Emergence of sukuk bonds in capital market

Sukuk is commonly referred to as sharia-compliant bonds or Islamic equivalent of conventional bonds. It is often labelled as a secure return through an ethical investment. Unlike conventional bonds, which merely confer ownership of a debt, sukuk grants the investor a share of an asset, along with the commensurate cash flows and risk. In fact, sukuk/Islamic bonds are structured in such a way as to generate returns to investors without infringing Islamic law (that prohibits riba or interest). The key characteristic of sukuk - the fact that it provides for partial ownership in the underlying asset - is considered sharia-compliant. This basic feature means that Islamic investors have the right to receive a share of profits from sukuk's underlying asset.

Domestic and foreign investors buy sukuk having various structures approved by the sharia boards of Islamic scholars. Issuance of sukuk has proven its resilience during the recent periods of turbulence in global capital markets. Since the beginning of 2000, sukuk has become an important Islamic financial instrument in raising funds for long-term project financing. The first sukuk were issued by Malaysia in 2000, followed by Bahrain in 2001. Since then, sukuk has been used by both the corporate sector and the states for raising alternative financing. According to Global Islamic Finance Report-2014, despite the fact that sukuk issuance was affected by the global financial crisis, sukuk has been growing in popularity since 2011. Sukuk issuance increased from US$ 14.9 billion in 2008 to $23.3 billion in 2009. Sukuk saw strong issuance in 2017 - at $97.9 billion, up 45.3 per cent compared to the $67.4 billion issued in 2016, according to data from ratings agency. So-called "jumbo issuances" were seen in Saudi Arabia and other Gulf Cooperation Council (GCC) economies in 2017, whereas the year 2016 saw Islamic-majority Malaysia issuing sukuk the most. With Asia showing particular strength, even so the sukuk market is still a niche one, with huge potential for growth. The sukuk growth rate is currently 10-15 per cent in global financial markets.

The emergence of sukuk has been one of the most significant developments in Islamic capital markets in recent years. Sukuk instruments act as a bridge. They link their issuers - primarily sovereigns and corporations in the Middle East and Southeast Asia - with a wide pool of investors, many of whom seek to diversify their holdings beyond traditional asset classes. In this way, funds raised through sukuk can be allocated in an efficient and transparent way to infrastructure initiatives and other deserving projects in the 56-member countries of IDB, as well as communities in over 100 non-member countries. Sukuk represents undivided shares in the ownership of tangible assets relating to particular projects or special investment activity. As is already said, a sukuk investor has a common share in the ownership of the assets linked to the investment, although this does not represent a debt owed to the issuer of the bond.

In the case of conventional bonds, the issuer has a contractual obligation to pay to the bond holders, on certain specified dates, interest and principal. In contrast, the sukuk holders, each under a sukuk structure, hold an undivided beneficial ownership in the underlying assets. In essence, modern sukuk has emerged to fill in a global capital market gap. Islamic investors want to balance their equity portfolios with bond-like products. As sukuk is  asset-based security - not debt instruments, it fits the bill. In other words, sukuk represents ownership in a tangible asset, service, project, business, or joint venture. Each sukuk has a face value (based on the value of the underlying asset), and the investor may pay that amount or (as with a conventional bond) buy it at a premium or discount. With sukuk, the future cash flow from the underlying asset is transferred to the present cash flow. Such bond may be issued for existing assets or for assets that will exist in the future. Investors who purchase sukuk are rewarded with a share of the profits derived from the asset. They don't earn interest payments, because doing so would violate sharia.

As with the conventional bonds, sukuk is issued with specific maturity dates. When the maturity date arrives, the sukuk issuer buys them back (through a middleman called a Special Purpose Vehicle). However, with sukuk, the initial investment isn't guaranteed; the sukuk holder may or may not get back the entire principal (face value) amount. That's because, unlike conventional bond holders, sukuk holders share the risk of the underlying asset. If the project or business, on which sukuk is issued, doesn't perform as expected, the sukuk investor must bear a share of the loss. Most of the sharia scholars believe that having sukuk managers, partners or agents with promise to repurchase sukuk for the face value is unlawful. Instead, sukuk is generally repurchased, based on the net value of the underlying assets (each share receiving its portion of that value) or at a price agreed upon at the time of the sukuk purchase. In practice, some sukuks are issued with repurchase guarantees just like the issuance of conventional bonds. Although not all sharia scholars agree that such arrangement complies with Islamic law, a product called sukukijara may come with a repurchase guarantee.

In case of asset ownership, the conventional bonds don't give the investor a share of ownership in the asset, project, business, or joint venture they support. They're a debt obligation from the issuer to the bondholder, whereas sukuk gives the investor partial ownership in the asset on which the sukuk are based. The asset on which sukuk is based must be sharia-compliant. On the other hand, conventional  bonds can be used to finance any asset, project, business or joint venture that complies with local legislation. Conventionally, each bond represents a share of debt, but each sukuk represents a share of the underlying asset. The face value of a conventional bond price is based on the issuer's creditworthiness including its rating, whereas the face value of sukuk is based on the market value of the underlying asset.

As far as investment rewards and risks are concerned, conventional bond holders receive regularly scheduled (and often fixed rate) interest payments for the life of the bond, and their principal is guaranteed to be returned at the bond's maturity date, while the sukuk holders receive a share of profits from the underlying asset (and accept a share of any loss incurred). As effects of costs, the conventional bond holders generally aren't affected by costs related to the asset, project, business or joint venture they support. Performance of the underlying asset doesn't affect investor rewards. On the other hand, sukuk holders are affected by costs related to the underlying asset. Higher costs may translate into lower investor profits and vice versa. Sukuk can be structured alongside different techniques. While a conventional bond is a promise to repay a loan, sukuk constitutes partial ownership in a debt (Sukuk Murabaha), asset (Sukuk Al Ijara), project (Sukuk Al Istisna), business (Sukuk Al Musharaka), or investment (Sukuk Al Istihmar).

This principle is widely understood to mean the uncertainty in contractual terms and/or the uncertainty in the existence of an underlying asset in a contract, which brings up issues for Islamic scholars when considering the application of derivatives. Sharia also incorporates the concept of maslahah or 'public benefit', denoting that if something is overwhelmingly in public good, it may yet be transacted - and so hedging or mitigation of avoidable business risks may fall into this category, but there is still much discussion yet to come regarding this issue.

The characteristics that distinguish sukuk from other Islamic instruments of investment vehicles and which have contributed to its widespread prevalence, are: (a) principle of participation in profit and loss, (b) documents issued on behalf of the owner of categories of equal value, and (c) issued and traded in accordance with the terms and conditions of sharia. The sukuk securities tend to be bought and held and, as a result, small slice of the securities enter the secondary market (allowing them to be traded). What's more, only public sukuk are able to enter this market as those are listed with the stock exchanges.

At the moment, lack of standardisation, narrow liquidity and concern over insolvency regimes are key impediments, among others, for further growth of the sukuk asset class. In developing domestic sukuk markets, policymakers should use a framework similar to that of the development of conventional bond markets. Establishment of well-functioning money markets, efficient primary markets and security offering regimes and a robust and diversified investor-base will be important. A market infrastructure that facilitates trading, price transparency, efficient clearing and settlement of transactions, hedging tools to support risk management by issuers and investors, and a credible legal and regulatory framework will be imperative.

Dr Muhammad Abdul Mazid is a former Secretary to the government and Chairman of NBR. [email protected]