Islamic bond defaults and the standstill requested for Dubai's Nakheel will transform the market as investors demand more transparency and subject new issues to forensic due diligence.
Investors in real estate developer Nakheel were stunned following the announcement on Wednesday that the company and its owner state-run Dubai World would delay by at least six months repayment on billions of dollars in debt.
Nakheel had a $3.5-billion (U.S.) Islamic bond, the largest ever issued, maturing on Dec. 14, an obligation the market widely expected to be honoured.
"If there are lessons to be learned here, it is that due diligence is all important. Compliance to sharia in its structuring does not ensure the success of a sukuk or of any product or business," said Yusuf Talal DeLorenzo, chief sharia officer at fund management company Shariah Capital.
The sukuk market was already jittery before the news from Dubai. Earlier this month prominent Saudi business group Saad said it would miss the payment of the second bi-annual coupon on its $650-million Golden Belt Sukuk Belt 1 Sukuk domiciled in Bahrain..
In May Kuwait's Investment Dar said it defaulted on a $100-million sukuk.
In its simplest form sukuk are certificates proving ownership of an asset, but unlike bond holders, sukuk investors do not receive interest but rather returns generated by the underlying assets pooled under special purpose vehicles (SPV).
The events have shaken the reputation of sukuk as safer and more transparent than their conventional counterparts - just as the market was recovering from a slump in 2008, with issuance up 40 per cent in the first 10 months of the year.
They also show that sukuk do not necessarily grant ownership of the underlying assets, which would in theory make investors safe in case of default.
"Clarity on the structure is essential. The Islamic finance industry must do all it can to avoid accusations of mis-selling products," said a senior industry figure, who spoke on condition on anonymity.
The nature of the sukuk also plays a role in where Islamic debt is ranked in debt restructuring processes such as the ongoing ones at Saad and Investment Dar.
"It will be interesting to see whether the recovery value will be higher than at the senior debt," Mohieddine Kronfol, managing director at Dubai asset manager Algebra Capital, said of the Saad sukuk.
Even when investors fully understand the structure of the sukuk, it is not certain their ownership rights will be reinforced, said an Islamic finance expert who declined to be named.
"The reality is that Middle Eastern property law is so weak that even with asset-backed, people have little confidence in the success of that claim," the expert said, adding most investors did know the risks involved.
"All the rating agencies have never rated Middle Eastern sukuk in reference to the assets, they only ever rated them in reference to the credit rating of the sponsoring entity. They were rated as unsecured liability," he said.
A dramatic selloff, although possible, looks improbable, according to Indraj Mangat, a partner at law firm Eversheds' Islamic Finance Group.
"The defaults in the Gulf sukuk markets are more a reflection of the broader economic difficulties in the Gulf than an indictment of sukuk per se. It is possible that investors may judge sukuk on the defaults but that is like throwing the baby out with the bath water," he said.
Investors however will become more discerning.
"Lending in the Gulf has often been based on the perceived value of the family name of the borrower or its backers. The current announcement sees that position being eroded, " said Amjad Hussain, head of banking and Islamic finance, Middle East at law firm Eversheds.
"The defaults in the Gulf will now act as a catalyst for lenders to encourage them to adopt a more impartial and diligence-led process. This is good for the long-term development of the Gulf economies including on corporate governance-type issues," Mr. Mangat said.