This article is written by Chandana Pradeep, from the School of Law, University of Petroleum and Energy Studies, Dehradun. This article analyzes the concept of sukuks in the Islamic finance markets as well as tries to understand the difference between conventional bonds and Sukuk.
Table of Contents
Introduction
There are diverse laws all around the world and one law that has always been quite versatile is the Sharia law (Islamic law) as they have exciting concepts. One such concept that is under the Islamic law is that of sukuks, as this is a type of money lending or bond which is entered into which complies with the law of Islam.
Concept of Sukuk
The term Sukuk has its word root from the Arabic language which roughly translates to “legal certificates” and is a separate type of bond which is entered into by the Muslims as the common type of bonds which are entered into are not permissible according to the religion of Islam. Sukuks were introduced when there was a need for securities which were flexible according to the conditions of the economy and also when there was a need for it to comply with the Muslim Sharia law as the Islamic law prohibits “Riba” or interest.
It is defined as “an Islamic financial certificate, similar to a bond in Western finance, that complies with Islamic religious law commonly known as Sharia”.
This type of financial bond aligns with the Islamic law of Sharia which makes it permissible for people of this religious belief to enter into. This type of bond focuses more on paying off profit and not on the interest which is payable and generally involves assets which are tangible.
When it complies with rules and regulations of the Sharia law, it has key factors such as:
- Any profit which a person is being benefited from by entering into these types of bonds if their means are from trading or any risk which is being taken commercially.
- Any form of interest is not permitted.
- The assets which are part of the bond should be permissible.
For a long time, Sukuk was only prevalent in parts where this religious group was in majority, but recently it has become as common as any other common bond which is being entered into. There is no concept of an obligation of debt in this type of money lending as once it is issued, the issuer sells these certificates to the investors and the issuer uses the money availed from the certificate to purchase any asset which complies with the Sharia law where the investors will also get partial ownership on.
Types of Sukuk
The approach of Sukuks vary from all the other agreements and bonds that are known, this is the first lending where the people who follow Islam used a “Structural Based approach”.
Broadly they are divided into two main types which are :
Trust certificates
Trust certificates are issued by an SPV (Special Purpose Vehicle) to the obligor who is the person who needs the capital to fund his projects, but they can only do so if there is proper jurisdiction following which certificates are issued to the investors upon an agreement.
Alternative remedies
In recent times, other methods have been developing as for the issuing certificates by the SPV it requires to have a particular jurisdiction, so there have been different structures developing with the course of time to enter into the Sukuk agreements which are in accordance with the local laws.
These types are further subdivided into:
Ijarah Sukuk
This type is related to assets or properties which are leased, the outcome of this would be to sell the leased property and the rental charges after the issuance of the certificate to the proportion which is stated in the certificate. In this sort of Sukuk, the liability of a property is transferred from the owner to a second person for an exchange of payment of rent.
Contractor’s Sukuk
This type of Sukuk is issued by suppliers of goods or by a contractor who is providing any service, and it can be issued only for commodities which are already existing or which will be provided in the future. This is a form as Sukuk as the parties entering into will both benefit after it has been sold in the market. An example will be when the Sukuk holder invests in a school or college until they are ready for demanding students.
Potential Services Sukuk
These are issued by suppliers or contracts who have assets which can be sold and they have an equal value to the holders of the Sukuk, and these holders can sell these to a stock market.
Istisna’s Sukuk
To enter into these agreements, there is a parallel agreement which is entered into and to put this contract into use, the private or public companies list out a list of specifications which have to be followed. Then the bidding process starts on how these holders of Sukuk will make the use of the agreement that they have entered into.
Salam Sukuk
These certificates have equal value and are used for putting the use of the capital that is required for specified products when there is a huge demand in them and their price would be paid in advance. Another contract is signed by the party who is buying the Sukuk with a third party which would be separate from the first one which had been entered.
Murabaha Sukuk
These are issued by merchants or an agent on behalf of him to finance a commodity which is being bought at a Murabaha, which is already pre-decided for the types of equipment needed to execute this contract and the holders of this Sukuk will be the owners of the equipment and they can keep the income which is generated by the equipment as well.
Zero-Coupon Non-Tradable Sukuk
Types of Sukuks are created when the commodity is not in existence as of yet and thereby cannot be made use of, and the certificates of these types of Sukuks cannot be traded as there are reasonable restrictions imposed by the Islamic law.
Musharaka Sukuk
These are issued by suppliers or agents who are appointed on behalf of him for financing a project, where the holders of the Sukuk will be the owner, this can be compared to that of a partnership except in cases where the Sukuk holders seek the help of partnerships for finance purposes.
Mudarabah Sukuk
This has been seen to be very successful in cases where there has been an investment done with an Islamic bank and the returns are calculated by the profits which have been generated. The certificates issued can be traded but it has not been done yet. The people who enter into this type of Sukuk have limited rights compared to the ones who have entered Sukuks based on equity.
Hybrid Sukuk
This is a Sukuk which is a combination of two Sukuks, as this helps for faster and effective mobilisation of the funds. It is necessary for 51% of the assets to be Ijarah assets.
Muzaarah Sukuk
These contracts are entered into to finance agricultural costs by entering into a Muzaarah contract and both the parties will be joint owners according to terms and conditions which are already pre-decided.
Musaqat Sukuk
These Sukuks are entered into for financing of plants and their cost, and both the parties become partners.
Musharakah Sukuk in Investment Agency
These will be issued by the investment agents and they manage the investments by acting as a mediator.
Mugharasah Sukuk
These are issued by landowners for costs incurred during plantation-based upon a contract. Both the parties will have equal partnership over the asset.
Sukuk of reducing ownership
These are issued by owners who have an innovative idea and both the parties that have entered into it will be partners and finance the project. There has to be a contract that has to be entered by both the parties which state that full ownership will be later given to the original creator.
Investors credit exposure
Even though a Sukuk is issued by an SPV (Special Purpose Vehicle), in usual situations the investor will not be in the forefront and face any exposure to the credit risk exposure related to the SPV, but this has changed in recent years and investors have been exposed to the credit risks.
The investors who are being approached, have to look into whether this serves as a helping hand to the person who is approaching or also towards any other estate represented by the assents for the agreement which is being entered into. The risk can only be calculated when these two have been answered, which makes it very important for the investor to know if the rights have been transferred permanently to the SPV.
Asset-based vs asset-backed
There are two different types of structure for a Sukuk which are namely asset-based and asset-backed Sukuk.
Asset-based Sukuks
This type of Sukuk is used when an asset is bought and then that is sold, invested etc on behalf of the investors using the funds which were raised by the certificate which had been issued. There is a promise which is being made called Wa’aad Mulzim and this type of structure is compared to that of a sale-lease agreement. This type of structure only gives the holders of the beneficial ownership of the Sukuk, there is no attention given to the risk of the assets but more importance is given to how reliable the investors are.
Asset-Backed Sukuks
This is a process where the investors are given a share of their asset which is tangible along with the risk that is involved. It is a sale transaction where the assets are sold off using SPV( Special Purpose Vehicle) which has the assets which are to be issued back. There is no recourse given to the buyers of these Sukuks if the other person payments are comparatively less. In case a liquidation happens the holders of the Sukuk do not have to add their assets to it. Therefore this type is not very popular and it is often compared with the concept of equity.
Advantages and disadvantages of Sukuk
Advantages
- Tool for management of liquidity and funds– The assets can be sold off or purchased at secondary markets, which is an added benefit for the parties who are holders of the Sukuk.
- Accessible Islamic markets– The people who are actively part of the Islamic markets have it to their advantage and can find potential investors quickly.
- Assets distributed equally– All the assets are distributed equally between the two parties and there is no chance of any sort of discrimination taking place.
- Demand in Sukuk– There are a lot of investors in the Islamic markets as there is a huge demand for sukuks since time immemorial, even if it is not considered as a popular type of finance.
Disadvantages
- Time taking– The process of documentation is too long and rigorous and this is a factor which discourages people from investing in Sukuk.
- No clarity– In case of a default happening, there is not enough precedent to help the parties involved to know how to proceed as there is no transparency in the procedures.
- Expensive– This type of finance is comparatively more time taking as there are a lot of additional costs which are involved such as appointing of Sharia scholars and there is nobody which can settle any dispute as everything lies on the opinion of the scholars appointed and they do not have any uniform opinion.
Sukuk versus conventional bonds
Though these two terms are thought to be the same, they do have their differences, which are as follows:
Difference in ownership
Sukuks only give partial ownership rights for any of the assets which the Sukuk is needed for whereas a conventional bond has an obligation of debt between the issuer and the holder of the bond and the holders of these shares do not get any sort of ownership rights.
The difference in the criteria for investment
Both of these have a difference in investment, while sukuks to have investments should have an asset which is compliant with the Islamic law, whereas conventional bonds can finance any sort of business, finance etc and the only criteria are that it should be according to the rules and regulations of what is prescribed by the law.
Unit of issue varies
In the case of sukuks, each Sukuk represents an underlying asset while in the case of conventional bonds, each of the bonds represents the share of the debt.
Price determination
Both of these have a difference in price determination, while Sukuk calculates its value based on the value of the underlying asset in the market while on the other hand, conventional bonds are calculated solely based on how creditworthy the issuer is.
Risks and rewards
Holders of Sukuk have a share which is predetermined from the underlying asset for any profit or loss incurred; however, for the bondholders, they receive a regular interest which is fixed till the bond exists and once the bond matures the principal will be returned.
Cost effect
Holders of Sukuks are highly affected by the cost of the underlying asset as they have partial ownership of the same and if there are high costs, it means that there will be lower profit for the investors and bondholders are not affected by the cost related to what they have financed, thereby not affecting the rewards of the investors.
Working of Sukuk
Sukuks issue a certificate of representation of the shares which are of equal value which shows the ownership and investment in assets, businesses etc. which comply with the Islamic law and is authenticated by a Sharia scholar. Sukuk is usually entered into with the motive of earning profits from the investment and these investors receive part of the profit which is already decided before through an agreement.
When the investors become a Sukuk holder, they get a certificate which is the evidence of their own in these assets that they are investing and once the Sukuk matures, the principal amount will be given back.
Steps for issuing the certificate
There a few common steps for issuing the certificate which is as follows:
- The originator is the company which requires the capital and they set up an SPV (Special Purpose Vehicle) which protects the assets from creditors.
- Sukuk certificates are issued by SPV which can be further sold to investors.
- The originator purchases the assets required from selling the certificates to the investors.
- SPVs are bought by the originator.
- The SPV pays the money from selling the assets to the originator.
- The SPV makes lease arrangement for the asset to the originator who makes lease payments to the SPV.
- Once the lease has come to an end, the originator purchases the asset back at a value which is very nominal from the SPV who distributes the money received to the holders of the certificate.
Conclusion
Though this type of financial investments is not that popular, there has been a shift of focus towards the Islamic Capital market in the recent years and this has helped in investors gaining a major role in the process of Sukuk.
Even though Sukuk promises on profit that is not the only criteria that are needed in the present economy but customer satisfaction is also an important factor. Islamic capital markets will be of lot more significance in the coming years when there will be substantial growth in the income of Islamic countries.
References
- https://shariaportfolio.com/5-key-differences-between-sukuk-and-conventional-bonds/
- https://www.imoney.my/articles/investing-in-sukuk-how-does-it-work#:~:text=Think%20of%20Sukuk%20as%20Islamic,prohibit%20%E2%80%9Criba%E2%80%9D%20or%20interest.&text=The%20value%20of%20the%20bond,you%20get%20your%20money%20back.
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