What is Sukuk?
Sukuk, another term which came into existence in the late 2000s is an islamic financial certificate, or popularly known as Islamic Bonds. Sukuk is very similar to bonds in western countries, with only difference being that Sukuk is guided by Sharia which is an Islamic religious law. Islamic law prevents ‘riba’ or interest on your bond, and is not permissible to be paid on your Sukuk.
How does sukuk bonds work?
The issuer of sukuk sells the bond to a group of investors, upon which the issuer uses the proceeds from the bonds to buy an asset. The investor also has a partial ownership over the asset that the issuer will buy out of the proceeds from selling Sukuk to the investors.A contract needs to be signed, where the issuer needs to make a contractual promise of buying the bond back at a par value.
Implementation of sukuk.
Sukuk represents shares, which are undivided when it comes to owning them in a tangible asset. All the debt related to sukuk is owned by the issuer of the bond, and a part of the asset is owned by the investor, which is linked to a specific investment activity. So the basic difference between bondholders and sukuk holders is that, the sukuk holders will receive a portion of the earnings from the asset. The main motive behind creating sukuk is to link the returns from the asset and cash flows of debt financing to an asset being purchased, and distributing the profits of the sukuk effectively.
Origination of sukuk
Sukuk was first introduced in Malaysia in the year 2000, which was followed by Bahrain in the year 2001. Sukuk bonds are mostly used by Islamic Corporations and State run organizations. Sukuk can also be explained with an example of Trust certificates, which are issued by SPV (Special Purpose Vehicles). Special Purpose Vehicles were created by the organisations to raise funds.
Let us try to understand the basic differences between Sukuk and Traditional bonds:
Asset Ownership: In Traditional bonds, investors don’t get a share of ownership in the asset. They are just a debt obligation to the issuer of the bond. In Sukuk bonds, the investors get a partial ownership in the asset on which the sukuk was issued.
Issue Unit: When it comes to traditional bonds, each conventional bond represents a unit of debt. Each sukuk represents a share of the underlying asset.
Rewards and Risks: Traditional bond holders regularly receive interest on the bonds that they have invested, for the life of the bond. Traditional bond holders get the guarantee of receiving their principal amount back at the bond’s maturity date. Sukuk holders receive a share of the profit from the asset that they have invested in and accept a share of any loss incurred on the asset.
Issue Price: The face value of the bond price is based on the issuer’s creditworthiness when it comes to traditional bonds. The face value of Sukuk is depended upon the market value of the underlying asset.
Investment Criteria: Generally, traditional bonds can be used to finance any asset or project, but the underlying asset of sukuk should be sharia compliant.
Sukuk and Traditional bonds, both can be sold in the secondary market.
Market share of sukuk
The popularity of sukuk in the markets has increased in between 2011 and 2015. According to International Islamic Financial Market, the total sukuk issued has been increased to $767 Billion in between 2011 and 2015. Sukuk bonds have witnessed a lot of popularity in Asia and the region of GCC. Sukuk bonds enjoy a substantial amount of liquidity compared to its Traditional counterparts. As sukuk bonds involve more of assets than debt, they have witnessed a rising popularity amongst investors in the international market.
Average return from sukuk bonds
Sukuk securities have known to give an average return of 5% compared to any fixed deposits and bonds, whose highest return has been averaged to 1.75%. Sukuk bonds also come with a greater risk, but as they say more the risk, merrier will be the profits. As Islamic economy has seen a rapid growth, the link to the higher average return of sukuk bonds is pretty applicable.
There are basically five types sukuk bonds in the Islamic Market:
Mudharabah (Profit Sharing): In this type of a sukuk bond, profits will be shared between the issuer and the investor based on a pre agreed profit ratio. In the case of loss, all the loss will be borne by the investor, unless there was some negligence on the side of the venture and issuer.
Musharakah (Profit and Loss Sharing): This basically like a partnership between two parties, who have agreed to finance a venture. All the parties agree to finance the capital either through cash or in any other kind. Profits are shared on the basis of a pre agreed ratio, and the losses are divided on the basis of capital contribution.
Murabahah (Cost plus sale): In this type of sukuk, basically a contract of sale and purchase is made between the parties, where the cost and profit margin is made known to the parties.
Al-Wakalah (Investing through an investing agent): In this type of a contract, a party sanctions another party to act on behalf of the principal party based on the agreed terms between them.
Ijarah (leasing): In this type of a sukuk contract, a party(lessor) leases out its asset to another party, on few agreed terms for a predetermined period. The ownership of the asset will always lie with the lessor.
The most important point to understand is, that the value of a sukuk is linked to the value of its underlying asset. Hence, it becomes important to understand is, the productivity of the underlying asset, not money or inflation. According to the recent Islamic market dynamics, sukuk is a great starting point for issuers and investors investing in the asset.