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Empirical Findings from
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ISRA Research Project:
A Diagnosis of Tranching in Light of Shariah Principles
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By Shabnam Mokhtar
[email protected]
Presentation Outline
Introduction to Tranching



Definition & Mechanicms
Benefit & concerns
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Case studies of tranching in Sukuk issuance

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Islamic Asset Based Sukuk: Malaysia (Senior vs Junior)
Islamic Asset Backed Securities: Malaysia & Global
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Sale based sukuk
Lease based sukuk
Equity Based Sukuk
Application of Tanazul in different type of sukuk
Alternative approaches toTanazul
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Introduction
to Tranching
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Definition of Tranching
Tranche means slice, piece,
portion

Tranching – slicing of capital
structure in bond issuance
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Classes of liabilities
Layers of bond
Senior, mezzanine, junior
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Tranching – emulate
different capital structure in
a firm
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Senior
($95m)
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Mezzanine ($2m)
Junior ($3m)
Subordination
Tranching is done via subordination

Subordination is a process of prioritizing the order in which
losses are allocated to the various layers of bonds (S&P, 2008)

Subordination is the act of one party acknowledging by written
record that a debt is inferior to the interest of another in the
same property (Assi, 2008)
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Subordination is a technique to rank the rights of different
creditors over same collateral (Assi, 2008)
How tranching is done
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Types of tranching
Multi Rated Multi Class
Multiple Classes
Different rating for each
Class






Class A – AAA
Class B – AA
Class C – BBB
Class D – unrated
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Non pari passu loss
sharing
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Time Tranche
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Tranching represent
different maturities
Same rating for all tranche
5 tranches with maturity
ranging from 1- 5 years
But all rated AAA
Pari passu loss sharing
Benefits of tranching
Cheaper cost of funding
1.






AAA – 2% return, $95m
A – 5 % return, $2m
Unrated – 15% return, $3m
Annual cost = $2.45 m
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Larger investor group
2.
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One class of BBB bond (10% return, $100m)
Multi-class, multi rated bond:
Different risk apetite: Secured vs high risk investor
Tranching allows tapping into broader investor group
Concerns over tranching practice
Asset Quality:
1.
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Shariah concern
2.
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Mis-perception of asset quality & underlying risk
Average pool rating – BBB, but via tranching can have AAA
AAA is only safe if the underlying assumption of default is
correct. Example - assumption of default rate 7%
Lower pool quality, higher number of tranches
(Coval, Jurek & Stafford, 2008) and (Frank & Weber, 2009)
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Subordination/Prioritization
How is it done
What were the underlying relationship of parties
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Case studies e
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Tranching in Sukuk
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Islamic securities Guideline: Malaysia
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Total number of Sukuk (6/4/2010) = 7
Multi rated multi class tranching = 5
Time tranched = 2
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Islamic Asset Backed Securities: Global
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Islamic Asset Backed Securities: Malaysia

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Total number of Sukuk (6/4/2010) = 306
Junior or subordinated Sukuk = 15 (about 5%)
Total number of asset backed Sukuk = 4
Multi rated multi class tranching = 3
No tranching = 1
Bil
Date of
Issuance
Issuer
Underlying Contract
Issue Size
(RM mil)
Tanazul
Senior structure
(if any)
Note
1
30/1/2004
Glomac Berhad
BBA
RM 60
NO
BBA
BAIDS – Jr MUNIF
2
27/10/2003
BBA
RM 250
NO
BBA
3
23/10/2002
New Pantai Expressway
Sdn Bhd
Lingkaran Trans Kota Sdn
Bhd
BBA
RM 148
NO
Murabahah
4
15/5/2006
Malayan Banking Bhd
BBA
RM1,500
5
23/6/2008
Istisna'
RM 230
6
7/10/2008
MRCB Southern Link
Berhad
Serrisa Sinar Berhad
Murabahah
RM 20
7
30/5/2008
DHTI Capital Sdn Bhd
Murabahah
RM 10
8
15/6/2007
PINS Capital Sdn Bhd
Murabahah
9
27/7/2006
Cellular Structures Sdn Bhd
10
26/5/2006
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NO
NA
NO
Istisna'
NO
Murabahah
NO
Murabahah
RM 10
NO
Ijarah
Murabahah
RM 8
NO
Murabahah
Tele-Flow Capital Sdn Bhd
Murabahah
RM 10
NO
Murabahah
25/9/2009
CIMB Islamic Bank Berhad
Musharakah
(among investors)
RM 2000
NO
NA
12
28/12/2007
Binariang GSM Sdn Bhd
Musharakah
(among investors)
RM 3,017
NO
Musharakah
Sr: Jr (85:15)
13
30/4/2007
Nucleus Avenue (M) Berhad
RM 1,700
NO
Musharakah
Sr: Jr (70:30)
14
21/12/2006
AmIslamic Bank
RM400
24/11/2006
OCBC Bank
Agree Upfront
(p7)
Waive its right
(p16)
NA
15
Musharakah
(among investors)
Musharakah
(among investors)
No info
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RM200
NA
Effect of subordination (no tanazul)
Waterfall Priority (p20)
Ranking (p14)


Holders of the
ICP/IMTN shall rank
prior to the holders of
the Junior IMTN in
terms of priority and
security.
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(1) All fees under ICP/IMTN and
Junior IMTN;
(2) Payment of profit portion in
relation to the ICP/IMTN;
(3) Payment of principal of the
ICP/IMTN
(4) Payment of profit portion in
relation to the Junior IMTN;
(5) Permitted Investments; and
(6) Upon the expiry of the
ICP/IMTN Programme, payment of
profit and principal of the Junior
IMTN
Source: DHTI Capital issued in May 2008
Tanazul utilized
1206 AmIslamic*

1106 OCBC
The Sukukholders will further
agree upfront that their claim on
such
portion
of
the
abovementioned cash flows from
the Musyarakah Venture and the
trust created in favour of the
Sukukholders will be subject to
subordination and agree to make
available such cash flows and the
Trust Assets to the Issuer to first
meet all deposit liabilities and other
liabilities of the Issuer except those
liabilities which by
their terms
rank pari passu in right and
priority of payment with or
subordinated to the Subordinated
Sukuk Musyarakah (p7).
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Each Holder irrevocably waives its
rights as a creditor to the extent
necessary to give effect to the
subordination provisions of the
IT1 Capital Securities. Each
Holder agrees that at the time
when a winding-up proceeding
any amounts that would be due to
such Holder will be applied:-
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(a) first, to the payment in full of
all claims of depositors and all
other obligations of the Issuer
ranking senior to IT1 Capital; and

(b) thereafter, to the payment,
equally and rateably, to IT1
Capital Securities. (p16)
* AmIslamic explicitly used "tanazul" in the PTC but for the effect of incentive fee (p5-6)
Tranching in Asset Backed Sukuk


Tranching in Islamic Asset Backed Securities is more
intense compared to tranching in Asset Based Sukuk
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We will review both Malaysian and Global Islamic Asset
Backed Sukuk
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Issuer
1
ABS Plantation
Asset
2
Golden Crop
Return
3
Dura Palms
4
ABS Logistic
5
Menara ABS
6
Caravan I
(Hanco)
7
Tamweel
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Underlying
Contract
BBA/Ijarah
(three SnP)
Details
Waterfall
Tanazul
Different
priority
NO
Different
priority
NO
A, B, C, D
(multi rated)
Different
priority
NO
A1-A10, B, C, D, E
(multi rated)
Different
priority
NO
A1-A4, B1-B3, C
(multi rated)
Different
priority
NO
Ijarah
1. Purchase of leased asset
(vehicles).
(Lease was to third
2. Issuer issue 2 classes
party)
(Sukuk & RPS)
Sukuk & RPS
Different
priority
NO
Ijarah
1. Purchase of leased asset
(properties).
(Lease was to third
2. Issuer issued Sukuk
party)
(4 classes)
A, B, C, D
(multi rated)
Different
priority
Implied
tanazul
(agree to
dispose/
waive right)
1. Sale & leaseback between
A, B, C (multi rated)
originator & Issuer (SPV)
2. Issuer enter into Sale & buy
back with investors (3
classes)
Ijarah/
1.
Musharakah
(No details on 2.
number of lease)
Ijarah
(three leases)
Classes
Sale & leaseback between
Sukuk (5 tranches,
originator & Issuer (SPV).
multi rated) &
Issuer issued Sukuk Ijarah
Musharakah
(5 tranches) & Musharakah
arrangement
(LTAT)
1. Sale & leaseback between
originator & issuer (SPV).
2. Issuer issued Sukuk Ijarah
(4 classes)
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Ijarah
(Eight leases)
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Ijarah
1. Sale & leaseback between
originator & issuer (SPV).
(No details on
number of lease) 2. Issuer issued Sukuk Ijarah
(14 classes)
1. Sale & leaseback between
originator & issuer (SPV).
2. Issuer issued Sukuk Ijarah
(8 classes)
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Issuer
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Musyarakah One
Capital
9
Cagamas MBS
10
11
Sun Finance
(Sorouh)
East Cameron
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Underlying Contract
Details
Musharakah
1. Purchase of
receivable.
(Different
Musharakah for each 2. Musharakah
among investors
tranche )
(5 time
tranches)
Musharakah
1. Purchase of
receivable.
(No info on number of
2. Musharakah
Musharakah)
among
themselves (6
time tranches)
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Mudarabah
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Musharakah
Waterfall
Tanazul
5 series with one
rating
(time tranche)
No priority
among
tranches
NO
6 tranches with one
rating
(time tranche)
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No priority
among
tranches
Tanazul for
incentive fee,
not
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A, B, C and
Subordinated
(multi rated)
Different
priority
NO
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1. Purchase of land
plot sold on
conditional basis.
2. Mudarabah
between issuer
SPV and Prop Co
(Abu Dhabi SPV)
1. Purchase of
hydrocarbon.
2. Musharakah Purchaser SPV
(US based) is
owned by
originator &
independent
member
Classes
One class of Sukuk No tranching
(no tranching)
NO
Overview of selected structures

ABS Plantation – BBA/Ijarah

ABS Logistic – Ijarah

Menara ABS Ijarah (unique approach to lease)

Tamweel –Istithmar with Tanazul

Time Tranche in Musharakah
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Alternative approach:
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Golden Crop – Ijarah + Musharakah
Sorouh – Mudarabah with Musawama
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ABS Plantation (BBA/Ijarah)
Sale & Buy
Back
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Sale of
Plantation
Lands (7)
ABS Plantation
(SPV)-Issuer
Originator
(Benta & Subs)
Ijarah
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Points to ponder:
This deal utilized three SNPs, with
different assets to have priority.
 Is tranching in Sale Based Sukuk
permissible if there was only one SNP
between Issuer & Investors?
 Since all assets are leased to the same
party (co-mingled), must the payment
to the different classes match the
actual collection of the asset sold?
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Class A
2
Class B
3
Class C
Class
Rating
Return
A (50m)
AAA
6%
B (45m)
AA
6.75%
C* (80m)
Not Rated
35%
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* No cash was raised on Class C. It was
issued to Originator as part of purchase
price paid
Effect of subordination (no tanazul)
Post-EOD Waterfall
Pre-EOD Waterfall
1.
2.
3.
4.
5.
6.
Return of Class A
Return of Class B
Principal of Class A
Principal of Class B
Principal of Class C
Return of Class C
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Deals that used this approach:
1. ABS Plantation
2. Golden Crop
3. Dura Palms
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Return of Class A
Principal of Class A
Return of Class B
Principal of Class B
Principal of Class C
Return of Class C
ABS Logistic (Ijarah)
Originators
(Tiong Nam &
Subs)
Sale of
warehouses
(23)
ABS Logistic
(SPV)-Issuer
Ijarah
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Observations:
1. What is the underlying transaction
between Issuer & Investors – Bay’, Ijarah, or
Shirkah?
 PTC said undivided beneficial
ownership of properties(p12)
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2. Does the underlying transaction affect
permissibility of tranching?
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Issue
Sukuk
Senior
Mezanine
Junior
Subordination in ABS Logistic (No Tanazul)
Ranking (p5)

As between the classes,
the Sukuk are ranked in
the following descending
order of priority:

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(a) the most senior, Class
A Sukuk;
(b) Class B Sukuk;
(c) Class C Sukuk (bank
guaranteed);
(d) Class D Sukuk; and
(e) the most junior, Class E
Sukuk.
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Waterfall Priority (p14-15)
1. Return of Class A
2. Principal of Class A
3. Return of Class B
4. Principal of Class B
5. Return of Class C
6. Principal of Class C
7. Return of Class D
8. Principal of Class D
9. Return of Class E
10. Principal of Class E
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Source: ABS Logistic OC issued in May 2007
Menara ABS Structure
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Unique Lease Approach in Menara ABS
Tranche
% of ownership
Rating
Return
A1 (240m)
20%
AAA
5%
A2 (55m)
6%
AA2
A3 (40m)
5%
A1
A4 (10m)
2%
B1 (30m)
2%
B2 (40m)
3%
B3 (85m)
C (600m)
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5%
57%
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A2
AAA
5.3%
5.8%
6.3%
4.35%
AAA
4.55%
AAA
5%
Not rated
10%
The 4 office buildings were worth about RM1.029 billion.
There were 8 lease contracts involved, representing
ownership proportion of different classes of Sukukholders
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Source: p11-16, 24, 26 of PTC
Subordination in Menara ABS, (No Tanazul)
Pre-EOD Waterfall
1.
2.
3.
4.
5.
6.
Return of Class B
Return of Class A
Return of Class C
Principal of Class B
Principal of Class A
Principal of Class C
Post-EOD Waterfall
1.
2.
3.
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4.
5.
6.
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Return of Class A (reserve)
Return of Class B
Principal of Class B
Principal of Class A
Accrued & Deferred return
A& C
Principal of Class C
Profit share of Class C
Observation:
1. Unlike other waterfalls, since class C was issued (and cash raised) to a party which
was not the originator, the pre-EOD waterfall includes the payment of return to
Class C
2. The deal created different accounts for periodic distribution, redemption of Class
B and Redemption of Class A&C (refer p46-51 for details)
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Tamweel Sukuk Ijarah
Sale of
Properties
(title transfer)
Obligor
Originator
(Tamweel)
Property
Financing
based on
IMBT
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Class
Rating
Return
A ($177m)
AA
LIBOR +
0.35%
B ($15m)
BBB+
C ($10m)
BB-
D+ ($7m)
Not rated
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LIBOR +
3.95%
LIBOR + 10%
Class D was not issued (i.e. held by
originator).
+
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LIBOR + 1.2%
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$
Issue Sukuk
Tamweel
Properties Ltd
(DIFC SPV)
Acquire Beneficial Rights
Tamweel
Residential ABS
(Caymans SPV)
Effect of subordination (Tamweel)
Post-EOD Waterfall
Pre-EOD Waterfall
1.
2.
3.
4.
5.
6.
7.
8.
27
Return of Class A
Return of Class B
Return of Class C
Principal of Class A
Principal of Class B
Principal of Class C
Return of Class D
Principal of Class D
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2.
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3.
4.
5.
6.
7.
8.
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Return of Class A
Principal of Class A
Return of Class B
Principal of Class B
Return of Class C
Principal of Class C
Return of Class D
Principal of Class D
Tamweel (Implied Tanazul)

A Noteholder, by its acquisition and holding of a Note, is
deemed to agree that (as provided by the Conditions):


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(a) the Noteholders of a class of Notes may agree to dispose of their
right to receive payments under the Notes as they wish;
(b) the Noteholders of another class of Notes (being co–investors)
may receive payments of a higher or lower rate of Variable Return, as
the case may be; and
(c) in the disposition of such rights to receive payments, the
Noteholders of one class of Notes may agree that their rights to
receive payments under the Notes and the payments when made
(but only such rights and payments) are reserved and used to enable
the Noteholders of another class or classes of Notes to receive
payments under the Notes in priority to them.
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Source: Condition 2.12 Status of Notes, p38 of Tamweel Offering Circular
Time Tranche in Sukuk Musharakah
Musharakah One
Cagamas
2 (215m)
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AAA
5
3 (260m)
AAA
7
4 (515m)
AAA
10
5 (410m)
AAA
12
6 (400m)
AAA
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Series
Rating
Maturity
Class
1 (115m)
AAA
1
1 (250m)
2 (115m)
AAA
2
3 (115m)
AAA
3
4 (115m)
AAA
5 (107m)
AAA
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Rating
Maturity
AAA
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Alternative Approaches
Golden Crop – Ijarah & Musharakah
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Sukuk Ijarah – had 5 multi rated classes
Then entered into Musharakah with LTAT
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Sorouh – Application of Musawamma
b.

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Use 2.5% pro-rata profit distribution
Then sequential allocation
Applied Musawama to create offsetting obligation
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Structure of Golden Crop Islamic ABS
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Golden Crop – Details on Classes
Type
Series
Rating
Sukuk Ijarah
1 (234m)
AAA
2 (57m)
4 (26m)
5 (52m)
Musharakah
300m
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3 (73m)
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AA2
A2
A3
BBB
Not rated
Observation:
 Does Sukuk Ijarah rank higher than Musharakah arrangement?


Again in Sukuk Ijarah what is the relationship between Issuer &
Investor?
Compare PLSA vs Golden Crop arrangement
32
Sorouh/Sun Finance Sukuk Mudarabah
Sale of Land
Plots(title
transfer)
Obligor
Sale of plots
on conditional
basis
Originator
(Sorouh)
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$
Class A
Class B
Class C
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Issue Sukuk
PropCo
(Abu Dhabi SPV)
Mudarabah
Sun Finance
(Jersey SPV)
Trustee Priority of Payment in Sorouh


In keeping with Shari’a principles, 2.5% of the Profit
Payments to be paid to the Certificateholders on each
Periodic Distribution Date will always be distributed on a
pari passu basis amongst the holders of the Class A Sukuk
Certificates, the Class B Sukuk Certificates and the Class
C Sukuk Certificates.
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The remainder of the Profit Payments to be paid to the
Certificateholders will be paid sequentially to the holders
of the Class A Sukuk Certificates, the Class B Sukuk
Certificates and the Class C Sukuk Certificates.
34
Musawama Application


Shari’a principles require the holders of the classes of Sukuk
Certificates that received capital in priority to the holders of
another class of Sukuk Certificates to pay amounts to the
holders of such classes of Sukuk Certificates.
However, the Trustee will covenant that, should such a
circumstance of loss occur, it will enter into a musawama or
other arrangement in order to ensure that the obligations of
the senior classes of Certificateholders to return amounts of
capital to more junior classes of Certificateholders is set off
against the obligation of the junior classes to pay the senior
classes under the relevant Shari’a compliant arrangement
effected at such time, with the result being that no amounts
will be payable from one class of Certificateholders to another.
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p12 of Sorouh Offering Circular
Simply put (Sorouh Musawama…)

Due to subordination, the junior class absorbs losses first

Shariah requires the senior class to pay back the junior
class


If this happens, then Junior enter into Musawama with
Senior (i.e. Junior buy from Senior)
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i.e. Senior’s obligation to pay Junior  A
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o
C
this creates obligation for Junior to pay senior  B
Set off A & B, so there is no obligation for senior to pay
back the non-pari passu loss
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Summary
Tranching is more intense in Asset Backed Sukuk
1.


In asset based Sukuk – usually only senior vs junior segregation
If too many tranches, it should raise some concern on why it is so?
l
ia
t
n
2.
Sale based Sukuk – can tranching be done if the investors are
buying into pool of asset instead of separate assets?
3.
Lease based Sukuk – what is the transaction between issuer
(SPV) and Sukukholders?



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o
C
f
n
e
id
If it’s Bay’ can we have tranching?
If it’s co-ownership, can we have tranching?
Possible solution: Menara ABS approach: co-own pool of asset, lease
agreements based on proportion of ownership
Summary (continued)
Equity Based Sukuk
4.

Does having separate Musharakah for each tranche help
solve the issue of subordination?

What about Sorouh’s approach of sharing small portion of
profit on pari passu basis then sequential sharing together
with Musawama arrangement?

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e
id
t
n
Does Ijarah rank higher than Musharakah:

5.
o
C
f
n
l
ia
Golden Crop vs PLSA approach
Islamic banks usually raise subordinated capital
independent of other Sukuk issuance. Maybe this type of
issuance deserves a separate analysis?
Q&A
f
n
o
C
39
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id
t
n
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ia