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Home > Capital Markets Checklists > Sukuk: Islamic Bonds

Capital Markets Checklists

Sukuk: Islamic Bonds


Checklist Description

This checklist describes sukuk, the shariah-compliant equivalent of interest-bearing fixed-income instruments.

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Definition

Sukuk, an Arabic word meaning financial certificates, refers to the shariah-compliant equivalent of interest-bearing fixed-income instruments. Following the first issue around a decade ago, sukuk have become one of the fastest-growing areas of Islamic finance as borrowers and investors look to meet their requirements while ensuring compliance with their principles and values.

Given that the charging of interest is strictly forbidden by shariah law, sukuk securities are instruments constructed in such a way as to avoid the accrual of interest and thus be fully compliant with Islamic principles. Sukuk, the plural form of the Arabic word sakk, represent claims to the ownership of assets or a pool of underlying tangible assets, proportionate to the size of the investment. In contrast, conventional bonds are debt obligations, valued on the basis of cash flows derived from the issuer’s contractual commitment according to pre-agreed dates, interest, and principal repayment. Investors in sukuk hold the right to both a share of revenues generated by the underlying asset and a share of any realization of the underlying sukuk asset. While sukuk bear many similarities to conventional fixed-income assets, a sukuk investment is founded on the part-ownership of an approved asset in return for a price which offers the investor the potential to benefit from a rise in the price of the underlying asset. The key difference between sukuk and conventional bonds is that sukuk are always asset-backed.

Since the turn of the millennium, sukuk have emerged as a key means for banks, sovereign borrowers, and multinational corporate borrowers to raise finance as an alternative to conventional syndicated financing, in a way fully compliant with Islamic principles.

Sukuk come in various forms, according to the issuer’s requirements. They can be issued to help finance specific new projects, while asset-specific sukuk are often employed to sell the beneficiary right of existing assets. Quasi-government organizations can also make use of balance sheet-specific sukuk to raise finance for multiple projects.

Sukuk deals typically fall into four main categories: ijarah, mudharabah, musharakah, and istisna’a. Ijarah sukuk are commonly employed in longer-term financing, typically leasing arrangements. Mudharabah sukuk are often used for profit-sharing between investors and entrepreneurs in ventures. Musharakah sukuk are used to finance businesses on the basis of partnership contracts, and sukuk istisna’a are frequently used in the financing of major infrastructure projects. Sukuk are issued in many forms, such as ijarah floating-rate sukuk, murabahah fixed-rate sukuk, and salam sukuk, a form of bond which cannot be sold and must therefore be held until maturity.

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Advantages

  • The development of the sukuk market over recent years has provided opportunities for both borrowers and investors unable to access conventional bond markets due to their noncompliance with shariah principles.

  • After dramatic growth, sukuk instruments are now both liquid and readily tradable.

  • Sukuk securities are rated by mainstream credit agencies, making their risk profiles comparable with mainstream fixed-income instruments.

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Disadvantages

  • Under certain circumstances, sukuk can present additional taxation or stamp duty costs for the issuer.

  • Islamic law’s broad exclusion of the trading of instruments at above or below par (their redeemable value on expiration of the particular issue) can severely restrict the structures available for sukuk issuers, although interpretations differ between countries and regions as to what is acceptable practice: for example, sukuk are traded on the secondary market in Kuala Lumpur at levels above or below their par values.

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Action Checklist

  • Sukuk issuers must ensure that their securities are fully compliant with shariah law; otherwise they run the risk of being categorized alongside conventional interest-bearing bonds.

  • Sukuk are by their very nature controversial in that some more conservative Islamic scholars believe that sukuk infringes the riba principle by effectively putting a time value on money. Issuers should therefore take advice from shariah experts on how best to avoid compromising the risk and profit/loss sharing requirements to ensure the widest possible investor base for their issues.

  • Where the sukuk are a debt owed to the investor by the issuer, the investor can either hold the sukuk until maturity or sell the issue at par, without the option of selling on the secondary market.

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Dos and Don’ts

Do

  • Expect some ongoing debate over the suitability of sukuk for Muslims. Despite their rapid growth over recent years, some Islamic scholars contend that sukuk may not be truly compliant with Islamic law, given that pricing still factors in the time value of money.

  • Issuers should remember that sukuk investors have an inherent right to transparency in how their funds are being used and should therefore be fully prepared to keep investors informed about how the underlying assets are being employed.

Don’t

  • Don’t expect liquidity in the secondary sukuk market to be as high as that of most conventional bonds, as sukuk securities are typically acquired by long-term holders.

  • Don’t ignore the risk that the issuer could default, despite the well-intentioned principles behind sukuk.

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Further reading

Books:

  • Nathif, Adam, and Thomas Abdulkader. Islamic Bonds: Your Guide to Issuing, Structuring and Investing in Sukuk. London: Euromoney Books, 2004.
  • Warde, Ibrahim. Islamic Finance in the Global Economy. Edinburgh, UK: Edinburgh University Press, 2007.

Articles:

  • Jabeen, Zohra. “Sukuk as an asset securitisation instrument and its relevance for banks.” Review of Islamic Economics 12:1 (2008): 57–72.
  • Vishwanath, S. R., and Sabahuddin Azmi. “An overview of Islamic sukuk bonds.” Journal of Structured Finance 14:4 (Winter 2009): 58–67. Online at: dx.doi.org/10.3905/JSF.2009.14.4.058

Report:

  • Islamic Financial Services Board. “Capital adequacy requirements for sukuk, securitisations and real estate investment.” Standard IFSB-7. January 2009. Online at: www.ifsb.org/standard/ifsb7.pdf

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