By Konstantin Vasilev Member of the Board of Directors of Cbonds, Ph.D. in Economics
Updated August 06, 2023
What is a Sukuk?
A sukuk represents an Islamic financial certificate, akin to a bond found in Western finance, adhering to the principles of Islamic law known as Sharia law for clarity. As interest-based bonds are not permitted in Islamic finance, the sukuk issuer should match the subject-verb agreement. They sell a certificate to a group of investors and utilize the funds to acquire an asset in which the investors hold direct partial ownership. Additionally, the issuers commit to repurchasing the sukuk at its face value on a specified future dates.
How do Sukuk work?
Sukuk work as a unique Islamic financial instrument designed to comply with Islamic religious law, which prohibits interest-based transactions (riba) and financial speculation. Since traditional Western debt instruments with interest payments are not allowed in Islamic finance, sukuk offer an alternative way to raise capital and provide investment opportunities while adhering to profit and risk-sharing principles.
The popularity of sukuk, Islamic financial instruments, has surged since their first issuance in Malaysia in 2000, followed by Bahrain in 2001. Today, sukuk have gained widespread acceptance globally, becoming a prominent component of the fixed-income market for both Islamic corporations and state-run entities.
When a sukuk is issued, it represents an ownership share in a tangible asset related to a specific project or investment activity. Instead of being a debt obligation owed by the issuer, like a conventional bond, a sukuk holder effectively owns a portion of the asset linked to the investment. This arrangement allows investors to receive returns and cash flows associated with the asset, effectively distributing the benefits of the investment.
The key feature of Sukuk is their conformity to Sharia principles, which emphasize the sharing of profits and risks between parties involved in the transaction. This means that the issuer and the sukuk holders each take a portion of the risks associated with the investment. Consequently, the return on sukuk investments is not guaranteed, unlike the fixed interest payments provided by conventional bonds.
Since Sukuk are based on tangible assets and profit-sharing, they offer a way for Muslims to participate in investments and capital-raising activities without violating the principles of their faith. This makes sukuk a viable option for raising funds for identifiable assets or specific projects while complying with Islamic financial principles.
Types of Sukuk
According to the Sharia Standard 17 on Investment Sukuk issued by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), there are 14 different types of sukuk structures. However, among these structures, the most widely used types of sukuk are as follows:
Ijara Sukuk. Also known as "Lease Sukuk," these involve the sale and leaseback of an underlying asset. The issuer sells the asset to investors, who then lease it back to the issuer for a predetermined rental fee. At the end of the lease period, the asset ownership may transfer back to the issuer.
Mudaraba Sukuk. This type of sukuk is based on the principle of "Mudaraba," a form of partnership where one party provides the capital (the investors) and the other party (the issuer) manages the investment project. Profits are shared between the parties according to pre-agreed ratios, while losses are borne solely by the investors.
Musharaka Sukuk. "Musharaka" means joint venture partnership. In this sukuk structure, investors pool their funds with the issuer to finance a project or investment. Profits and losses are shared based on the agreed ratios, and the sukuk holders become co-owners of the underlying assets.
Murabaha Sukuk. This type of Sukuk is based on the "Murabaha" contract, which is essentially a cost-plus financing arrangement. The issuer purchases an asset based on the investors’ funds and then sells it to the investors at a marked-up price. The profit margin is known upfront, making it a fixed-income sukuk.
Salam Sukuk. "Salam" refers to a forward sale contract, where the investors provide funds upfront for the future delivery of specific commodities. Acting as the seller, the issuer uses the funds for its financing needs and promises to deliver the commodities at a predetermined future date.
Istisna Sukuk. This type of Sukuk is similar to Salam Sukuk but involves the purchase of goods or assets that are yet to be manufactured or constructed. The investors provide the funds, and the issuer undertakes to deliver the completed goods at a specified future date.
These sukuk structures represent the most commonly utilized formats in the Islamic finance industry. Each type offers unique characteristics, providing investors and issuers with various options to meet their specific financial needs and adhere to Sharia principles.
Asset-based vs. asset-backed sukuk
Asset-backed Sukuk:
Involves granting the sukuk holder a share of a tangible asset or business venture along with a corresponding share of the total risk.
In this structure, a true sale transaction occurs, where the originator sells the underlying assets to a special purpose vehicle (SPV) that holds these assets and issues the sukuk backed by them.
Sukuk holders do not have recourse to the originator if payments under sukuk are less than usual, and they must assume any losses in case of impairment of sukuk assets.
Provides variable returns and does not carry default risk since the risk of profit and loss arising from the underlying asset is shared with the investor.
The underlying assets are transferred to the SPV through a true sale, and the sukuk holders become owners of the underlying asset through the SPV.
Asset-based Sukuk:
Involves the issuer purchasing the underlying assets and then investing, trading, or leasing them on behalf of the investors, using the funds raised through the issued certificates (sukuk).
Asset-based sukuk are issued without the actual sale of the underlying asset, and instead, it involves a binding promise from the originator to repurchase the underlying assets at maturity.
Sukuk holders have beneficial ownership in the asset, meaning they have specific property rights, but the legal title to the asset belongs to another person (the originator).
Sukuk holders have recourse to the originator if there is a shortfall in payments and they have an unsecured debt claim against the originator.
The source of payments to investors is the cash flow of the source organization, not the underlying asset itself.
The structure focuses on the creditworthiness of the sponsors of the sukuk and does not give importance to the asset risk since investors have no recourse to the underlying assets.
The process of issuing Sukuk
Formation of Special Purpose Vehicle (SPV). A corporation seeking funding (known as the "originator") establishes a special purpose vehicle (SPV). The SPV serves as an intermediary and is designed to protect the underlying assets from potential creditors, providing a level of security for investors.
Creation and Sale of Sukuk Certificates. The SPV creates Sukuk certificates, representing ownership shares in the underlying asset or business venture. These certificates are then sold to investors seeking to invest in the Sukuk.
Utilizing Proceeds to Purchase the Asset. The originator uses the funds raised from selling the Sukuk certificates to purchase the required asset that serves as the basis for the Sukuk.
Asset Transfer to SPV. The purchased asset is transferred from the originator to the SPV, making the SPV the legal owner of the asset.
Payment of Revenues to Originator. The SPV generates revenues from the asset and pays them to the originator. These revenues can be in the form of lease payments or profits generated by the asset.
Leasing Arrangement. The SPV then arranges for the asset to be leased back to the originator. As a result, the originator becomes the lessee, making regular lease payments to the SPV.
Distribution of Income to Sukuk Holders. The SPV distributes the lease payments received from the originator to the Sukuk holders as lease income. The income distribution reflects the proportionate ownership of the underlying asset held by each Sukuk holder.
Buyback at Lease Expiry. When the lease period comes to an end, the originator has the option to buy back the asset from the SPV at its nominal value. The proceeds from this buyback are then distributed to the Sukuk holders by the SPV, completing the Sukuk issuance process.
Advantages and disadvantages of Sukuk markets
Advantages of Sukuk markets
Providing Sharia-Compliant Returns. Sukuk markets offer investment opportunities that comply with Islamic principles. This allows investors who adhere to Sharia law to participate in financial markets without compromising their religious beliefs.
Broadening Investors’ Choice. Sukuk markets provide investors with a broader range of investment options, especially for those seeking access to Islamic capital markets. This diversification allows investors to allocate their funds across various Sharia-compliant assets.
Disadvantages of Sukuk markets
Additional Costs. The structuring and issuance of sukuk can involve higher costs compared to conventional bonds. Specialized expertise is required to ensure compliance with Sharia principles, leading to additional legal, advisory, and administrative expenses.
Structuring Constraints. Sukuk structures are subject to compliance with Islamic principles, which can lead to certain constraints in their design. This might limit the flexibility and innovation available in conventional financial instruments.
Lack of Market Depth. The Sukuk market may have less liquidity and depth than conventional financial markets. This limited market liquidity can result in challenges for investors looking to buy or sell sukuk instruments at desired prices.
Sukuk examples
The most common type of Sukuk is in the form of trust certificates. These certificates are also subject to Western law, but the structure is more intricate. The organization establishes an offshore special purpose vehicle (SPV) to raise funds, which then issues trust certificates to qualified investors. The investment proceeds are utilized for a funding agreement with the issuing organization, and investors receive a share of the profits associated with the underlying asset.
However, this structure is applicable only if the SPV can be established in an offshore jurisdiction that permits such trusts. In some cases, this may not be feasible. In such situations, an alternative civil-law structure can be used for the Sukuk. This involves setting up an asset-leasing company in the country of origin, which acquires the asset and leases it back to the organization seeking financing.
Sukuk vs. traditional bonds
Differences between Sukuk and Conventional Bonds
Principle. Sukuk involves ownership of tangible assets or business ventures, while conventional bonds represent debt securities. Sukuk holders have a share in the underlying asset, making them partial owners, whereas bondholders are creditors to the issuer.
Yield. The yield on sukuk is tied to the profits generated by the underlying asset. If the asset’s value increases, the sukuk may appreciate in price, providing potential capital gains to investors. On the other hand, the yield on conventional bonds is primarily dependent on the fixed interest rate offered by the issuer.
Law. Sukuk are structured to comply with Islamic law (Sharia), which prohibits interest (riba) and certain economic activities. As a result, sukuk-backing assets and the entire transaction must be in line with Sharia principles. Conventional bonds have no such religious constraints and can be used to finance any legal entity, regardless of its Sharia compliance.
Price. The price of sukuk is closely linked to the value of the underlying assets. If the assets perform well, the sukuk’s price may reflect this positive performance. In contrast, the price of conventional bonds is largely determined by their credit rating. Bonds with higher credit ratings tend to have higher prices.
Similarities between Sukuk and conventional bonds
Cash Flows. Both sukuk and conventional bonds provide investors with payment flows. Sukuk investors receive returns from the profits generated by the underlying asset, while bondholders receive recurring interest payments.
Profit of Investors. Both sukuk and conventional bonds allow investors to earn returns on their investments. Sukuk holders gain profits linked to the underlying asset’s performance, while bondholders receive fixed interest payments.
Low-Risk Assets. Sukuk and conventional bonds are generally considered less risky than more volatile investments like stocks. They offer a more stable and predictable income stream, making them attractive to risk-averse investors.
