By Elwaleed M. Ahmed, Legal Consultant, Head of Foreign Affairs Dept, Kuwaiti Law Firm
For an Islamic market to exist in the proper manner, it must have all of the relevant products that assist the growth and expansion of the Islamic finance market. Hence, considering the fact that bond issuance and trading are important means of investment in the modern economic system. Thus, the Islamic financial system also needs to include, at the early stage, the development of Islamic capital markets to provide an alternative source of financing, as well as to create broader and more diverse Islamic financial instruments for investors.
Therefore, the Islamic finance industry has developed various Sukuk (i.e. “Sharia-compliant structures”) in order to provide investment opportunities and to meet the financing needs of businesses and investors who want to comply with the Islamic Sharia principle.
Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) defines Sukuk as ‘certificates of equal value representing undivided shares in tangible assets, usufruct and services...or the asset of particular projects or special investment activity’. Accordingly, Sukuk are asset-backed, Sharia-compliant trust certificates and tradable financial instruments which reflect the value of a particular asset or assets. Sukuk are financing vehicles which comply with Sharia law. In order for Sukuk to be Sharia-compliant, the Sukuk holder must have a proprietary interest in the assets which are being financed. Moreover, Holding a Sukuk confers a beneficial interest to the holder - in terms of holding a proportional ownership of the underlying asset - as well as the income that it generates. Therefore, a Sukuk needs to be backed by a specific, tangible asset throughout its entire tenure. Moreover, the Islamic sukuk is a new source of funding for vital infrastructure projects and a way to keep funds working for the benefit of the local economy.
Furthermore, the Sukuk, or Islamic bond, has established itself as one profitable product that holds great potential in the Islamic finance market. Therefore, the market for Sukuk is growing and their attraction as alternative to conventional methods of saving and investment has an appeal to a growing investor base. Hence, Sukuk issuances represent a new development in global capital market; it is one of the fastest growing sectors in Islamic finance.
In this article I will explain the requirements for sukuk formation, Sukuk’s unique feature, and how more sukuk issuance is necessary for the sukuk’s secondary markets to flourish. Moreover, I will highlight the comparison between the Islamic sukuk and the conventional bond. Finally, I will briefly describe the basic Sukuk instruments in Islamic finance and the challenges facing global Sukuk issuance.
Sukuk formation
The primary condition for issuance of Islamic Sukuk is the existence of underlying tangible assets on the balance sheet of the issuing entity. The identification of sufficient underlying tangible assets, either in ownership or in a master lease, is the most important step before the issue of the Sukuk certificate. Furthermore, Sukuk may be issued both on existing as well as specific assets that may become available at a future date. Thus, a properly made Sukuk limits the debt to the value of the underlying assets.
Although, sharia compliance requires a company to limit its debt to no more than 35 per cent of total assets, restricting excessive leverage and interest income is capped at 10 per cent. Thus, any assets can be transferred into sukuk, with the condition that at least 51 percent of the underpinning assets must be leased-back as ‘real assets’, not debt instruments.
Moreover, the assets that will be converted into Sukuk must be obtained from acceptable Islamic deals, meaning not investing in any transactions against the Islamic Sharia principles. Accordingly, Sukuk, or trust certificates, are issued by the issuer to the Sukuk holders, who thereby acquire a proprietary interest in the assets of the issuer. Then the issuer, acting as trustee, collects such income and distributes it to the Sukuk holders in accordance with their proportional interest in the assets. Hence, the returns on Sukuk certificate are tied with the income generated through the underlying asset in the transaction.
Unique feature
The issuance of sukuk is a significant mechanism for raising money in the capital markets. Unlike other Islamic banking vehicles, Sukuk have unique characteristics and offer significant benefits. For example, they are tradable in secondary markets because they are backed by real assets, they are assessed for quality by international rating agencies (as are all other conventional financial instruments before their issuance), and they provide regular periodic income streams during the investment period with easy and efficient settlement and a possibility of capital appreciation.
Moreover, Sukuk are becoming more popular, both because they provide the means to raise government finance through sovereign issues, and as a way for companies to obtain funding through the offer of corporate Sukuk. Thus, the importance of Sukuk lies in its ability to transfer assets into liquidity without the need to go into long legal complications for the investor. In addition, Sukuk can transform an asset’s future cash flow into present cash flow and may be issued on existing as well as specific assets that may become available at a future date. Hence, infrastructure is a perfect use of Sukuk because you are raising funds for a specific project – and the assets that you create can generate ‘return’ to pay Sukuk holders.
Furthermore, Sukuk offers an attractive yield because repayments are not dependent on cash flows of the borrowing company but from a future IPO of strategic government sovereign issues or from corporate Sukuk. Therefore, it is the Sukuk’s unique structure, with IPO rights, that captured the capital market’s attention.
Another interesting feature of the Sukuk that it not just guaranteed wider global investors audience but also provides, in most instances, lower prices to issuers and is considered a source of cash flow and finance for the originator.
Secondary market
Even though the Sukuk market is developing rapidly, it remains primarily a market where holders keep Sukuk to maturity and most of the Sukuk that have been issued are held by large institutions so that the assets are unavailable for the average private investor. Therefore, active trading is constrained due to the limited number of issuances and the fact that most investors hold on to these certificates owing to a lack of alternative instruments in this asset class. On the other hand, many experts believe that the Sukuk secondary market will become reality only when corporate Sukuk issuances are increased in global markets.
Until recent years, there have not been sufficient Sukuk transactions in the market to create an appropriately diversified asset portfolio for a secondary market to exit. For a Sukuk secondary market to flourish, there must be a widespread Sukuk issuance that could lay the groundwork for the emergence of Islamic capital markets. Thus, a critical mass of Sukuk issuances is needed. Some experts estimate that this critical mass is about $400 billion worth of issuances, amounting to some 270 individual issuances worldwide. Another factor that will lead to Sukuk secondary market growth has to be the move away from sovereign to corporate Sukuk as either a way to raise
Capital or to refinance conventional debt.
There is also a need for Islamic borrowers to list their deals outside their home jurisdictions; this will makes secondary trade easier from a regulatory point of view for foreign investors. The consequences of widespread Sukuk issuance and cross-border Sukuk sales will be greater harmonization in the way that Sukuk are structured and laying the groundwork for the emergence of Sukuk secondary markets.
Comparison
Sukuk are similar to asset-backed conventional bonds, but instead of a fixed annual interest rate, payouts to investors over the life of the bond are derived from leases, profits or sales of tangible assets such as property, equipment or a joint-venture business.
Contrary to the position in case of a conventional bond which is a contractual debt obligation entitling the holder to receive interest and principles on specified dates, a Sukuk holder is entitled both to share in the revenues generated by the Sukuk assets and to share in the proceeds of the realization of the Sukuk assets. On the other hand, Sukuk holders are also under an obligation to maintain the asset and to bear losses. In contrast, the holders of conventional bonds do not have these obligations and are only entitled to receive interest.
Like conventional bonds, Sukuk certificates can be negotiated and traded freely in the market. But the tradability of Sukuk certificates is strictly contingent upon the nature of the underlying asset during the term of Sukuk, since the sale and purchase of debt is not permissible under Islamic Sharia. In addition, Sukuk investors have an implicit right of information on the use of their funds and the nature and performance of underlying assets, which is not usually the case in conventional bonds. This can serve to give the investors peace of mind with the guarantee that their funds are being used for the intended purpose. Moreover, the fact that Sukuk are asset-backed gives investors reasonable assurance that they will be able to retrieve a major part of their investment if the issuer defaults (Sukuk investors have an undivided share in the ownership of the Sukuk assets).
Basic instruments
A Sukuk transaction can be structured in a number of different ways, depending upon the type of underlying assets and the specific financing needs of the issuing entity. The transaction may be based upon any one of the permissible Islamic financing transactions. The following are the basic Sukuk instruments in Islamic finance:
Mudaraba (Profit/Loss-Sharing) investment partnership: The contract is between a financier and an entrepreneur or investment manager, where risks and rewards are shared. Both individuals receive an agreed share in the case of profits. In the event of incurring a loss, the financier bears any loss of capital while the entrepreneur loses his time and effort.
Murabaha (Cost Plus) purchase and resale: Instead of lending out money, the capital provider purchases the desired commodity (for which the loan would have been taken out) from a third party and resells at a predetermined higher price to the capital user. By paying this higher price over installments, the capital user has effectively obtained credit without paying interest.
Musharaka (Joint Venture): An equity financing arrangement widely regarded as the purest form of Islamic financing, where partners contribute capital to a project and share its risks and rewards. Profits can be divided up in any agreed ratio, while losses must be in proportion to the capital invested.
Ijara (Islamic lease agreement): Instead of lending money and earning interest, Ijara allows the bank to earn profits by charging rentals on the asset leased to the customer. Moreover, an Ijara contract is where the financier buys and leases equipment or other assets to the business owner for a fee or more often called rental income. The duration of the lease as well as the fee must be set in advance and mutually agreed. Sometimes there are two contracts involved in this concept.
The first contract, Ijara contract (leasing/renting) and the second contract, Bai’ contract (purchase) are undertaken one after the other. For example, in a car financing facility, a customer enters into the first contract and leases the car from the owner (bank) at an agreed rental over a specific period.
When the leasing period expires, the second contract comes into effect, which enables the customer to purchase the car at an agreed price. Moreover, Islamic leasing creates a great potential for securitization, because lease finance is easier to practice as it involves less documentation and takes less time to conclude a deal. Unlike lending, it does not need collateral and no thorough enquiries into the creditworthiness of the lessee (this is due to the physical presence of a tangible asset, the subject of the lease).
Istisna (Pre-delivery financing and leasing): an instrument used to finance long-term projects.
It is a contractual agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery or a future payment, and future delivery. Often used for financing the manufacture or construction of houses, plants, projects, and building of bridges, roads, and highways.
Challenges
Like all financial instruments, Sukuk are also subject to a number of risks. The rapid growth of Islamic finance globally has given rise to many structural challenges facing the industry. The lack of standardization is hindering liquidity. It prevents investors from knowing what risk they are assuming when they invest and increases the costs associated with sukuk issuance.
Moreover, the Sharia Board in the Middle East and elsewhere that approves Islamic Sukuk for sale to Muslims hold slightly different interpretations about what is acceptable, making Islamic investors nervous about buying bonds from outside their jurisdiction.
Sukuk are actually extremely difficult instruments to structure because they require extensive and costly legal and religious advice and a lot of different skill sets and resources to make it work. Therefore, corporations and banks shy away from such structures because of the legal risks and also the potential costs of pioneering such instruments.
Moreover, since Sukuk trading sizes tend to range in the millions of dollars, they are out of reach for all but the wealthiest Muslim investors. In addition, anyone who buys into a Sukuk typically buys it and holds it. Moreover, difficulties in defining rates of return on these instruments have also constrained the development of money and inter-bank market.
Conclusion
If they are to penetrate non-Islamic markets, Islamic products must compete with conventional products. Islamic products cannot exist only because of faith. Thus, efforts should be intensified to develop new financial products that embody the virtues of Islamic banking. This would evolve Islamic financial instruments into distinct, innovative and cutting-edge products. Thus, the development of an active and vibrant Sukuk market is of fundamental importance to the continuing development and growth of the Islamic finance industry. Even though sovereign, institutional, and corporate issues are now common, there is much scope for innovation in the use of Sukuk to expand the Islamic capital market.
As building confidence in the Sukuk market is fundamental for the development of Islamic finance, it is essential to regulate and modernize the systems that determine the operations of Sukuk products.
Another consideration is that Islamic financial services and products are generally well suited to meet the demands of the modern world in terms of rules, regulations and systems. Adopting common policies on certain financial instruments and best practices for their supervision and accounting are critical for future market and industry development in the context of global competitiveness.
Thus, there will be continued strong growth in the Sukuk market as there is increasing standardization of Sukuk documents in the marketplace which will drive costs of issuing Sukuk down. A sound, well-functioning Islamic financial system can pave the way for regional financial integration. It can also contribute to regional economic and social development by financing economic infrastructure and creating job opportunities.
