Maldives nears first sovereign default on Islamic bonds

Ishan @seefromthesky/Unsplash

• Island nation issued $500m sukuk
• Value slumped in August
• Investors concerned about debt

The possibility of the first ever sovereign sukuk default by the Maldives would have negative repercussions for new sukuk issuance and the broader sharia-compliant fixed income market, industry experts have warned.

Sukuk are sharia-compliant bonds that were developed as an alternative to conventional bonds, which are not considered permissible by many Muslims as they pay interest and may finance businesses involved in activities not allowed under Islamic law.

Only 62 out of the 22,794 sukuk issued this century have defaulted, according to S&P Global. All these defaults were on corporate, not government sukuk, while only 12 were in hard currencies.

With no sovereign sukuk defaults, the documentation for such debt is a poorly understood area of law, in part due to a lack of precedent, says Ali Hakim, a senior associate for sovereign advisory services at the global management consultancy Alvarez & Marsal.

"Despite the large size of the sovereign sukuk market, most lawyers and investors remain relatively unfamiliar with sukuk compared with conventional debt-instruments,” Hakim says.

The Maldives issued a $500 million, five-year sukuk in April 2021. The sukuk was sold with a profit rate – effectively the interest rate – of 9.9 percent. After starting at a par value of 100, its price was 77.1 on September 26, having rebounded from a low of 69.9 on August 30.

Alvarez & Marsal

The slump in its par value reflects investor worries about the Maldives’ ability to repay. The country’s debt interest payments amounted to 3.6 percent of gross domestic product in 2022, the most recent data, and the highest since records began in 1990.

The Maldives’ external (foreign currency) debt totalled $3.1 billion in 2022, the most recent International Monetary Fund data shows.

The IMF wrote in a report in March 2024: "Maldives remains at a high risk of external and overall debt distress. External refinancing pressures are expected to peak in 2026.”

The Maldives must repay $557 million in 2025 and more than $1 billion in 2026, a figure that includes the $500 million sukuk, says Fitch Ratings, which in August downgraded the Maldives and warned that the country’s deteriorating finances “have made a default event more likely”.

Sukuk structures can vary. The Maldives sukuk is partly asset-backed. As a government sukuk, these assets are likely to be real estate, says Habib Ahmed, a professor of Islamic law and finance at the University of Durham in the UK.

In a sukuk, the underlying assets are placed in a special purpose vehicle, which is then rented back to the obligor – or seller – of the sukuk to make it sharia compliant: investors receive rent, not interest, as well as repayment of the principal amount on maturity.

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“The key question is if there is a default, how do investors recover their capital,” Ahmed says. “In terms of structuring, there shouldn’t be too much difference between a sovereign and a corporate sukuk.

“Investors are not interested in the asset. They just want their capital back, plus the returns. So, there's an undertaking that the government [the obligor] will buy back the asset at the original par value.”

Should the Maldives fail to make the coupon payments, the government will repurchase the underlying assets and then renegotiate repayment terms of what is now a new debt it owes to the sukuk holders.

Alvarez & Marsal

“It will become an unsecured debt,” Ahmed says. “Instead of pursuing bankruptcy, which would result in a huge loss, sukuk holders usually prefer to renegotiate.”

Previous corporate sukuk defaults have “had an adverse impact on the sukuk market,” he says.

“So, there will likely be an adverse effect if the Maldives defaults in terms of investors becoming more cautious about future sovereign sukuk issuance. Until now, investors thought it was only corporate sukuk which could default.”

Hakin at Alvarez and Marsal says that although sukuk are in effect like unsecured bonds, that does not necessarily mean their inherent risk has been underpriced.

“The demand for sharia-compliant sovereign assets significantly outstrips the supply, despite the fact that it is a growing market. With so many dollars chasing so few assets, it is not surprising that some sovereigns have managed to raise money using sukuk at lower costs than conventional bonds,” he says.

Reza Baqir, managing director for sovereign advisory services at Alvarez & Marsal in Dubai, says: “If the current ‘sukuk discount’ for some issuers reflects a belief that sukuk are less risky than bonds, then if and when a sovereign defaults on a sukuk for the first time, that hypothesis will be tested.”