Introduction to Islamic Banking and Finance: Principles and Practice M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni

1
Introduction to Islamic Banking and Finance
Principles and PracticeM. Kabir Hassan, Rasem
N. Kayed, and Umar A. Oseni
Chapter 7Islamic Bonds
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Learning Objectives

• Upon the completion of this chapter, the reader
  should be able to
• 1. Understand what sukuk is, its historical
  origin and benefits, and the distinguishing
  features of sukuk from conventional bonds
• 2. Understand how Islamic bonds are structured,
  and distinguish between different types
• 3. Be familiar with the AAOIFI standards on
  Islamic bonds, and the characteristics of
  investment sukuk and Shariah rulings defined by
  these standards
• 4. Differentiate between sovereign and corporate
  ratings of Islamic bonds, and the methodology
  used to rate products

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What are Sukuk?
Learning Objective 7.1 Understand what sukuk is,
its historical origin and benefits, and the
distinguishing features of sukuk from
conventional bonds.

• Sukuk an Arabic term for financial certificate
  it is the Islamic equivalent of bond
  
• Sukuk asset-backed instruments, and tradable
  Shariah compatible trust certificates
• AAOIFI defines Sukuk as
  Certificates of
  equal value representing undivided shares in the
  ownership of tangible assets, usufructs and
  services or (in the ownership of) the assets of
  particular projects or special investment
  activity (AAOIFI 2008, p. 307)
• The IFSB defines Sukuk in its Capital Adequacy
  Standard (IFSB-2) as certificates that represent
  the holders proportionate ownership in an
  undivided part of an underlying asset where the
  holder assumes all rights and obligations to such
  asset

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What are Sukuk?
Learning Objective 7.1 Understand what sukuk is,
its historical origin and benefits, and the
distinguishing features of sukuk from
conventional bonds.

• A Brief History of Sukuk
• Sak, the singular form of sukuk was used to
  refer to documents or certificates representing
  obligations, contracts, conveyances of rights
  executed in conformity to the principles of
  Shari'ah
• The earliest usage of the sukuk receipts relates
  to the method of payment of the soldiers during
  the Umayyad Caliphate in the 1st century of the
  Islamic calendar where soldiers were given
  commodity coupons in place of cash
• During the medieval period, sak was used as the
  main instrument for transferring obligations
  arising from commercial transactions, thus
  reducing movement of cash between cities

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What are Sukuk?
Learning Objective 7.1 Understand what sukuk is,
its historical origin and benefits, and the
distinguishing features of sukuk from
conventional bonds.

• A Brief History of Sukuk
• In the modern practice of Islamic finance, sak is
  used to provide alternative funding for financing
  projects through asset securitization
• The Islamic Fiqh Academy of the Organization of
  Islamic Cooperation (OIC) ruled for legitimacy of
  the concept of sukuk

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What are Sukuk?
Learning Objective 7.1 Understand what sukuk is,
its historical origin and benefits, and the
distinguishing features of sukuk from
conventional bonds.

• Benefits of Sukuk
• 1. Among the best ways of financing large
  enterprises beyond the ability of a single party
  to finance
• 2. Provide an ideal means for investors seeking
  to deploy streams of capital and at the same time
  are able to liquidate their positions with ease
  should the need arise
• 3. Manage liquidity for banks and Islamic
  financial institutions
• 4. A means for the equitable distribution of
  wealth

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What are Sukuk?
Learning Objective 7.1 Understand what sukuk is,
its historical origin and benefits, and the
distinguishing features of sukuk from
conventional bonds.

• Advantages of Sukuk include
• Diversification of fund sources
• Secondary liquidity
• Creation and enhancement of profile on the
  international market
• Infrastructural development in Muslim countries
• Pricing benchmark
• Sizeable financing

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What are Sukuk?
Learning Objective 7.1 Understand what sukuk is,
its historical origin and benefits, and the
distinguishing features of sukuk from
conventional bonds.

• Differences Between Sukuk and Conventional Bonds
• 1. Conventional bonds are contractual debt
  securities, while sukuk represent the undivided
  ownership of each of the sukuk holders in the
  underlying asset
• 2. Returns in conventional bonds comes in
  interest (coupon) and the principal amount
  whereas in sukuk, the return is in profits
• 3. In conventional bonds, the contractual
  relationship between issuer and investor is
  debt/credit, while it is a partnership
  relationship in sukuk

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What are Sukuk?
Learning Objective 7.1 Understand what sukuk is,
its historical origin and benefits, and the
distinguishing features of sukuk from
conventional bonds.

• Differences Between Sukuk and Conventional Bonds
• 4. Sukuk holders have ownership rights in the
  underlying asset, while conventional bonds
  merely represent a debt certificate
• Sukuk must be asset-backed, while conventional
  bonds may be backed by financial assets such as
  receivables, which are not allowed in the case
  of sukuk
• (Refer to Table 7.1 in the text book for major
  differences between Sukuk and Bonds)

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• Types and Structure of Islamic Bonds
• Sukuk can be of many types depending on the types
  of Islamic finance products used in its
  structuring
• AAOIFI identified fourteen major sukuk-structured
  products (Table 7.2 in the textbook)
• Sukuk have been classified as
  - Tradable
  sukuk
  - Non-tradable sukuk
  - Debt
  based suluk
  - Equity based
• (Refer to Table 7.3 of the textbook for
  classification of sukuk according to types)

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• The Most Common Investment Sukuk
• Mudarabah Sukuk (Trust Investment Bonds)
• Musharakah Sukuk (Partnership Investment
  Bonds)
• Ijarah Sukuk (Leased Asset Bonds)

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• The Fourteen Sukuk Structures of AAOIFI
• 1. Sukuk ijarah (leased assets certificates)
• 2. Sukuk ijarha mausufa bi dhima (forward lease
  certificates)
• 3. Sukuk manfaa ijarah (usufruct of a lease
  certificate)
• 4. Sukuk manfaa ijarah mausufa bidhima (usufruct
  of a forward lease certificate)
• 5. Sukuk milkiyat-al-khadamat (ownership of
  services certificates)
• 6. Sukuk al-salam (forward contract certificates)
• 7. Sukuk al-istisnaa (manufacturing certificates)

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• The Fourteen Sukuk Structures of AAOIFI
• 8. Sukuk al-murabahah (cost-plus certificates)
• 9. Sukuk-al-musharakah (partnership certificates)
• 10. Sukuk al-mudarabah (trustiInvestment
  certificates)
• 11. Sukuk al-wakalah (investment agency
  certificates)
• 12. Sukuk al-muzraa (sharecropping certificates)
• 13. Sukuk al-musaqa (irrigation certificates)
• 14. Sukuk al-mugharasa (agricultural
  certificates)

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• Structuring of Islamic Bonds
• The replication of conventional bond features
  excluding characteristics impinging on
  fundamental principles of Shariah in commercial
  transactions e.g. prohibition of riba and gharar
• The process of modelling and structuring Islamic
  bonds requires basic knowledge of major Islamic
  finance products e.g. mudarabah, musharakah,
  ijarah, murabahah, wakalah
• Islamic finance experts developed, modeled and
  structured finance products through Islamic
  financial engineering

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• Mudarabah Sukuk (Trust Investment Bonds)
• Investment sukuk representing ownership of units
  of equal value in the Mudarabah equity
• Registered in the names of the sukuk holders on
  the basis of undivided ownership of shares in the
  Mudarabah equity
• Usually structured as an agreement between the
  rabb al-mal who provides the capital and the
  entrepreneur which may be an investment company
  or a Special Purpose Vehicle (SPV)
• Returns shared in accordance with the percentage
  of share ownership of each sukuk holder
• Losses are borne by financiers but necessary
  measures mitigate risks (through the process of
  securitization)

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• Basic Features of Mudarabah Sukuk (MS)
• As articulated in the Resolution of the
  Islamic Fiqh Academy of the OIC in its fourth
  session in 1988
• 1. Mudarabah Sukuk (MS) represent common
  ownership and entitle holders to share in
  specific projects against which the MS have been
  issued
• 2. Contract based on the official notice of the
  issue or the prospectus, which must provide all
  information required by Shariah for a Qirad
  contract
• 3. The MS holder is given the right to transfer
  the ownership by selling the sukuk in the
  securities market at his/her discretion

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• Basic Features of Mudarabah Sukuk (MS)
• The sale of MS must follow the rules listed
  below
• -If mudarabah capital is in money, the trading
  of MS will be like the exchange of money for
  money and it must satisfy the rules of Bai al
  Sarf
• -If the mudarabah capital is in debt, it must be
  based on principles of debt trading in Islamic
  jurisprudence
• - If capital is a combination of cash,
  receivables, goods, real assets and benefits,
  trade must be based on the market price evolved
  by mutual consent

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• Basic Features of Mudarabah Sukuk (MS)
• 4. The manager/SPV who receives the funds
  collected from the subscribers to MS can also
  invest his/her own funds
• 5. Neither prospectus nor MS should contain a
  guarantee, from the issuer or the manager of the
  fund, for the capital or a fixed profit, or a
  profit based on any percentage of the capital
• Accordingly
• (i) the prospectus, or the MS issued pursuant to
  it, may not stipulate payment of a specific
  amount to the MS holder (ii) profit is to be
  divided, as determined by applying the rules of
  Shariah
  (iii) the profit
  and loss account of the project must be
  published and disseminated to MS holders

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• Basic Features of Mudarabah Sukuk (MS)
• 6. It is permissible to create reserves for
  contingencies, such as loss of capital, by
  deducting from the profit a certain percentage in
  each accounting period
• 7. The prospectus may also contain a promise made
  by a third party, to donate a specific sum,
  without any counter benefit, to meet losses in a
  given project, provided such commitment is
  independent of the Mudarabah contract
• (The Resolution of the Islamic Fiqh Academy of
  the OIC in its fourth session in 1988)

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• Figure 7.1
• Structure of
• Mudarabah Sukuk

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• Steps Involved in the Structure of Mudarabah
  Sukuk
• A company which needs liquidity establishes an
  SPV
• The SPV issues sukuk certificates to
  investors/sukuk subscribers
• Cash generated used as capital in Mudarabah
  contract between SPV and an organisation
  appointed to manage the business
• The Mudarabah business is carried out and profits
  are periodically distributed among the two major
  parties the company and the SPV
• The SPV pays the investors/sukuk holders
  according to the units of their individual shares
  in the invested capital

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• Musharakah Sukuk
• Musharakah Sukuk are investment bonds which
  represent the ownership of the partnership equity
• Musharakah Sukuk can be used for the mobilization
  of funds for new project, develop an existing
  project or finance a huge business activity based
  on joint venture contracts
• The Musharakah certificate given to all sukuk
  holders represent their proportion of ownership
  in the assets of the project being undertaken
• The Musharakah certificates are treated as
  negotiable instruments which are tradable in the
  secondary market they can be bought and sold in
  the capital markets

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• Musharakah Sukuk
• The structure of a Musharakah Sukuk is based on
  the joint venture partnership
• Profit is shared according to an agreed
  predetermined ratio
• Any loss is shared according to the individual
  contribution of the parties/sukuk holders
  involved
• Every subscriber is entitled to participate in
  the management of the business if he or she
  wishes

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• Insert Figure 7.2
• A Musharakah Sukuk Structure

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• Ijarah Sukuk
• Ayub (2007, pp. 400-401) defines ijarah sukuk as
  the securities representing ownership of
  well-defined and known assets tied up to a lease
  contract, rental of which is the return payable
  to the sukuk holders
• The contract of ijarah has been
  - Structured
  and transformed as a competitive bond in the
  secondary market
• - Structured to allow the mobilisation of funds
  for development of long term infrastructure
  projects via the issuance of ijarah sukuk
• - Used as securitization of a tangible asset
  e.g. a hospital or airport

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• Different Variations Ijarah Sukuk
• 1. Sukuk of ownership in leased asset
• - It is issued with the sole aim of selling the
  asset to the sukuk holders through the transfer
  of title
• - The sukuk holders jointly own the asset
  through undivided ownership and are entitled to
  profits and losses accordingly
• - This form of ijarah sukuk can be used for the
  purchase of a new asset

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• 2. Sukuk of ownership of usufructs of assets
  - It is issued to conferring the right of
  usufruct in the sukuk holders where they become
  joint owners
• - The sukuk holders only become owners of
  usufruct (manfaa) of the assets since the
  owners of asset have leased its usufruct to the
  sukuk holders
• - Sukuk holders can also sublease the usufruct
  of the asset to a third party
• 3. Sukuk of ownership of services
  - Issued to
  subscribers to confer the ownership in such
  services to the sukuk holders
  - The sukuk holders may also
  sublease such services to a third party

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Structuring Islamic Bonds
Learning Objective 7.2 Understand how Islamic
bonds are structured, and distinguish between
different types

• Figure 7.3
• Ijarah Sukuk Transaction

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AAOIFI Standards for Islamic Bonds
Learning Objective 7.3 Be familiar with the
AAOIFI standards on Islamic bonds, and the
characteristics of investment sukuk and Shariah
rulings defined by these standards.

• Characteristics of Investment Sukuk
• Certificates represent the rights and obligations
  of the owner
• Common share in the ownership of the underlying
  asset
• Shari'ah compliance
• Trading of investment sukuk and the rights they
  represent
• Return and losses are commonly shared by
  certificate holders

30
AAOIFI Standards for Islamic Bonds
Learning Objective 7.3 Be familiar with the
AAOIFI standards on Islamic bonds, and the
characteristics of investment sukuk and Shariah
rulings defined by these standards.

• Shariah Rulings and Requirements
• Shariah rules and requirements contained in
  AAOIFI Standards of sukuk are classified into two
  categories
• - Shariah requirements in the issuance of
  investment sukuk
• - Shariah rules in trading in investment sukuk

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AAOIFI Standards for Islamic Bonds
Learning Objective 7.3 Be familiar with the
AAOIFI standards on Islamic bonds, and the
characteristics of investment sukuk and Shariah
rulings defined by these standards.

• Significant AAOIFI Pronouncement on Sukuk in 2008
• Guidelines on sukuk issued earlier by AAOIFI have
  generated controversy among Shariah scholars,
  market players and investors
• The AAOIFI Pronouncements on sukuk in 2008
• - Do not stand as substitutes for the earlier
  guidelines - They are merely
  clarifications/directives on guidelines to avoid
  misapplication of requirements for issuance of
  investment sukuk and the Shariah rulings for
  their trading in the Islamic capital markets

32
Rating of Islamic Bonds
Learning Objective 7.3 Be familiar with the
AAOIFI standards on Islamic bonds, and the
characteristics of investment sukuk and Shariah
rulings defined by these standards.

• Ratings of Islamic Bonds
• Bond credit rating is the assessment of the
  credit worthiness of a corporations debt issues
  or government bonds. The designated grades range
  from AAA which is considered as the highest
  grade to C
• Credit rating allows potential investors to make
  informed decisions before subscribing to debt
  securities.
• There are over 50 rating agencies that have been
  established across the world. The leading global
  rating agencies include, Moody's Standard
  Poor's, and Fitch Rating of Islamic Bonds

33
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Ratings of Islamic Bonds
• Different countries have their own rating
  agencies, such as Malaysia, India, Bangladesh,
  and Sri Lanka
• The two popular classifications of bonds while
  rating their quality are
• - investment grade bonds
  - junk bonds
• The Islamic International Rating Agency (IIRA)
  which was established by the IDB began operations
  in 2005 and has since been striving to ensure
  quality in the Islamic finance industry

34
Rating of Islamic Bonds
Learning Objective 7.3 Be familiar with the
AAOIFI standards on Islamic bonds, and the
characteristics of investment sukuk and Shariah
rulings defined by these standards.

• Types of Islamic Bonds Ratings
• Islamic bonds can be rated on two bases
  -
  Sovereign
  - Corporate
• First Sovereign Ratings
• Sovereign credit rating is the credit rating of a
  sovereign entity such as a national government
• The risk level of the regulatory, political,
  economic and legal atmosphere comprises a crucial
  factor in sovereign credit ratings  

35
Rating of Islamic Bonds
Learning Objective 7.3 Be familiar with the
AAOIFI standards on Islamic bonds, and the
characteristics of investment sukuk and Shariah
rulings defined by these standards.

• In the country risk rating, Euromoney Country
  Risks consider the following factors in the
  ranking of countries by risk
  
  - Political risk
• - Economic performance/projections
• - Structural assessment
• - Debt indicators
• - Credit Ratings
• - Access to bank finance
• - Access to capital markets

36
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• IIRA Ratings
• The six basic categories used by IIRA in
  analysing sovereign sukuk and the likelihood of
  any default on debt obligations at maturity are
• - Politics and Policy Continuity
• - The EconomyStructure and Growth Prospects
• - Budgetary and Fiscal Policy
• - Monetary Policy and Flexibility
• - The External Accounts
• - Internal and External Debt

37
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Figure 7.4
• First Page of IIRA Sovereign Ratings of Turkey
  in 2008

38
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Types of Islamic Bonds Ratings
• Corporate credit rating is a credit worthiness
  rating in form of financial indicator to
  potential investors of debt securities such as
  sukuk
• Corporate credit ratings play a significant role
  in the economy of a country and, more
  importantly, it promotes stability and
  sustainability in the financial industry
• The level of risk surrounding a business entity
  determines the confidence prospective investors
  will have in it
• Corporate entities must adopt best practices
  (reducing their risk level, demonstrating
  ability to meet financial obligations)

39
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• In the Islamic financial markets, corporate
  ratings involve
• - Bond/sukuk ratings
• - Banks financial strength ratings
• - Shariah quality ratings
• - Corporate governance ratings
• - Real estate ratings etc

40
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Rating Products and Methodology
• The rating products in Islamic financial markets
  consist of all types of issuers and sukuk issues.
  The IIRA identified the following eight major
  rating products
• - Sovereign Ratings
  - Issuer Ratings
  
  - Bond/sukuk Ratings
  - Insurer
  Financial Strength Rating
  - Banks Financial Strength Rating
  
  - Shari'ah Quality Ratings
  - Corporate
  Governance Ratings
  
  - Real Estate Ratings

41
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Sovereign Ratings
• A reliable third party gives an opinion on the
  feasibility of the repayment of the issuer or an
  issue of its financial obligations within the
  record time
• The general rating of countries as sovereign
  entities is first carried out before the rating
  of particular issue or institution
• Methodology
• Involves both qualitative and quantitative
  factors
• Assessing the likelihood of default on debt
  obligations for sovereign sukuk

42
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• IIRA considers the following six analytical
  categories while assessing the likelihood of
  default on debt obligations for sovereign sukuk
• - Politics and Policy Continuity
• - The EconomyStructure and Growth Prospects
• - Budgetary and Fiscal Policy
• - Monetary Policy and Flexibility
• - The External Accounts
• - Internal and External Debts

43
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Issuer Ratings
• Rating sukuk issuer with special emphasis on
  ability to fulfill its financial obligation
• Non-financial organs such as the corporate and
  Shariah governance of the entity from the
  bond/sukuk ratings
• Methodology
• In rating the issuer
  
• - Non-financial organs rated with particular
  regards to credit worthiness and continued
  ability to fulfil debt obligations to
  stakeholders
• - Overall financial and institution credit
  worthiness of issuer determines level of
  investors confidence potential

44
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Bond/Sukuk Ratings
• Rating of sukuk in financial markets is as
  important to investors as to the issuer
• Investors aspire to receiving dividends in a
  timely manner after subscribing to sukuk
• Methodology
• Documented terms and covenants of the issued
  sukuk are evaluated and the risk/return is
  measured
• Viability of such sukuk in the secondary market
  will proportionally increase the number of
  subscribers

45
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Insurer Financial Strength Ratings
• Financial strength of the insurer of the sukuk
  will help in avoiding or mitigating risks
• Insurer of the sukuk must have corporate ability
  and requisite financial strength to meet
  contractual obligations
• IIRA aims to be a source of reliable information
  and ratings, encouraging growth of a financially
  strong insurance industry
• IIRA believes it has a vital role encouraging
  prudent management of insurance companies and
  improving the industrys strength for the benefit
  of all stakeholders

46
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Insurer Financial Strength Ratings
• Methodology
• IIRA assesses
  
  - The current financial strength and the
  sustainability of such financial strength of the
  insurance company
• - The capability of the insurance company to meet
  the obligations of the policy holders and other
  contract holders such as the shareholders
• Qualitatively, the country risks of the domicile
  of such company as well as its business profile
  are analysed

47
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Banks Financial Strength Rating
• IIRA adopts global financial practices in rating
  both Islamic and conventional financial
  institutions
• The main issues in banks financial strength
  ratings is investment quality and credit
  worthiness
• The key subject headings in IIRAs asset quality
  analysis are - Banking Environment
  - Credit or
  Investment Policies and Loan Administration
  Procedures
  - Portfolio
  Composition and Characteristics
  - Risk Management
  Practices
  - Lending History and Performance
  - Forecasting the
  portfolio and quality
  - Analytical conclusions regarding economic
  values

48
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Banks Financial Strength Rating
• Methodology
• Fundamentals for assessment of banks financial
  strength
• - Market assessment
  - Consideration of
  factors determining asset quality
  - Liquidity and fund management
  - Asset/Liability
  management
  - Capital adequacy
  - Adjustments to
  achieve economic reality
  - Finance, information systems, planning
  disciplines- Earnings Performance
  
  - Ownership and management performance,
  reflecting all the above
  
  - Emphasis on ability of financial institution to
  make profits and pay dividends

49
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Shari'ah Quality Ratings
• Seek to assess the level of Shariah compliance
  of Islamic financial institutions, corporate
  entities or conventional financial institutions
  offering Islamic financial services or products
  such as sukuk
• The Shariah quality rating aims at informing the
  investing public on the level of compliance of
  certain corporate entities with the requirements
  of the Shariah

50
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Shari'ah Quality Ratings
• Methodology
• Assessing levels of compliance of financial
  institutions or corporate entities with the
  requirements of the Shariah
• - Authentication of products and services
• Safeguards against comingling of funds in the
  case of an Islamic window or branch of a
  conventional financial institution
• Code of ethics adopted by the institution
• Policy of the calculation of profit or loss and
  the consequent sharing of same

51
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Corporate Governance Ratings
• Prospective investors consider the ratings of
  corporate governance/corporate entities before
  investing
• IIRA issues an independent opinion of available
  managerial structure and practices though variety
  of characteristics e.g.
  
  - Transparency and adequate disclosure
  - History,
  board performance, demonstrated trustworthiness
  
  - Management who is the actual
  governor (CEO or executive team)
  
  - Effectiveness the top management team/process
  
  - Shareholders

52
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Corporate Governance Ratings
• Methodology
• Best practices in the corporate governance rating
  of corporate entities are used as benchmarks for
  assessment rather than using standards of
  particular country/jurisdiction
• The level of fairness, transparency,
  responsibility and accountability are considered
  key in the evaluation process
•  

53
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Real Estate Ratings
• IIRAs rating on real estate pertains to the
  overall rating of the developer and is not a
  rating of a particular project unless a specific
  project rating is requested
• The rating is assigned after taking into
  account
• - Market characteristics
• - The organizational structure and management
  quality of the developer
• - Assessment of each of the projects in the
  portfolio the developer is executing

54
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Real Estate Ratings
• Methodology
• The real estate rating methodology designed by
  IIRA aims at providing the stakeholders with a
  balanced view of the strengths and weaknesses of
  the developer and to create a healthy environment
  in the industry
• IIRA will analyze all on-going projects of the
  developer and arrive at an overall rating of the
  developer
• The developers activities such as the
  performance of its architects, engineers,
  contractors, and other necessary personnel are
  rated accordingly

55
Rating of Islamic Bonds
Learning Objective 7.4 Differentiate between
sovereign and corporate ratings of Islamic bonds,
and the methodology used to rate products

• Rating Symbols and Definitions
• Rating agencies convey respective opinions or
  decisions to the investors and other stakeholders
  through the use of symbols
• Level of credit worthiness or the grade is
  determined by certain symbols
• The IIRA has two major categories of rating
  symbols - The International Scale
  Ratings focuses on foreign- currency debt,
  external account liquidity, and factors
  affecting a countrys balance of payment
• - National Scale Ratings emphasises on the
  capacity of a government and other institutional
  borrowers within a country to meet their local
  currency debt obligations

56
Key Terms and Concepts

• Corporate credit rating
• Equity-based sukuk
• Debt-based sukuk
• Foreign direct investment
• Ijarah
• Islamic capital market
• Islamic financial engineering
• Junk bonds
• Mudarabah Sukuk

• Mudarib
• Negotiable sukuk
• Non-tradable sukuk
• Rabb al-mal
• Riba
• Secondary market
• Sovereign credit rating
• Sukuk
• Tradable sukuk
• Trust certificate