A sukuk is an Islamic financial certificate, similar to a bond in Western finance, that complies with Islamic religious law known as Sharia. Traditional Western interest-paying bond structures are not permissible under Sharia, so issuers sell sukuk certificates to investor groups, using the proceeds to purchase assets in which the investors have a direct partial ownership interest. The issuer must also contractually promise to buy back the sukuk at a future date at par value.
Key Takeaways:
– A sukuk is a Sharia-compliant bond-like instrument used in Islamic finance.
– Sukuk involves direct asset ownership interest, while bonds are indirect interest-bearing debt obligations.
– Both sukuk and bonds provide investors with payment streams; however, income from sukuk cannot be speculative as it would make it non-halal.
Understanding Sukuk:
With the rise of Islamic finance, sukuk have gained popularity since 2000, when they were first issued in Malaysia. Bahrain followed in 2001. Today, sukuk are used by Islamic corporations and state-run organizations globally, occupying an increasing share of the global fixed-income market.
Islamic law prohibits ‘riba,’ or ‘interest’ as understood in the West. Therefore, traditional Western debt instruments cannot be used for raising capital or investment. Sukuk were created to link debt financing returns and cash flows to a specific asset, distributing the asset’s benefits. This allows investors to circumvent the Sharia prohibition and still benefit from debt financing. However, sukuk can only raise financing for identifiable assets.
Thus, sukuk represent aggregate and undivided shares of ownership in a tangible asset related to a specific project or investment activity. Investors in sukuk do not own a debt obligation from the issuer but instead own a piece of the asset linked to the investment. This means sukuk holders receive a portion of the earnings generated by the associated asset, unlike bond holders who receive periodic interest payments.
Sukuk vs. Traditional Bonds:
Sukuk and conventional bonds share similarities but also have key differences:
Similarities:
– Both provide investors with payment streams.
– They are issued to raise capital for a firm.
– Both are considered safer investments than equities.
– Sukuk investors receive profit from the underlying asset periodically, while bond investors receive periodic interest payments.
Key Differences:
– Sukuk involves asset ownership, while bonds are debt obligations.
– If the asset backing a sukuk appreciates, the sukuk can appreciate, whereas bond yield is strictly due to its interest rate.
Assets backing sukuk are halal. Bonds, on the other hand, are often riba and may finance non-Sharia compliant businesses or fuel speculation.
Sukuk valuation is based on the value of the assets backing them. A bond’s price is largely determined by its credit rating. Sukuk Example: Trust Certificates. The most common type of sukuk comes in the form of a trust certificate. These certificates are also governed by Western law. However, the structure of this type of sukuk is more nuanced. The organization raising funds first creates an offshore special purpose vehicle (SPV). The SPV then issues trust certificates to qualified investors and puts the proceeds of the investments toward a funding agreement with the issuing organization. In return, the investors earn a portion of the profits linked to the asset. Sukuk structured as trust certificates are only applicable if the SPV can be created in an offshore jurisdiction that allows such trusts. This is sometimes not possible. If an SPV and trust certificates can’t be created, a sukuk can be structured as an alternative civil-law structure. In this scenario, an asset-leasing company is created in the country of origin, effectively purchasing the asset and leasing it back to the organization in need of financing.