Sukuk-Islamic Bond

Class Lecture (Final)

Islamic Financial System (Fin-5402)

Sukuk-Islamic Bond

Sukuk commonly refers to the Islamic equivalent of bonds. However, as opposed to 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. As such, Sukuk securities adhere to Islamic laws sometimes referred to as Shari’ah principles, which prohibit the charging or payment of interest.

How Sukuk (Islamic Bonds) Differ from Conventional Bonds

Modern sukuk emerged to fill a gap in the global capital market. Islamic investors want to balance their equity portfolios with bond-like products. Because sukuk are asset-based securities — not debt instruments — they fit the bill. In other words, sukuk represent ownership in a tangible asset, usufruct of an 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.

Ensuring sharia compliance with sukuk

The key characteristic of sukuk — the fact that they grant partial ownership in the underlying asset — is considered sharia-compliant. This ruling means that Islamic investors have the right to receive a share of profits from the sukuk’s underlying asset.

Putting bonds and sukuk side-by-side

When you have the basics about how conventional bonds and sukuk work, it’s time to put them next to each other. This table offers a quick look at the key ways in which these investment products compare.

Distinguishing Sukuk from Conventional Bonds
	Conventional Bonds	Sukuk
Asset ownership	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 bond holder.	Sukuk give the investor partial ownership in the asset on which the sukuk are based.
Investment criteria	Generally, bonds can be used to finance any asset, project, business, or joint venture that complies with local legislation.	The asset on which sukuk are based must be sharia-compliant.
Issue unit	Each bond represents a share of debt.	Each sukuk represents a share of the underlying asset.
Issue price	The face value of a bond price is based on the issuer’s credit worthiness (including its rating).	The face value of sukuk is based on the market value of the underlying asset.
Investment rewards and risks	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.	Sukuk holders receive a share of profits from the underlying asset (and accept a share of any loss incurred).
Effects of costs	Bond holders generally aren’t affected by costs related to the asset, project, business, or joint venture they support. The performance of the underlying asset doesn’t affect investor rewards.	Sukuk holders are affected by costs related to the underlying asset. Higher costs may translate to lower investor profits and vice versa.

Types of Sukuk: 6 types

Sukuk al mudaraba (sukuk based on equity partnership)

In simple mudaraba contracts, investors are considered to be silent partners (rab al mal), and the party who utilizes the funds is the working partner (mudarib). The profit from the investment activity is shared between both parties based on an initial agreement.

The same type of contract applies to sukuk. In a mudaraba sukuk, the sukuk holders are the silent partners, who don’t participate in the management of the underlying asset, business, or project. The working partner is the sukuk obligator.

The sukuk obligator, as the working partner, is generally entitled to a fee and/or share of the profit, which is spelled out in the initial contract with investors.

Sukuk al murabaha (cost plus or deferred payment sukuk)

A murabaha contract is an agreement between a buyer and seller for the delivery of an asset; the price includes the cost of the asset plus an agreed-upon profit margin for the seller. The buyer can pay the price on the spot or establish deferred payment terms (paying either in installments or in one future lump sum payment).

With sukuk that are based on the murabaha contract, the SPV can use the investors’ capital to purchase an asset and sell it to the obligator on a cost-plus-profit-margin basis. The obligator (the buyer) makes deferred payments to the investors (the sellers). This setup is a fixed-income type of sukuk, and the SPV facilitates the transaction between the sukuk holders and the obligator.

The murabaha contract process begins with the obligator (who needs an asset but can’t pay for it right now) signing an agreement with the SPV to purchase the asset on a deferred-payment schedule. This agreement describes the cost-plus margin and deferred payments.

Special purpose vehicle (SPV)

Sukuk al-salam (deferred delivery purchase sukuk)

In a salam contract, an asset is delivered to a buyer on a future date in exchange for full advance spot payment to the seller. Sharia allows only salam and istisna contracts to be used to support advanced payment for a good to be delivered in the future. This same mechanism is used for structuring the salam sukuk.

In salam sukuk, the sukuk holders’ (investors’) funds are used to purchase assets from an obligator in the future. The SPV provides the money to the obligator. This contract requires an agent (which may be a separate underwriter) who will sell the future assets because the investors want money in return for their investment — not the assets themselves.

The proceeds from the sale (typically the cost of the assets plus a profit) are returned to the sukuk holders. Salam sukuk are used to support a company’s short-term liquidity requirements.

 Sukuk al-ijara (lease-based sukuk)

The ijara contract is essentially a rental or lease contract: It establishes the right to use an asset for a fee. The basic idea of ijara sukuk is that the sukuk holders (investors) are the owners of the asset and are entitled to receive a return when that asset is leased.

In this scenario, the SPV receives the sukuk proceeds from the investors; in return, each investor gets a portion of ownership in the asset to be leased. The SPV buys the title of the asset from the same company that is going to lease the asset. In turn, the company pays a rental fee to the SPV.

The ijara contract process begins when a company that needs an asset but can’t afford to purchase it outright contracts with an SPV, which agrees to purchase the asset and rent it to the company for a fixed period of time.

      Sukuk al musharaka (joint venture sukuk)

The musharaka contract supports a joint venture business activity in which all partners contribute capital, labor, and expertise. The profit and losses are shared among all parties based on agreed-upon ratios.

With musharaka sukuk, the sukuk holders (investors) are the owners of the joint venture, asset, or business activity and therefore have the right to share its profits. In a musharaka sukuk, unlike sukuk based on mudaraba, a committee of investor representatives participates in the decision-making process. Musharaka sukuk can be traded in the secondary market.

The musharaka sukuk process begins when an obligator signs a musharaka contract with the SPV that specifies a profit-sharing ratio and indicates that the obligator will transfer assets (such as cash and property) to the joint venture.

Sukuk al istisna (Islamic project bond)

Istisna is a contract between a buyer and a manufacturer in which the manufacturer agrees to complete a construction project by a future date. The contract requires a fixed price and product specifications that both parties agree to. If the end product doesn’t meet contract specifications, the buyer can withdraw from the contract.

Istisna sukuk are based on this type of contract. The sukuk holders are the buyers of the project, and the obligator is the manufacturer. The obligator agrees to manufacture the project in the future and deliver it to the buyer, who (based on a separate ijara contract) will lease the asset to another party for regular payments.

The process of issuing istisna sukuk begins when the obligator (manufacturer or contractor) and the SPV sign an istisna contract.