Sukuk is one of the fastest growing markets in the Islamic finance sector. In this second part of our Islamic Finance Basics series, we look at the underlying principles of sukuk, its development as an asset class and how it compares to conventional instruments. Research by Mahinaz El Aasser to date, and a compound annual growth rate of 28. 14% as of the end of last year.
Total sukuk makes up a prominent and growing part of the Islamic finance market, which was estimated to be worth
The commonly used definition of sukuk was set by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI); an Islamic international autonomous not-for-profit corporate body that prepares accounting, auditing, governance, ethics and Shariah standards for Islamic financial institutions and the industry. In Standard number 17 of the Shariah Standards for financial institutions, issued in 2008, AAOIFI defined sukuk as follows: Investment Sukuk are certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or in the ownership of the assets of particular projects or special investment activity. For the sake of simplicity and convenience, sukuk are often considered as the Islamic equivalent of conventional bonds. Like bonds, sukuk are aimed at providing financial investment, although in a way that abides by Shariah rules.
But it is also common to hear people speak of a sukuk as having elements of an equity product, given it involves ownership or recourse to assets. To understand better the similarities and differences of these products, the following provides a comparison between sukuk, bonds and shares: Promising to repurchase sukuk for its face value is considered unlawful. Sukuk should be repurchased on the net value of the underlying assets or at a price agreed upon at the time of the sukuk purchase. Some sukuk are issued with repurchase guarantees, but not all Shariah scholars approve on this.
Aside from these differences, sukuk and bonds have some similarities – Marketability: Sukuk are monetised real assets that are liquid, easily transferred and traded in the financial markets. – Ratability: Sukuk are easily analysed by international and regional rating agencies, which facilitates their marketability. – Enhanceability: Different sukuk structures may allow for credit enhancements or wraps that broaden their appeal to risk-averse investors in the Islamic investor sphere, as well as conventional investors outside the Islamic financial markets. – Versatility: The variety of sukuk structures defined in the AAOIFI standards allow for structuring across legal and tax domains of products that need diverse financing needs.
They may offer fixed-or variable-income options; may achieve cross-listing capabilities and are compatible with global bond regulations such as Regulations S and 144A. To issue sukuk, several parties are involved and specific items should be mentioned in the termsheet (offering circular). These include: – Obligor: Sometimes referred to as sponsor, originator or debtor. This term usually refers to the bond issuer who is contractually obliged to make principal repayments and coupon payments.
The obligor can be a sovereign (such as Government of Indonesia); a quasi sovereign, which acts on behalf of the government in certain functions (such as Saudi Electricity Company); a corporate borrower, which is privately owned (such as Abu Dhabi Islamic Bank); or a supra-national (such as the World Bank or Islamic development Bank). – Issuer: Sometimes issuers are the same as obligors and sometimes not; an issuer can act on behalf of the obligor. For example, the Ministry of Finance of a country can be the issuer acting on behalf of its government (the obligor in this case). The issuer can also be categorised in the above mentioned four types.
, the issuer develops, registers and sells securities for the purpose of financing its operations. Issuers are legally responsible for the obligations of the issue and for reporting financial conditions, material developments and any other operational activities as required by the regulations of their jurisdictions. – Special purpose vehicle (SPV): sometimes referred to as Special Purpose Entity (SPE), or bankruptcy-remote entity. Usually the SPV is the same as the issuer, sometimes it is not (such as the following case: Obligor Government of Indonesia, issuer Ministry of finance, SPV Perusahaan Penerbit SBSN Indonesia).
An SPV is more of a middleman; its operations are limited to the acquisition and financing of specific assets. It is usually a subsidiary company with an asset liability structure and legal status that makes its obligations secure even if the parent company goes bankrupt. SPVs are usually used for several reasons, such as; minimising risk to the obligor so that it would not be subject to liability and to take advantage of tax facilitations offered in certain countries such as Cayman Islands and Jersey. – Arranger: is the institution that structures the sukuk as in the financial and Shariah engineering of the sak itself.
– Bookrunner/underwritter/dealer: is the institution that sells the sukuk in the market. i. e, that does the marketing campaign which is commonly referred to as the roadshow. – Manager: is a general function, sometimes used interchangeably with arrangers or bookrunners.
– Trustee: a party that oversees the rights of sukuk holders from the beginning till the end of the sukuk issuance. – Maturity date: The date on which the sak or bond investor will be repaid the face value of the sak/bond. – Par value (face value): The value of the issued sak/bond a holder would receive at maturity. – The rate of return: The percentage of the face value which represents the annual return of the sakk or bond.
The return may be divided into quarterly, semiannual, or annual payments. – Type of sak: the structure of the sak that will be issued. AAOIFI has classified fourteen types that will be discussed in the coming episodes of this series. i.
e. ijara, murabaha, musharaka, etc. Among controversies around sukuk is the question of trading the notes. Since sukuk are not debt products, trading is considered permissible.
Thus trading of sukuk is defined to be the sale of underlying assets to a third party, so that he replaces the old sukuk holder in the ownership of these assets. But there are some Shariah conditions for every type of sukuk for trading to be permissible (for example: signing the lease agreements prior to the sukuk issuance). Since sukuk is a relatively new financial instrument, theres still no worldwide regulation of its trading. The main platforms for official sukuk trading are on Saudi Arabias Tadawul as well as Bursa Malaysia.
Many sukuk are traded over the counter (OTC), however. Another point of contention has been around the structure of sukuk and whether it should be asset based or asset backed. After the default of several sukuk in 2008, there was public debate about the fact that the defaulted sukuk were asset based and not asset backed. This prompted AAOIFI to intervene and set the main differences: Nathif J.
adam & Abdulkader Thomas, n. a. , Islamic Bonds: Your Guide to Issuing, Structuring and Investing in Sukuk, Euromoney Books, p. 53-54