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 Islamic bond, the largest ever issued, maturing on December 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
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 ten 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 of 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.