do not differ
from conventional bonds. This rating is given for Islamic instruments only after
making sure to guarantee return and the payment of nominal value at maturity.
Sukuk are a real hybrid financial instruments that combine
characteristics of both conventional bonds and shares. Investors should have a
degree of risk aversion smaller than the holders of conventional bonds but
higher than the shareholders. The detention of obligations is suitable for
investors with high degree of risk-averse, compared to shareholders whose
exposure is greater. Unlike bondholders, the sukuk holders will be exposed to
additional risks. In addition to conventional risk such as interest rate risk,
exchange rate risk (if the currency used is different to local currency) and credit
risk, the sukuk holders are exposed to investment risk, capital or price of
collateral risk (i.e. in ijara sukuk, the underlying tangible assets are likely to
depreciate), liquidity risk (limited growth of the secondary market: sukuk are
less liquid compared to conventional bonds) and Shari'ah compliance risk (the
risk refers to the loss of asset value as a result of the issuers' breach of its
fiduciary responsibilities with respect to compliance with Shari'ah or changes in
Shari'ah interpretations). Muslim investors, who are concerned that the sukuk
comply with highest Shari'ah quality and are conforming to widely accepted
Shari'ah standards, are ready to tolerate levels of higher risks than conventional
bonds. At the same time, investors are hoping for higher yields than

9
Abderrahmen Yosri Ahmed, (2010), The experience of Sukuk in the balance of shari'ah and
its purposes, Working Paper in Arabic, Imam Mohammed Ibn Saud Islamic University.
23
conventional bonds, which are based both on the investment project quality
and the team or the manager (trustee) who ensures the good implementation
of project, remuneration system and its distribution of the value it produces,
documentation of investment processes and governance following the Shari'ah
standards.
3.2. Methodology for rating sukuk
We briefly introduce general mechanics of a sukuk transaction in order
to exhibit how the cash flow operations really function. The number of step in
structuring process vary by category, we can summarize in five step:
1. The originator places well-defined, identifiable assets from the whole
of the company into an SPV and will obtain the proceeds of the Sukuk
issue. This is done especially (asset transfer) to separate the assets from
the risks associated with the potential bankruptcy or insolvency of the
originator and to place them in a vehicle (SPV) that has a low likelihood
of becoming involved in a bankruptcy or insolvency proceeding10.
2. The SPV is the entity that actually issues the sukuk, and is also the
entity that passes on the proportional ownership rental payments to
investors from the originator.
3. Investors buy the sukuk issue and make a principal payment to the
SPV.
4. The originator is then responsible for making periodic rental payments
for the use of the assets and the SPV passed the rentals to investors.

10
MCMILLEN, Michael JT, (2008), Asset securitization sukuk and Islamic capital markets:
structural issues in these formative years, Wisconsin International Law Journal, 25, PP703-
772.
24
 5. At maturity, or a dissolution event, the SPV sells the assets back to the
seller or originator; the amount of the sale will be used to repay sukuk
holders or investors.
Mohammed Taqi Usami (2009), has taken the view of Reuters11 that
85% of the current sukuk structures of gulf sukuk do not comply with Islamic
law. The majorities of sukuk were 'asset based' rather than 'asset backed' with
the pre-determined coupon and guaranteed the repurchase at the nominal
(face) value on maturity and in the absence of a transfer in asset ownership to
investors. In February 2008, the AAOIFI was established six recommendations
for the issuance of sukuk as below:
1- In order to be tradable, sukuk issuances have to be backed by real
assets, the manger must establish the transfer of ownership to sukuk
holders.
2- Sukuk must not represent receivables or debt except in the case of a
trading or financial entity selling all of its assets, or a portfolio with a
standing financial obligation.
3- If profits are below the expected earnings, the manager has no right to
ask for a loan to cover this deficit to ensure payment to investors.
Otherwise, and as set in the prospectus, the manager has the possibility
to establish a reserve to cover the years of deficit.
4- It is not permissible to agree to repurchase assets from sukuk holders at
nominal value upon maturity. It is possible, however, that the contract
specifies an agreement of repurchase of the asset with the market

11
Report by Reuters entitled "Most sukuk 'not Islamic' body claims" on 22 November 2007
at www.arabian business.com/ most-sukuk-not-islamic-body-claims-197156.html
25
 value, for a price agreed to at the time of their purchase, in accordance
with Shari'ah rules of partnership and on the subject of guarantees.
5- Except for Ijarah sukuk, it is possible for the lessee (is not an investment
manager, investment partner, or agent) to agree to purchase the leased
assets upon maturity at their nominal value.
6- Shari'ah supervisory boards should be involved in all stages of
implementation of sukuk structure to check the compliance with
Shari'ah.
Following this recommendation of AAOIFI, we propose general rating
guidelines for sukuk. Rating methodology consist of assessing both credit rating
and fiduciary rating of sukuk. Fiduciary rating resembles credit rating in its
method and its diligence process, but the risks measured are very different.
Credit rating is a published ranking, based on risk financial analysis, specifically
as it relates to one's ability to meet payment obligations. Fiduciary rating
evaluates the risk of fiduciary failure and/or financial loss to which an
organization's ability to protect and enhance the assets entrusted to its care. It
is, therefore, a measure of trustworthiness rather than of creditworthiness. The
fiduciary rating opinion is focused on corporate and Shari'ah Governance,
Compliance with Shari'ah principles and Asset Manager Quality.
Credit Rating:
The credit rating assessment is focused on sukuk structure (asset-based
sukuk vs. asset-backed structure); the role and credit quality of participants in
the transaction; the cash flow generated by the specific underlying assets; as
well as the legal and implications of Shari'ah on the structure; and internal
credit enhancement and/or a third party guarantor that may be provided by the
borrower.
26
 1- Structure of sukuk:
As indicated above, the structure of sukuk will have a great impact on
cash flows generated by the underlying assets and risk profile of the sukuk. It is
admitted that asset-based sukuk, where investors have only the beneficial title
of assets through the SPV, are rated using a similar methodology applicable on
conventional corporate and project finance (Standard and Poor's, Moody's and
Fitch). In contrast, when sukuk are asset-backed, with a true sale of ownership,
the rating methodology will be more complex as the cash flows are generated
from the exploitation of the tangible asset. In the current analysis, we focus
principally on asset-backed sukuk.
2- Risk analysis before issuance of sukuk
Investors are exposed to complicated risks that are not all exclusive to
sukuk issues. Specially, investors face to a variety of risks identified below:
 Market risk
Market risk is defined as the risk on instruments traded in well-defined
markets (Heffernan, 2003). Market risk is composed of interest rate risk, foreign
exchange rate risks and commodity risks.
 Interest Rate Risk (Rate of return risk)
Interest rate risks can be considered as rate of return risks for all types
of fixed rate sukuk i.e. Zero coupon sukuk (sukuk Al-Istisna'a and sukuk Al-
Murabaha), fixed rate Ijara (lease) sukuk, Salam sukuk and all fixed rate
Hybrid/Pooled sukuk (as fixed rate bonds). Maturity plays a very essential role
in increasing the impact of this risk; the longer is the maturity, the higher is the
risk for the investor. Others sukuk certificates i.e. floating rate Ijara sukuk are
also exposed indirectly to interest rate fluctuations through the prevalent
27
benchmarking with LIBOR in their financing operations. For Musharakah (Joint
Venture) sukuk, the exposure to interest rate risk is similar to the case of
floating rate, but the rate is not indexed with a benchmark (LIBOR),
consequently least exposed to this risk.
According to the sukuk structures that stipulate a fixed rate return or
floating rate of return indexed to LIBOR, Taqi Usmani (AAOIFI, 2007) has raised
bad practices. There is frequently an article in the sukuk contract that stipulates
in case of actual earnings surpass the interest rates i.e. LIBOR, the surplus shall
be rewarded to the manager (a partner or mudarib) an incentive for good
management. In contrast, if the actual profits are below the interest rates, the
manager may take it upon himself (by recourse to a personal loan) to pay out
the difference to sukuk holders. Such agreement is prohibited by Shari'ah, the
prescribed percentage in some sukuk is not linked to the expected cash flows
from the firm, but to the cost of financing or to the interest rates. Sukuk should
be based on the firm expected cash flows.
 Foreign exchange rate risk
Sukuk, with an underlying asset generating returns in a foreign
currency, are exposed to unfavorable exchange rate fluctuations. Originators as
guarantors by assuming foreign exchange rate risk can covered the exposition
by holding well-diversified assets (the composition of assets in the pool)
generating multiple currency returns. This strategy, of diversifying the pool in
different currencies, ensures to completely compensate the foreign exchange
impact for both originators and investors.
 Commodity and Collateral risks

28
 Price risk relates to the differences in the fair-market and book values
of the underlying asset and commodities. Ijara Sukuk are most exposed to this
as the values of the tangible assets may depreciate more rapidly as compared to
market prices. A program of maintenance of the assets and liquidity of the
sukuk in secondary market can contribute to decrease the exposure in price
risk. Salam sukuk is also more exposed to price risks, but such risk can be
reduced if investors entering into similar contracts with third parties.
 Credit and counterparty risk
Credit risk refers to the probability of loss of principal or loss of a
financial reward stemming from an issuer failure to meet a contractual
obligation. Credit risk is closely attached to the potential return of underlying
assets, the most distinguished being that the yields on sukuk correlate strongly
to their perceived credit risk.
Chapra and Khan (2000) and Khan and Ahmed (2001) determine
various unique credit risks that are particular to Islamic finance. Currently, the
major sukuk issuances have principally involved assets based on Istisna, Salam,
Ijarah and Murabaha contracts. There is several credit risk considerations
related with these modes of finance. In the case of Salam or Istisna' sukuk, the
credit risk would take the form of settlement/payment risk arising when one
party to a deal pays money. The Murabahah sukuk has also a unique basis of
credit risk when one party delivers assets before receiving its own assets or
cash, thus, exposing it to potential loss, Khan and Ahmed (2001). In addition to
default on rent payment for both types of Ijara sukuk, the credit risk is more
serious when rates of interest are floating than fixed rates. In case of
Mudarabah or Musharakah (profit-sharing modes of financing) the credit risk
will be non-payment of the percentage of profit to the sukuk holders by the

29
entrepreneur when it is payable (because problem agency cost or asymmetric
information concerning the current profit of the project). These types of sukuk
have a high default risk. in the case of fixed rate sukuk, counterparties will be
more prepared to default as debt rearrangement at higher interest rates is not
allowable under Shari'ah. Credit risk of the special purpose vehicle (such as a
trust) and originator will require to be evaluated separately mainly if the sukuk
holders has right to recourse and the underlying assets fail to face creditor
losses.
 Shari'ah compliance risks
The risk of Shari'ah is the probability of loss due to a decline in the
value of the underlying asset as a consequence of the issuers’ violation of its
fiduciary responsibilities with regard to compliance with Shari'ah. Prospectuses
contain clauses of cancellation of sukuk contracts for non-compliance with
shariah. The rate of return required by investors must include an additional risk
premium of Shari'ah component.
The sukuk structures must reflect both the approach of Shari'ah
compliance and preserve competitiveness. Given the great growth in sukuk
markets the non-compliance of sukuk structure with Shari'ah rulings remains a
possibility, Zaidi (2007). Muslim investors will be vigilant to ensure selection of
those sukuk that are of the highest Shari'ah quality. There are a number of
discrepancies regarding the interpretation of Shari'ah and so the applicability of
Islamic financial instruments.
 Liquidity risk
Sukuk are illiquid instruments compared to conventional bonds caused
by the lack of secondary market activity. Such illiquidity imposes more risks for

30
investors that seek to trade their holdings if it is needed. There is currently no
well structured and adequately liquid secondary market and most of the sukuk
tend to be held until maturity (risk of transfer of certificates ownership with loss
of value). Liquidity risk is serious for Salam sukuk and Zero Coupon Sukuk
(Istisna and Murabaha) because are entirely non-tradable in the second market.
Salam Sukuk contracts are based on underlying commodities trading of such
securities could result in speculation. Zero Coupon Sukuk do lead to debt
ownership; trading of debt securities being non-compliant with Shari'ah.
 Operational risks
There are numerous other risks specific to the operation of the sukuk.
We can classify these risks in three types. The first one is related to originators
such as default risk (in case the originator fails to pay, the sukuk holders can
exercise the right to nullify the contract and oblige the obligor to buy back the
assets) and coupon payment risk (the originator may fail to pay the required
coupons on time). The second source of risk is related to nature of assets such
as redemption risk (the risk that the assets may not be fully redeemed) and
specific risks (the risk of loss of the assets mainly for equipment and
construction but less impact for land). The last one is related to SPV (the special
purpose vehicle is dependent of the bankruptcy of the originator).
3- Legal structure of sukuk
Trade should take place based upon a legal structure: there should be a
contract. A contract is essential and has to be executed. The legal structure of
sukuk should emphasize the separation of the underlying assets of those of the
company to not have problems in case of insolvency of the originator/seller.
The legal structure of sukuk determine the way of payment of investors if
unfavorable events negatively affect the underlying assets or the manager
31
and/or the obligor, causing fail to pay or incapacity to service required cash
flow transfers. The underlying assets should be sold legally and there must be a
real transfer of these assets from the issuer. That is why this is very important in
the context of any securitization and from the perspective of any secured
financing.
According to Shari'ah’s perspective, sukuk should be backed by a
specific and tangible or identifiable asset right through its entire possession and
investors must have an ownership interest in the assets which are being
financed. The rating of assets may lend greater transparency. Following the
ruling of the Shari'ah Board of AAOIFI, the issuer of sukuk must endorse the
transfer of proprietary of such assets in its books and must not keep them as his
own assets. Such contract should be legal, valid, binding and applicable to all
parties and the laws of the country which the assets and the company are
based, Yean (2009). In sukuk structure (i.e. Ijara sukuk), the SPV is generally a
subsidiary corporation with an asset/liability structure and legal status that
makes its obligations protected even if the parent company goes bankrupt. The
SPV must be "bankruptcy-remote entity" whose operations are restricted to the
purchase and financing of specific assets.
4- Trustworthiness and profile of deal participants
In order to achieve credibility, originators or borrowers, which
considered as the principal participants in sukuk transaction, would have to
establish a formal sukuk program that clearly identifies the relationship with
investors or sukuk holders. The communications between issuers and investors
must be transparent and regular, permit to improve the quality of due diligence
and allay concerns about corporate governance. The role and credit quality of
key participants and ability to perform (profile) their roles in the transaction

32
such as the borrower, the lessee(s) or obligor(s) and the guarantor(s) should be
considered in analysis of sukuk rating.
5- Cash flow analysis
The analysis of cash flows has a great importance for rating sukuk. In
the case of bonds/debts, the cash flows used to ensure the payment are
eventually resulting from an investment generating a profit. Sukuk Ijara are very
close to bonds in nature, the cash flows derived from this type of sukuk are
long-term contractual lease payments originating from a particular assets. To
comply with Shari'ah, the rental payable by the originator and guaranteed by
the SPV to investors should be not a pre-determined rental income but market
rental (from cash flows generated by assets). The combination of the guarantee
and the repurchase undertaking at the original sale price fundamentally means
that investors are not in reality taking any asset risk; rather, they are exposed to
the credit risk of the obligor. In contrast, Mudaraba sukuk are close to equity
(quasi-equity), the rating is related primarily to the aptitude of the underlying
assets to generate sufficient cash flow to meet all of the issuer's financial
obligations. Shariah compliant sukuk structures and conventional asset-backed
securities recognize that the issuer transfers the ownership of the tangible
assets to the sukuk holders. Both are projected to generate expected returns for
investors from the cash flows generated from the use of assets. Ratings on this
kind of sukuk could be different (higher or lower) to ratings on the originator.
6- Credit enhancement12

12
Fabozzi, Frank J., Kothari, Vinod, 2008, Introduction to Securitization, John Wiley & Sons,
Inc.
33
 Credit enhancement is a key part of the securitization transaction in
structured finance, and is central for rating. Credit enhancement reduces the
sukuk holder's exposure to the risk by offsetting possible losses (Barbour,
Norton and Slover (1998)). There are many credit enhancement methods that
are incompatible with Islamic laws, and need to be recognized. There are two
major types of credit enhancement: internal and external.
 Internal credit enhancement
The internal credit enhancement in a convention will consist of some
of the following: cash account or reserve account (a reserve is formed to
compensate the issuing trust for losses up to the amount allocated for the
reserve.); excess spread13 (the amount by which the income generated from the
underlying assets exceeds the expected payment for investors and the
transaction costs14.); subordinated tranches (the risks shared by different
tranches in terms of losses, sequential payment of the cash flows generated of
the use of assets are different. This technique is used when two or more
investors consent to obtain different risk/return profiles against the same
collateral. The Shari'ah compliance of this structure is still under debate
(Damak, (2008)). The reason for non-tranching is to share the profit on the pool
but to share the risk according to the share of investment and over-
collateralization (the face value of the assets in the collateral pool is larger than
the face value of the asset backed securities issued, a way for guaranteeing the

13
Kothari, Vinod, 2006, Securitization the Financial Instrument of the Future, John Wiley &
Sons (Asia) Pte Ltd, 2 Edition.
14
According to the AAOIFI (Shari'ah Standards No.17), it is permissible to establish a reserve
account for the purpose of covering such shortfalls to the possible extent, provided this
possibility is signaled in the prospectus.
34
performance of the underlying assets. Thus over-collateralization is
incompatible with Shari'ah principles).
 External credit enhancement
An external credit enhancement signifies that a third party which is not
directly implicated in the securitization process is providing guarantees on an
asset backed security. The letter of credit, as financial guarantees for securities,
provide for first-loss safety against losses up to a pre-determined amount. In
this product, for a fee, insurance provides a contract to guarantee the
performance of a certain amount of the collateral against defaults, thereby
absorbing the loss, Fabozzi, and Drake (2009).
In Islamic transactions, insurance, letter of credit and hedging are
considered forbidden under Shari'ah. However they have been replicated by
Islamic financial products. Mutual insurance (joint guarantee) or Takaful,
according to which the investor themselves pay a sum of money into a
collective pool of funds and withdraws money when a claim is made.
Monocline financial guarantee policies constitutes another source of guarantee
and considered as permissible par Shari'ah scholars. The investors obtain a
reduced yield on their investment in exchange for the provision of a guarantee
of their nominal value, Zongur (2010).
Fiduciary rating:
The objective of fiduciary rating is to raise the investor's level of
confidence in the local capital market. It is a measure designed for investors
who require knowing if their money is going to be properly managed, and so
compliant with Shari'ah. Fiduciary ratings can propose a different measure of
investment risk consisting on measuring a firm's ability to execute a particular

35
mission in a trustworthy way. It is therefore relevant to asset managers
operating on trust or confidence. According to RCP and Partners Gmbh
(2003)15, "fiduciary rating measures the risk taken by investors when they
entrust assets to third parties for management. It is a professional evaluation of,
and opinion on, the stability of an asset management organization and
sustainability of its investment performance". The rating is based on both
quantitative and qualitative assessment, providing improved screening and risk
control tools to professional investors.
Fiduciaries have the most important role in the investment process: the
components of the investment plan should be well defined, implemented, and
evaluated. Many definitions are specified to fiduciary. The American Heritage
Dictionary16 defines fiduciary as a person who stands in special relationship of
trust, confidence or responsibility in his obligations to others, as company
director or an agent of a principal. The Center for Fiduciary Studies defines
fiduciary as a person who is responsible for managing the assets of another
person and stands in a special relationship of trust, confidence, and/or legal
responsibility.
As indicated above, we are interested to fiduciary rating in relation with
asset manager quality, governance and compliance with Shari'ah principles.
1- Asset manager quality
Fiduciary rating measures the risk investors are exposed to in
entrusting their money to third parties such as asset managers. Taqi Usmani

15
RCP and Partners GMBH Report, 2003, Risk rating of asset managers: the investor's
measure of trust.
16
The American Heritage Dictionary, Second College Edition, Houghton Mifflin Company,
Boston, MA 1982, 1985.
36
(2007), has considered three kinds of sukuk managers: investment manager
(Mudarib( or partner (Sharik) or investment agent (Wakil). Investors assume
two types of risk, systematic risks and specific risks. According to the specific
risks, the manager is required to carry a control over a number of risks related to
compliance with Shari'ah, governance, ethics, transparency, culture, and
accountability and taking some risks like investment process, implementation
and management. Thus, fiduciary rating analysis the core sources of risk and
then measures the risk of failure of systems, processes and governance which
can impact directly on quality of asset.
The manger must be in full control of any structural risks inherent to
his project so that he does not violate his contractual obligations thereby
incurring financial losses to the damage of the investor. A fiduciary or manager
demonstrates prudence by the process through which investment decisions are
managed, rather than by showing that investment products and techniques are
chosen because they were labeled as prudent, Trone, Lynch, Rickloff, and
Frommeyer (2003)17. According to RCP and Partners Gmbh (2003), past
performance is no guarantee of future returns and provides little of the real
risks in an asset management, which lie in the quality of employee's of the
project, organization, processes, and total risk management. In contrast of credit
rating that focuses essentially in quantitative risks analysis and performance,
fiduciary rating focuses on a qualitative and objective analysis of organizational
structures (business rating) in addition to the entire variety of investment
process. These criteria are crucial in evaluating the asset manager's capacity to
deliver high-quality and consistent performance in the future and so ensure

17
Trone, D.B., Lynch, J.R., Rickloff, M.A., and Frommeyer, A.T., (2003), Prudent Investment
Practices, Foundation for Fiduciary Studies.
37
investors to put into perception of true risks. It is very important that the
investment is likely to meet the investor's expectations in future.
2- Governance and compliance with Shari'ah principles
Governance refers to governance structure and governance system.
The governance structure involves a set of relationships between a company’s
management, its board, its stakeholders; it deals with prevention or mitigation
of the conflict of interests of stakeholders, Goergen (2012)18. The governance
system is the system by which fiduciary activities are directed and controlled. It
defines the distribution of rights and responsibilities among all participants in
the fiduciary process, and indicates the rules and procedures for decision
making.
Fiduciary rating is also a quantitative judgment of governance quality,
based on an assessment of the fiduciary risk or likelihood that co-fiduciaries are
incapable to perform their duties towards beneficiaries, due to their non-
compliance with Shari'ah principles (implementation of the Shari'ah rules in
product development and supervision of operations to accomplish the Shari'ah
objectives), laws and procedures of fiduciary governance. Shari'ah principles
require financing to generate real economic benefits in that way preventing
financing for speculative operations with no real economic growth.
Conclusion
In this paper we discussed and analyzed a number of issues related to
the evolution, type's structures, risks and rating of Sukuk. The market for sukuk
certificates continues to grow and a significant facet of this growth is the
increased number of sovereign and corporate issuances. The AAOIFI has

18
Goergen, M, 2012, International Corporate Governance, Prentice Hall, Harlow.
38
defined 14 types of sukuk that comply with Shari'ah principles. These sukuk
can be asset-based sukuk or asset-backed sukuk. According to AAOIFI, the
majority of issued sukuk is asset-based and is not compliant with Shari'ah rules
where credit risk is that the originator fails to meet their obligations (repurchase
undertaking at the face value and payment of periodic fixed return by the
originator). The asset-backed sukuk are suitable for Shari'ah compliant
investment funds where sukuk holders are subject to market risk and thus the
repayment of capital cannot be guaranteed (at maturity of sukuk the capital
returned to investors depends on market asset value). There are many risks
associated to the issuance of sukuk such as credit risk (default on payments),
market risk (market value of asset falls on maturity), liquidity risk (limitation of
secondary market), rate of return risk (floating return) and Shari'ah risk (non-
compliant).
We are interested for rating the asset-backed sukuk that comply with
Shari'ah and so we believe that sukuk investor's preferences are different to
those in conventional bonds. Sukuk investors are willing to take additional risks
(liquidity risk, Shari'ah risk, market risk, etc.) compared to bondholders and
thus, they require an additional risk premium. The main three international
agencies of rating (Standard and Poor's, Moody's and Fitch) consider sukuk as
conventional bonds and no as financial innovations. In fact, during the last
decade, the majority of sukuk issued are Ijara sukuk which the structure of cash
flows is considered similar to bonds. These agencies have ignored the principal
goal of Islamic investors that seek to invest in sukuk that comply with Shari'a.
We have proposed an integrated methodology for rating the issuers of sukuk
that combines the credit rating and fiduciary rating. There are a numerous
admitted factors that influence the rating methodology of the issuer of financial
instruments. Our first contribution in this paper is the discussion of all factors in
39
relation to Shari'ah principles. The second contribution is the inclusion of
fiduciary rating within the process of rating of the issuers of sukuk. We believe
that research will provide a rating methodology more suitable for the issuer of
sukuk that can be used by investors, financial institutions and financial market.

40
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