A bond in essence is a loan. It is a financial instrument used to generate funding via debt. For this debt, interest is usually paid in fixed periodic instalments, with a balloon payment at maturity to pay back the principal. Both governments and corporations alike, use these funding sources which are popular in markets due to their low-risk profile compared to other investments. This fixed income structure however has no linkage to the debtors’ financial performance. It is paid regardless of this (unless of course the entity gets liquidated, but the creditors/bondholders are still usually prioritised over shareholders).
The closest comparative to a bond in Islamic finance is a Sukuk. This is a financial certificate that represents a portion of ownership into an asset or venture. This is instead of a debt obligation which has no ties to any real economic activity. The substitute of creditor to owner.
Sukuk can take different forms and be involved in a variety of different asset classes, projects, financial structures etc. It has flexibility in its applications, and provides a wide array of options to source funding from the wider market. This article will explore these analogs and will delve deeper into the theory of the instrument, what it aims to solve and how well it achieves this, but also where it falls short.
Ownership - how it changes everything.
As mentioned above and in previous articles (Aqila Finance), key principles in Islamic finance relate to risk-sharing and profit from liability. This also carries over to the Sukuk structure which represents a share in an asset or venture. Income is therefore tied to performance of the underlying asset rather than a predetermined payment schedule. This means Sukuk holders accrue variable rewards and share in both the upside and the downside, even if that downside results in an erosion of the originally committed principal.
This re-aligns the decoupling caused by exponentially growing debt. Those funding the business have a more vested interest in the business’ performance, and their rewards are directly correlated to such. This achieves a more equitable outcome.
Additionally Islam prevents the use of interest (Riba). The income that Sukuk provides is instead profits based on the income generated from the asset/venture itself. It is not simply a charge on debt.
The main structures
There are a number of different instrument mechanics the Sukuk can utilise. They vary in purpose, payment schedule and structure. This has created a spectrum of structures that ranges the instrument from being more debt-like, to being more equity-like in essence. Please note a lot of these underlying financial products/instruments have been covered in previous articles, so refer to these for more info - (Aqila Finance).
The key types of Sukuk in that order, are as follows:
Ijara (Sale-and-leaseback) - the most common and intuitive as it is familiar to a bond structure, but with equity-like characteristics. Here an originator of the Sukuk (e.g. a government in need of funding), calls on investors via a Sukuk to buy an asset they own, which then leases it back to the originator, as they still require said asset. The Sukuk holders are provided a right to receive rentals for leasing out the asset. At maturity the originator will then buy out the Sukuk holders’ ownership, and then eventually re-own the asset. These Sukuk holdings are tradable securities that can be listed on an exchange. The rental rate applied here tends to be benchmarked to a floating rate like SONIA, so the economics can, on the surface, track conventional debt.
Murabaha Sukuk (Cost-plus sale) - Here an asset (usually commodities) is sold with a deferred payment, at a markup. The Sukuk holders (investors) are the ones purchasing the asset (they are unlikely purchasing the asset themselves, but rather the originator purchases on their behalf or it is done via a third-party), who deliver the goods immediately to the originator of the Sukuk ( the one requiring asset, but needs it to be financed), who pays back on a deferred basis at a marked-up cost. The trading of this Sukuk on the secondary market however is forbidden by most scholars as it is effectively trading a debt.
Wakala (agency) - This Sukuk structure is increasingly becoming the structure of choice. Wakala transactions relate to an agency contract where one party acts on behalf of another party for a fixed fee. Here the agent would use expertise to select and manage investments on behalf of the investors. This is similar to Mudaraba (see below), but they don’t share in profits, and the fee is fixed. This is why it is popular as it represents more of a fixed-income instrument as returns are more predictable.
Musharaka / Mudaraba (Partnership structures) - as mentioned in previous articles, Musharaka relates to a joint venture whereby multiple investors combined their pooled investments to purchase an asset, whereas Mudaraba relates to a structure where not all partners contribute equity, but instead some offer their expertise for a predetermined share of profit. These are the closest to the theoretical risk-sharing ideal on paper. Unlike the Ijara and Murabaha structures, there isn’t likely to be a steady flow of income, with fluctuations in revenue and no guarantee on repayment of capital. There may be efforts to smooth the income scheduling; however this can conflict with its Shariah compliance.
Istisna (project finance) - Istisna’ is used by the Sukuk originator for the financing of large projects. The investors fund this via the Sukuk, of which then the originator uses this onwards to pay for the construction of certain infrastructure, where payments are made in instalments, according to pre-agreed milestones. Again the Sukuk here is tradable, however the certificates cannot be traded pre-maturely (i.e. before the construction of the asset).
Salam (forward sale) - Salam is used for forward sale contracts, whereby essentially you are financing the future production/delivery of certain goods. In the context of Sukuks, the investors pay for the funds upfront, and receive the return in the future once the goods are delivered and then sold at the end of the period. This acts similar to a Zero-coupon bond, which is simply used for short-term liquidity management. The certificates however cannot be traded on the secondary market unlike some of the other, aforementioned structures.
It is clear to see that these structures described are meant to function very differently from a bond, with the emphasis on risk and profit-sharing. There are however some failings in the current Sukuk offerings which deviate from the ideal Shariah outcome.
Asset-backed vs. Asset-based
The Sukuk instrument can be asset-backed or asset-based in nature, which refers to whether it is secured or not. An asset-backed sukuk is a genuine securitisation, involving an actual transfer of ownership from the originator to the investors (usually done via an Special Purpose Vehicle - SPV). Ultimately, the Sukuk holders become owners of the asset and with that they are directly exposed to the risks of the asset.
Asset-based Sukuk on the other hand are unsecured, with the asset acting as a peg. Beneficial ownership (where specific property rights belong to one person, but the legal title belongs to another) is transferred but not actual ownership. The originator of the Sukuk still retains the underlying asset; therefore the recourse here is the originator’s balance sheet, which on paper looks very similar to an unsecured bondholder position. It is therefore criticised by Shariah standards and scholars as it more closely mimics conventional debt instruments, but it is still widely tolerated and holds the dominant position in the market for the choice of underlying asset structures for Sukuk.
The purchase undertaking
In the more equity-based structures (e.g. Musharaka and Mudaraba) there have been instances of issuers attaching a binding promise (wa’d), to buy the certificates back at face value at maturity. This recreates precisely the guaranteed return that risk-sharing was meant to eliminate. It essentially transforms the Sukuk into interest-bearing loans.
There was a notable case where Sheikh Muhammad Taqi Usmani, intervened and disrupted the Sukuk market in 2007/8. During this period he was the chair of AAOIFI (Accounting and Auditing Organisation for Islamic Financial Institutions) Shariah board and in his role, he circulated a critique stating that approximately 85% of all Sukuk issued at that time globally, were not genuinely Shariah-compliant. This, in tandem with the 2008 financial crash, froze the Sukuk market as investors lost trust in the market, and the reputations of Islamic finance institutions and the integrity of Shariah advisory boards that signed off on them, came under question.
This forced a structural change in the Sukuk market and the Islamic finance industry as a whole. True value buy-backs were enforced as It banned issuers from offering fixed-price guarantees for equity-based structures. Instead, the buy-back had to be executed at the net asset value (market value) at maturity, to capture any movements in asset value over the period.
Case Study - Sukuk default
A foolproof way to test the legitimacy of Sukuk Shariah integrity is in the face of a default. One particular real-life example is the 2009 Dubai World crisis, which had asked to pause its overall liability balance sheet position , including its subsidiary Nakheel’s Sukuk. A $3.5bn Sukuk raised by Nakheel nearly faced default but was eventually bailed out by Abu Dhabi and the UAE Central Bank, at the very last moment, on the date of maturity.
This was a watershed moment for Islamic finance. This exposed the reality of asset-based Sukuk arrangements, which this Sukuk was one of. Investors quickly discovered that while the sukuk was linked to property assets for compliance purposes, they had no actual legal recourse or direct ownership title. They were in the same boat as conventional bondholders, they were essentially unsecured creditors.
Governance, ratings, and pricing
The actual Sukuk products are approved by Shariah boards, standardised (loosely) by AAOIFI and IFSB. In terms of ratings however they’re also rated by the same agencies as bonds (e.g. S&P, Moody’s etc) and priced off the same benchmarks.
When rating the issuance and determining how premium the financial product is , the rating agency uses the same criteria it would to determine the rating of a bond, with Shariah compliance not considered as a criterion (i.e. whether the Sukuk is graded the most premium rating - AAA, is not conditional on it being Shariah compliant whatsoever). This indicates that the market views the Sukuk and a bond as a substitutable risk.
What Sukuk looks like in western markets
Like many facets of Islamic finance, the Sukuk market in the west is nascent. The UK government was the first western country to issue a sovereign sukuk and completed two issuances, the first in 2014 of £200m and the second in 2021 of £500m. This shows that there was a real increase in demand in the UK’s reliance on Shariah compliant funding, however it is still growing far more slowly compared to conventional government debt issuance. This also isn’t a retail product like many government bonds, which limits access to your individual investor.
There are however a handful of global ETFs and mutual funds available to retail investors as a means to access various underlying Sukuk. The choice however is quite sparse, with only a handful of established providers available on your standard brokerage platforms.
Closing
The Sukuk is a flexible instrument that can be used to fund numerous projects, assets and ventures. It aims to achieve a more equitable funding methodology that prioritises risk and profit-sharing unlike conventional bonds. The reality however, has yet to truly reflect this. The market has preferred the asset-based structure over the asset-backed structure that better resembles the Shariah outcome. It has also tried to find loopholes via the purchase undertaking, to warp the risk apportionment.
Although there have been adjustments and corrections to this, there is still significant room for improvement. The market has engineered the Sukuk to almost replicate the risk-return profile of conventional debt. It mirrors the same benchmarks, the same ratings, the same economic outcome in default.
This financial instrument does not yet meet its own standards.
As mentioned in previous articles, Islamic finance as an industry is still developing and teething issues are inevitable. Leeway is provided by many scholars to allow the market to be able to compete and flourish.That leeway does however have limits.
The foundation is genuinely there to build upon, as the Sukuk is quite a unique financial instrument that can democratise sovereign and private investment that would otherwise not be available. As it stands now however I don’t believe Sukuk is meeting the standards it should be , and giving the product to Muslims they deserve.
Thanks for reading,
Aqila Finance.