Sukuk (Islamic Bond)

Sukuk are Islamic equivalent of fixed income bonds found in the western markets. Shari’ah scholars have varying opinions about legitimacy of Sukuk structure in Islam. This has made these products controversial. This is mainly due to the fact that Sukuk are similar to traditional bonds, almost guaranteeing the capital and giving fixed income. The promoters of Sukuk argue that these structures have been approved by Shari’ah Advisory Boards. The opponents argue that instruments themselves are designed by finance professionals and lawyers, not scholars. The main objections are around the controversy of guaranteed return and repayment of principle.

Islam prohibits interest based borrowing and any fixed rate of return is prohibited. All parties involved in a financial transaction should assume the risks involved. The returns of Sukuk seem like interest because it is not dependent on the risks associated with the underlying asset or the project. Shari’ah requires that the assets backing the Sukuk must be owned by the investors. The assets must be real and tangible and investors should have the proprietary ownership interest throughout the life of Sukuk. Some Sukuk have known to only grant the investors the right to earn any returns from the asset without actually transferring the ownership. This would make the issue noncompliant. Sukuk must be structured with a profit sharing arrangement and the returns should be based on the value of the asset. A benchmark interest rate can be used to determine competitive profit rate but actual disbursements to the Sukuk holders should be net of costs and management fees for the project.

The other argument against Sukuk is that majority of Sukuk carry a guarantee of repayment of entire principle upon maturity which avoids exposure to market risk. This is same as traditional bonds and makes the Sukuk noncompliant with Shari’ah. Leading scholars in Islamic Finance, Sheikh Taqi Usmani and Sheikh Nizam Yaquby, have ruled that the Sukuk cannot carry a guarantee of principal payback at face value. The resale must be based on net value of the assets or a price that is agreed upon at the time of purchase.

Sukuk investors, however, are looking to minimize market risk for a variety of reasons. This might be due to a desire to balance the portfolio. Takaful (Islamic insurance) companies which carry Sukuk, minimize risk in their portfolio to be able to handle insurance claims. For depreciating assets like machinery or automobile, the value at maturity would be much lower than the face value resulting in a loss for the investor. They will need to be compensated in some way to make the issues attractive. This is a challenge for Sukuk developers and new ideas are expected to come forward in this fast growing field.

Sukuk al-Ijarah

Sukuk al-Ijarah is one of the popular form of Sukuk. This is a classical sale-and-lease back structure. In this Sukuk, the owner of an asset raises funds by selling the asset to a Sukuk and leasing it back for rental payments. The Sukuk holders receive rental payments as returns. The primary parties of this Sukuk are the original owner of the asset and SPV (Special Purpose Vehicle) which purchases the asset from the proceeds of the Sukuk sales and then leases it back to the original owner. The investors will receive their share of rental payments after taking out the costs. At maturity, the SPV will sell the asset back to the original owner and distribute the proceeds to the investors to retire the issue.

Since al-Ijarah is one of the most common type Sukuk, it has been widely used both in Muslim world and also in some non-Islamic countries. We will use the example of a 2004 €100 million Sukuk issued in the federal state of Saxony-Anhalt in Germany to explain the key features of Sukuk al-Ijarah.

1. The originator of an asset requiring funding decides to use an asset to generate funds through Sukuk al-Ijarah. The underlying transactions are a certain number of specified buildings in Saxony-Anhalt owned by the Ministry of Finance
2. The originator sets up an SPV to raise funds through Sukuk to buy the asset. The SPV was set up in Netherlands for tax reasons.
3. The originator makes a sale and purchase agreement with SPV for the assets (buildings in our example).
4. Investors buy Sukuk certificates from SPV.
5. The SPV uses the funds received to purchase the assets. The buildings were sold to the SPV for 100 years.
6. Sukuk certificate show undivided owner of the assets providing rental income through lease and the resale to get back the principle at maturity.
7. SPV hold the legal title of the assets and leases the assets back to the originator on agreed terms in exchange for rental payments. The Netherlands SPV rented back the buildings to Ministry of Finance for a five year period.
8. The originator has possession and the right to use the assets.
9. The originator makes agreed rental payments to the SPV.
10. The rent income distributed to the investor in proportion to their investment . Germany Sukuk holders received variable rent benchmarked to the EURIBOR benchmark over the rent period. The Sukuk was listed on the Luxembourg Stock Exchange.
11. The SPV enters into a service agreement where the originator is responsible for maintenance, insurance (takaful), and taxes.
12. The originator as a lessee is responsible for any loss or damage to the asset due to negligent or improper use.
13. SPV holds the right to sell back the asset to the originator in case of default or at maturity of the Sukuk. The originator in that case will pay back the outstanding Sukuk debt so the SPV can pay back the investors.
14. At maturity the assets are purchased back by the originator and Sukuk holders are paid back. In the example, at the end of five years another new Sukuk can be issued since the agreement is for 100 years.
15. In case of delay in rental payments by the lessee, a donation will be made to a charity of SPV’s choice to keep compliance with Shari’ah.
    
16. When all payments are made the SPV by the originator, the SPV is dissolved.
17. When all payments are made the SPV by the originator, the SPV is dissolved .

Sukuk Risks

Risks associated with fixed income structure like traditional bonds are usually also applicable to Sukuk structures. Since Sukuk are different than bonds, there are additional risks that are specific to Sukuk. The following are some of the important risks associated with investing in Sukuk:

Credit/Default/Liquidity Risk: There is a risk that the Sukuk issuer will default on its obligations and not able to make payments when due. It might result from lack of sufficient cash flow or funds or due to bankruptcy or noncompliance.

Limited Recourse Risk: Sukuk involve some Special Purpose Vehicle (SPV) as a guarantee against default. There is a risk that the value of the SPV asset is less than the value of the Sukuk.

Inflation Risk: There is a risk that the investment in Sukuk may not be able to keep up with inflation thus decreasing the value of the investment.

Prepayment Risk: The investors buy Sukuk for the term of the project financed by it. They expect to make certain profit from it. If market condition change and interest rates drop, the Sukuk issuer could issue another instrument and pay off the previous Sukuk. This is the prepayment risk for the investor.

Performance Risk: There is a risk that the servicer of the Sukuk will not be able to perform his duty of collecting and distributing the principle and profits to the investor. This could be due to an number of reasons including accidents and natural disasters.

Political Risk:There could be adverse impact on the Sukuk due to financial, political or general economic conditions in the country where Sukuk us based out of. This could be due to local conditions or an impact of interconnected global markets.

Sovereign Risk: A country may not be able to meet its Sukuk debt obligations to due to over-borrowing.

The above risks are common between Sukuk and traditional bonds. There are additional risks that are specific to the Sukuk issues. These are as follows:

Interest-Rate Risk: Even though Sukuk are not interest bearing instruments, they use benchmark interest rates to provide competitive returns. Thus Sukuk certificates are exposed to interest rate fluctuations. If the market interest rate rises or drops compared to the rate used for Sukuk, the market value of issue to the investor will go high or low accordingly.

No Secondary Market; Limited Liquidity: The liquidity of Sukuk issues is limited since there is no secondary market . A secondary market may develop later but still no assurance that it will provide the liquidity and there is a risk that the market price of Sukuk might be lower than the original purchase price.

Shari’ah Compliance Risk: Every Islamic finance product has to comply with Shari’ah and runs a risk that that it might be deemed noncompliant. This could result in a loss of value to Sukuk holder. Sukuk are required to be compliant yet offer competitive rates to attract investors.

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