Rare MMF and Sukuk Default Brings Credit Risk to the Forefront

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The recent default of a sukuk, which is a Sharia-compliant financial certificate similar to a bond, in a Saudi Arabian money market fund (MMF) was a highly unusual event. Nevertheless, it raises important questions for short-term investors in the Gulf Cooperation Council (GCC) region regarding the investment guidelines and risk appetites of the funds in which they invest.

Defaults in securities underlying MMFs are rare globally, particularly for MMFs operating in conservatively regulated environments or those adhering to conservative investment guidelines. The most notable default to which MMFs were significantly exposed was the collapse of Lehman Brothers in 2008. Fitch Ratings is aware of only two other credit events affecting MMFs since then: one in South Africa in 2014, and one in China in 2019.

There have been an insignificant number of sukuk and bond defaults in the GCC, and, in such cases, debt restructurings have generally been informal out-of-court arrangements, partly due to creditor perceptions that local courts have a limited track record. Legal precedents for effective enforcement in many jurisdictions where sukuk issuance is prevalent are lacking, and therefore uncertainty whether certificate holders will be able to enforce their contractual rights in relevant courts remains.

However, as more corporates seek to tap into the sukuk market – potentially including those with weaker credit profiles – legal precedents clarifying creditor treatment in a default could eventually be set.

The defaulted sukuk was held in only one MMF in Saudi Arabia, and was therefore idiosyncratic in nature. That fund’s unit price fell by 6.7% in one day and experienced subsequent outflows, although they were not sufficiently large to cause liquidity issues for the fund.

Despite the default, appetite for Saudi MMFs does not appear to have diminished. Assets under management in Saudi MMFs reached an all-time high of SAR129bn ($34bn) at end-June 2020 – an increase of around 2% on the previous month’s total and of around 22% over the first half of 2020. However, Fitch expects that investors will scrutinise funds’ holdings and risk appetites more closely in the wake of this event and fund managers might take action to demonstrate – and strengthen, where necessary – their credit standards. Regulators, too, may respond.

Saudi MMFs are largely invested in bank deposits and similar securities. Sukuk and bond exposure is typically low, reflecting that sukuk and bonds tend to be longer-dated than bank deposits. Applicable regulation requires Saudi MMFs to maintain a maximum portfolio-wide weighted average life limit of 120 days, consistent with global best practices. However, Saudi regulation differs from other jurisdictions in that it does not specify a maximum individual asset maturity, meaning that Saudi MMFs can have some exposure to longer-dated securities, while maintaining a low aggregate maturity limit.

While the identity of the defaulted issuer was not publicly disclosed, Fitch believes it was a GCC corporate. The largest issuers of sukuk are governments, representing 65% of Fitch-rated sukuk issuance in 2Q20. Corporates are smaller, although not insignificant, issuers, representing 21% of the 2Q20 total. More importantly, the market largely comprises high-credit-quality issuers: 82% of outstanding sukuk rated by Fitch were investment grade as of end-2Q20. Corporate sukuk exposure, particularly lower-quality or longer-dated issues, or both, will probably become an area of focus for both MMF investors and managers.

Saudi Arabia is the GCC’s largest and longest-established MMF market, with the first local MMF launched in 1987. Locally domiciled MMFs make up a disproportionately large proportion of Saudi mutual fund assets, at around 80% of total assets under management. The only other GCC countries with locally domiciled MMFs are Kuwait and Oman, although other GCC countries have registrations from offshore MMFs, most of which are European. There is negligible registration of offshore funds in Saudi Arabia.