A sukuk is a form of financial certificate that is issued in compliance with Islamic finance principles and Sharia law. Sukuk is an Arabic word meaning 'deed, cheque, or legal instrument'.
The main purpose of a sukuk is to create returns for investors that are similar to the returns available on traditional fixed income bonds.
As the Islamic finance market has grown over the last few decades, so has the interest in and demand for sukuk bonds. Essentially, sukuk bonds are similar to traditional bonds in that they have parties who are involved in seeking a return on investment, and sukuk bonds are subject to the same credit rating as conventional bonds.
Sukuks are commonly used by corporations and even governments to finance their business operations.
ISLAMIC FINANCE PRINCIPLES AND SUKUK
Sharia law does not permit investors to partake in investment activities that involve riba. The payment or receipt of riba (interest) is strictly forbidden in Islam.
Most conventional Western market bonds are based on an interest paying structure, and this is not permissible for investors who do not want to receive or pay interest on their financial investments.
Sukuks were first issued over a decade ago in Malaysia who were forward-thinking when it came to creating and supporting financial investment products that Muslims could be involved in. Bahrain was quick to follow Malaysia in issuing sukuks, and these days sukuks can be found in economies across the globe.
Sukuks take up a respectable share in the fixed income market globally. Sukuks have emerged as a great Sharia compliant alternative to traditional interest based bonds.
Sukuks offer Muslim investors the opportunity to invest in bonds and subscribe to certificates that represent the right to actually receive a share of profits that are generated by an asset base. The profits are generated by the asset base being traded on the market.
What do we mean when we refer to fixed income bonds? Sukuks are fixed income bonds. This means that they are fixed income investments and they can provide what is considered to be a more steady stream of income.
Sukuks are considered to be Islamic bonds. They involve asset ownership which is direct, rather than indirect interest based bonds that Western markets tend to offer.
Any income, return, or profits generated from a sukuk cannot be derived from any speculative activity. This would render the return haram under Sharia laws.
So, how do sukuks work? What normally happens is that the issuer of the sukuk certificate will sell an investor a certificate. The proceeds of the sale are then used towards the purchase of an actual asset. The investor then has a partial interest in the asset based on their respective investment.
Another element of sukuk that is important to note is that the issuer of the certificate must promise that they will buy back the sukuk at a future date.
When it comes to sukuks, compliance with Sharia law means that any profits that are derived from the investment must be totally free of speculative activity and interest.
SUKUK VERSUS TRADITIONAL BONDS
As Islamic finance rules do not permit interest, this means that the traditional Western debt and loan instruments are not accessible to Muslim investors who want to comply with Sharia rules.
Sukuks have therefore become a great alternative for investors (Muslim and non-Muslims) to use sukuks as a viable alternative method of raising funds.
Sukuks are considered to be an interest in an asset, and not a debt obligation or debt instrument.
Conventional bonds and sukuks do have some similarities:
- Both traditional bonds and sukuks offer investors a stream of income payments. The payments on traditional bonds include interest payments, and the payments from sukuks are based on profits from the assets.
- Both bonds and sukuks are sold initially by issuers of the certificates.
- Sukuks and bonds are viewed as less risky than equity based investments
It is also important to note that often, conventional bonds finance businesses or industries that are deemed to be haram under Sharia law principles. These haram industries include the gambling industry, alcohol industry, and porn industry. Sukuk bonds cannot be linked to any form of haram activity or industry.
HOW ARE SUKUK CERTIFICATES ISSUED AND HOW DO THEY WORK?
Sukuks are usually found in the form of certificates, also known as trust certificates. In the United Kingdom, sukuk certificates are regulated by the Financial Services Authority. In other countries and economic landscapes across the world where sukuk certificates are issued, there is similar regulation of them.
There is a very specific process for issuing any form of financial certificate including sukuk certificates/ bonds.
The steps below outline the most common steps that are involved in issuing a sukuk certificate:
- Normally a company that requires some form of capital will establish a special purpose vehicle that is known as an SPV for short.
- The company is known as the originator.
- The special purpose vehicle aims to protect the underlying asset from potential creditors in the event that the originator gets into financial difficulties.
- The special purpose vehicle issues the sukuk certificates.
- These sukuk certificates are then sold on to investors for a price.
- The originator uses the funds raised from the sale of the sukuks to purchase the asset they want.
- The special purchase vehicle will then purchase the asset from the originator.
- The special purpose vehicle will then establish a form of lease to lease back the asset to the originator.
- The originator will make the necessary lease payments to the special purpose vehicle.
- The special purpose vehicle will then distribute the lease payments to the investors.
- Once the lease is terminated, the originator will buy back the asset from the special purpose vehicle at nominal value.
- The proceeds of the sale are then distributed by the special purpose vehicle to the holders of the certificate.
DIFFERENT TYPES OF SUKUKAs mentioned above, most sukuk certificates have been presented in the various global markets as trust certificates. It is very common for English common law to govern the law relating to sukuk trust certificates in different countries.
However, the management of sukuks varies from country to country so it is always advisable to do your research about the jurisdiction that regulates your sukuk. Information and transparency are key when it comes to any form of investment, especially sukuks. Where possible, always carry out an analysis of the sukuk product or service before you proceed.
The main types of sukuk are as follows:
- Trust certificates - in this form of structure the originator of the sukuk will create the special purpose vehicle and issue trust certificates to the investors. The proceeds are then used to build a portfolio of assets which will eventually yield a return.
- Civil law structures - these types of structures have emerged to enable sukuk transactions to be undertaken in accordance with the local laws of the country where the originator is based. One example of a country that used civil law structures when it comes to sukuks is Turkey. Turkey have passed their own legislation relating to sukuks which has to be complied with.
As Muslim investors have historically not had the opportunity to invest in bonds without an interest element, sukuk bonds have been welcomed across many global economies.
Sukuks are a great way of enabling investors to link returns with the cash flow of financing assets without the riba of traditional form of debt financing.
However, it is important to point out that sukuks as a form of financing should only be used for identifiable assets. Identifiable assets are those assets whose commercial value can be ascertained at any given point of time. Identifiable assets include things like real estate, equipment, cash, and stock.
In this way, the holder of the sukuk bond /certificate does not own a debt, but as the owner of the sukuk certificate, they own a share of the asset that is purchased using the sukuk funds.
Even though the special purpose vehicles that issue the sukuk certificates are usually brand new, this does not mean that investors will bear exposure to the credit risk of that special purpose vehicle.
ADVANTAGES OF SUKUK Here are some of the main advantages of investing in sukuks:
- For those looking for investment from Islamic economies and markets there is a great marketing benefit to sukuks who will appeal to investors looking for Sharia compliant ways of investing their money
- Sukuks are known to yield similar profit on par with conventional bonds
- More bank and financial institutions are offering sukuk products (always check the website of any organisation offering Sharia compliant products to ensure that you have all the information you need)
- The investor base of Sharia compliant investors is vast and continues to grow
- In addition to the Islamic finance investment market, there is also potential to tap into the ethical investment market which has developed over the last few decades and is always in the news
- Issuers of sukuk certificates are entitled to the same tax arrangements as the equivalent traditional financing arrangements
- Assets that are acquired by the sukuk bonds are jointly owned
- Instead of receiving interest, the holder of the sukuk certificate receives actual profits
- Sukuks offer banks the opportunity and tools to invest their excess liquid assets
- Sukuks can operate for contractual terms that are agreed upon between the parties
- Sukuks continue to grow with success attracting all kinds of high-quality investors including Muslim and non- Muslim investors
- Sukuks have been used across various locations and industries including transport, water, power, education, infrastructure and industrial