Introduction

Definition

Mechanics of a sukuk transaction

Types of sukuk

Asset-based versus asset-backed sukuk

Sukuk and the secondary market

A strong future for sukuk

Conclusion

INTRODUCTION

In the last chapter, we went through the main types of commercial transaction found in Islamic finance. We now turn our attention to a particular instrument known as sukuk. If one instrument from the Islamic finance industry could be singled out for its positive impact in raising the international profile of the industry and sparking the interests of governments, central banks, business and investors around the world, it would be sukuk. It has been central to putting Islamic finance on the ‘global map’ and will continue to play an important and central role in driving the industry forward. We have therefore dedicated a whole chapter to this instrument.

Sukuk, often called ‘Islamic bonds’, have grown in popularity in recent years as a sharia-compliant capital markets instrument enabling governments and companies to raise large amounts of capital. This growth has been fuelled by various factors:

• There is growing demand for sharia-compliant investment instruments – a recent survey¹ revealed that 54 per cent of investors invest in sukuk because they are sharia-compliant; these investors are mainly Islamic banks.
• Investors have been drawn to sukuk because of attractive yields and as a way of diversifying their investment portfolios – 20 per cent² of sukuk investors invest for this reason; these investors are mainly conventional banks.
• Issuers of sukuk have been attracted by the liquidity available in the Islamic world and as a means of diversifying their funding base.

The sukuk market is a key driver of the global expansion of the Islamic finance industry and is worth more than $237 billion.³ It has enjoyed strong growth in the last decade and this looks set to continue as more governments and businesses seek to tap into the liquidity and demand from investors. Indeed, the UK successfully issued its first sovereign sukuk in June 2014 for £200 million. This was the first sovereign sukuk outside of a Muslim country and it was oversubscribed by almost 12 times. At the time of writing, other countries such as South Africa, Oman, Tunisia, Morocco and Nigeria were working towards issuing sukuk to support and fund infrastructure projects.

This chapter describes how a basic structure works, the differences between conventional bonds and sukuk, the different types of sukuk that can be issued, and takes a look at some recent examples of sukuk issues in the market.

DEFINITION

Sukuk in Arabic means certificates (plural of sakk, meaning certificate). Sukuk is the term used in Islamic finance to refer to certificates representing undivided shares in the ownership of:

• tangible assets; or
• the usufruct of an asset; or
• particular projects or investment activities.

The sukuk issuer raises capital by selling an asset (or a stake in a project or business) to investors. These investors become the sukuk holders and, with a stake in the asset or project, have a right to revenues and profits generated in proportion to their ownership share.

Difference between sukuk and conventional bonds

While sukuk have been described as Islamic bonds, there are significant differences between sukuk and conventional bonds, as summarised in Table 6.1.

Table 6.1 A comparison between sukuk and conventional bonds

Sukuk	Conventional bonds
Sukuk holders invest in ownership of an asset or project	Bond holders essentially provide an interest-bearing loan
Return is based on the performance of the asset or project owned by investors	Return is interest, determined at the outset and not linked to the performance of any asset or investment
Sukuk holders, as beneficial owners of an asset/project, bear any losses generated by those assets/projects (to the extent of their ownership)	Bond holders are not exposed to losses borne by the bond issuer in the use of funds raised by the bond issue
Maturity of sukuk corresponds to an underlying project or activity	Bond term not necessarily linked to any underlying activity of bond issuer
Sukuk issue subject to sharia rules (e.g. sukuk proceeds must be used for sharia-compliant purposes)	Bond issues not impacted by sharia rules

MECHANICS OF A SUKUK TRANSACTION

Figure 6.1 illustrates the mechanics of a typical sukuk transaction.

Figure 6.1 A typical sukuk transaction

The party seeking to raise finance from the sukuk issue (usually a government or large corporation) is called the obligor. As we will see below, the relationship between the obligor and the sukuk investors can take a number of forms:

• A special-purpose vehicle (SPV) is normally established (often offshore for tax reasons) to represent sukuk holders. The beneficial owners of the SPV are the sukuk holders – sukuk certificates issued by the SPV represent evidence of this ownership.
• Monies from the sukuk issue go into the SPV and are used to acquire an asset or stake in a business or project. Similarly, returns from the sukuk investment will be paid into the SPV; individual sukuk holders will then be remunerated according to their individual investments from the SPV.
• A bank is usually engaged as a sukuk arranger. The arranger fulfils a number of functions, including establishing the sukuk structure and SPV, writing the prospectus for the sukuk issue, and underwriting, promoting and marketing the issue.
• A manager of the SPV will normally also be engaged. Their role is to manage the SPV on behalf of the sukuk holders and to be accountable to them for the performance and delivery of the stated investment objectives. Sukuk holders can change the manager if they are not satisfied with the performance of the manager.

Sukuk can be structured using a number of different types of contract that define the commercial relationship between the sukuk holders (as represented by the SPV) and the obligor. Key factors influencing what structure is used are:

• the underlying project, business or asset – for example, an ijarah contract is suited to a sukuk where the underlying asset of the sukuk can be leased, while a musharakah sukuk is more suited to a business venture;
• the risk/return profile of the sukuk – structures like ijarah lend themselves better to a lower-risk, fixed-income type return profile as lease rentals are predictable and the exit price can be determined at the outset, while structures such as musharakah and mudaraba (i.e. equity instruments) are generally more risky from an investor perspective, with less certainty as to the returns and the exit price cannot be determined at the outset.

We will now look at the main types of sukuk based on different contract types.

TYPES OF SUKUK

Sukuk al musharakah

The obligor contributes capital to the project and the sukuk holders, through the SPV, also contribute capital to the project. The normal rules and conditions of musharakah then apply to the obligor and sukuk holders as partners in the project. This type of sukuk is suitable for business projects where the obligor has capital to invest and wants to complement that by raising further capital.

In the case of KAPCO buying the stake of sukuk holders, this price cannot be guaranteed at the inception of the sukuk; this would contravene the essence of musharakah – profit and loss sharing. Indeed, a specific ruling by AAOIFI in February 2008 expressly prohibited obligors from providing a purchase undertaking to sukuk al musharakah investors in terms of a specific exit price. A purchase undertaking can be provided at the outset, but the actual price must be the market price at the time of exit.

Sukuk al mudarabah

The sukuk holders through the SPV provide the capital (as the rabb-ul-maal) and the obligor undertakes to manage and run the project (as the mudarib). Again the normal rules of mudarabah then apply to both parties as partners in the project. This type of sukuk is suitable for financing a business project or for providing asset management services, where the obligor does not want to contribute capital but rather provide business/investment expertise and resources. The only returns to both the obligor and sukuk holders are in the form of profits generated from the project or assets.

Sukuk al wakala

In this case an obligor can raise capital by selling assets to the sukuk holders; an agent (wakil) is then appointed on behalf of the sukuk holders to manage those assets under a wakala contract. The sukuk holders will typically look to receive a target profit rate from the assets being managed by the wakil; the wakil will charge a wakala fee for their services, which will usually include a fixed element plus a performance-related element.

The main difference between a sukuk al mudarabah and a sukuk al wakala is that in a mudarabah structure profit will be shared between the obligor and sukuk holders in a pre-agreed ratio, while in a wakala structure the wakil must receive a wakala fee for his services whether a profit is made or not. The sukuk holders will typically just receive up to the target profit return, with any surplus going to the wakil as a performance fee.

Sukuk al-ijarah

Typically, an asset owned by the obligor is sold by the obligor to the sukuk holders (the SPV) and then leased back by the obligor from the SPV through an ijarah wa iqtina (lease ending with acquisition).

The UK government used such a structure when it issued its first sovereign sukuk in June 2014. It raised £200 million by selling beneficial ownership rights in three buildings owned by central government to sukuk holders. It then leased those buildings from the sukuk holders for a five-year term at a rental yield of 2.036 per cent per annum. At the end of this five-year term, the UK government will buy back the beneficial rights to the building from the sukuk holders at par, i.e. at the price at which it sold the assets to the sukuk holders originally.

The sukuk is listed on the London Stock Exchange and can be traded on the market by investors.

In an ijarah structure of this kind, it is permissible to pre-agree the buyout price; the obligor can provide a one-sided purchase undertaking to buy the asset from the sukuk holders at a specified price at the end of the lease term. As noted above, in a partnership/equity contract such as musharakah it is not permissible to fix the exit price or the profit rate as this contravenes the essence of profit/loss sharing. (Sukuk usually mature between three and seven years.)

Sukuk al murabaha

The sukuk holders, as represented by the SPV, buy an asset and sell it to the obligor at a known mark-up. The obligor pays the SPV for this asset over a deferred period of time. This has been a popular technique in helping obligors raise asset finance; from a sukuk holder’s perspective it can be attractive as the cash flows and returns are known at the outset, subject to the obligor fulfilling his commitment to pay. Obligors also like it because they have certainty as to the timing and value of their cash outflows.

The major drawback with this technique is that such sukuk cannot be traded except at par. The sukuk certificates essentially represent debt receivable from the obligor and to trade debt is seen as trading money; therefore any trade except at par would be regarded as involving interest.

Indeed, this structure most closely resembles a conventional bond – like a conventional bond a debt is the outcome of the murabaha transaction.

Sukuk al bai bithaman ajil (also called sukuk al bai muajjal)

Bai Bithaman Ajil or Bai Muajjal refers to a sale on credit, with payment due at a future fixed date or within a fixed period. This is structured in the same way as sukuk al murabaha, except in this case the profit mark-up to the obligor is not disclosed. It therefore shares the same issue of not being tradable other than at par.

Sukuk al istisn’a

The obligor could raise money through a sukuk based on an istisn’a contract to finance the construction of property or infrastructure or the manufacture of an asset. As we saw in Chapter 5, when we discussed the application of istisn’a, the obligor could structure the istisn’a in conjunction with a leasing arrangement which involves a forward lease element (ijarah mawsoofa bil thimma) during the construction phase, and an ijarah wa iqtina in the post-construction phase. In such an application, the sukuk holders (via the SPV) would buy the asset being constructed through an istisn’a contract with the obligor (thereby providing finance to the obligor to carry out the construction). Then the obligor would contract to lease the asset from the SPV to provide returns to the sukuk holders during the term of the sukuk, and then buy the asset from the sukuk holders at the maturity of the sukuk at a stipulated price. The QEWC example in Chapter 5 is essentially the structure we are referring to.

Sukuk al salam

The relationship between the obligor and SPV could be structured as a salam transaction, in which the SPV through the sukuk issue raises monies to enter into a salam contract with the obligor. Here the SPV pays monies now in return for the obligor to supply a specified amount of a fungible commodity at a particular time and place in the future. The SPV will then usually enter a parallel salam (refer back to Chapter 5 under the salam section to remind yourself of how this works), with a view to making a profit and generating a return on investment to the sukuk holders.

Sukuk based on salam, like sukuk based on murabaha, cannot be traded except at par. In a sukuk al salam, investors hold a certificate denoting that they are the beneficial owners of a particular commodity to be delivered at a specified time in the future. The sharia views the obligation of the seller to supply a commodity in the future as a debt, therefore trading a salam sukuk certificate at anything other than what the sukuk holder paid for it would be considered as riba.

The Central Bank of Bahrain, on behalf of the Government of Bahrain, since June 2001 has been issuing short-term sukuk al salam (tenure of 91 days) on a monthly basis. The commodity used has been typically aluminium. It has been a mechanism of raising short-term finance for the government. The sukuk holders make a return on the onward sale of the aluminium through a parallel salam transaction.

The different types of sukuk described above represent the main structures used in the market, but this is not an exhaustive run-through of all the different types of sukuk – there are other structures that are possible and sometimes different structures are combined to produce ‘hybrid’ sukuk.

Figure 6.3 shows the relative amounts of capital raised through the main sukuk structures between January 2010 and September 2013.⁵

ASSET-BASED VERSUS ASSET-BACKED SUKUK

When sukuk were first developed, the requirement was to have 100 per cent tangible assets to provide full asset backing to investors. In asset-backed securities, the sukuk holders enjoy the full backing of the underlying assets as there is a true sale and legal transfer of the ownership of the assets to sukuk holders. Sukuk holders thus enjoy the guarantee of having recourse to the assets to recover their capital in the event that the obligor becomes insolvent or faces difficulties in meeting payments. However, corporates and governments faced challenges in finding suitable assets for the structuring of such sukuk. The assets were not available, or were not sufficient, or were already encumbered, or such sale of assets would be subject to transfer taxes. On the part of governments, especially in countries of the Gulf Cooperation Council (GCC), the law does not allow for the sale of public assets such as land and property to foreigners, which made the structuring of asset-backed sovereign sukuk difficult.

In 2002 Malaysia issued an asset-based sukuk al-ijarah in which there was no true sale of the underlying assets to sukuk holders; rather, sukuk holders would enjoy beneficial ownership of the assets throughout the life of the sukuk. In this case, in the event of default, sukuk holders would have recourse to the Federation of Malaysia (the obligor) instead of the sukuk assets. From this first issuance of asset-based sukuk, this structure has become more common than asset-backed sukuk throughout the world – although both forms of sukuk are in the market and still being issued.

While asset-based sukuk still require 100 per cent physical assets which are sharia-compliant to support the sukuk at the time of issuance, for those issuers who do not have sufficient physical assets for structuring sukuk, the concept of blended-assets sukuk was introduced. This type of sukuk combines sharia-compatible receivables and physical assets, with the main condition that the proportion of the physical assets has to exceed that of the receivables for sukuk issuance and trading. In the beginning, some sharia scholars required the majority portion to be at least 51 per cent or 66 per cent of the portfolio. In 2003, the Islamic Development Bank (IDB) issued a similar sukuk with a mixed portfolio consisting of 65.8 per cent ijarah assets combined with 34.2 per cent of murabaha and istisn’a receivables. In 2005, however, it was permitted to reduce the minimum physical assets to 30 per cent in a mixed portfolio sukuk.

Eventually, the requirements for physical assets became further diluted in order to meet the increasing demand of issuers who did not even have the 30 per cent physical assets. This led to the development of asset-light sukuk structures, which do not require any physical assets at the time of sukuk issuance. These sukuk are based on the mudarabah (profit sharing) or musharakah (profit and loss sharing) arrangements between the issuer and the sukuk holders and the proceeds raised from the sukuk holders are invested in the business or project on a mudarabah or musharakah basis.

SUKUK AND THE SECONDARY MARKET

In our description of the different types of sukuk, we have commented on the tradability of these sukuk. We have seen that sukuk that result in a ‘debt obligation’, such as in the case of a sukuk al murabaha and sukuk al salam, cannot be traded except at par. Sukuk that do not fall into this category, such as sukuk al-ijarah and sukuk al musharakah, can be traded before maturity.

Clearly the ability to liquidate and trade an investment instrument at any time is a positive feature when attracting potential investors. Hence while sukuk al murabaha has been a popular instrument, many of the new issues in the market are not using this structure due to the lack of tradability.

As the sukuk market has developed through the years with the issue of tradable sukuk, a secondary market has emerged and developed for those sukuk. A number of sukuk investments are now listed on major global stock exchanges, facilitating efficient and transparent trading. As a result many non-Muslim institutional and private investors have entered the sukuk market. At the same time, sukuk investment funds such as those offered by Emirates NBD and Qatar Islamic Bank UK (QIB UK) have emerged. These funds trade and invest in a portfolio of sukuk listed on stock exchanges around the world.

Another indication of the positive development of the secondary market is the appearance of ‘Islamic bond indices’. These indices are compiled by averaging the yield to maturity of selected sukuk and publishing this yield with an underlying index value for a given maturity. Examples of such indices are the Dow Jones Citigroup Islamic Bond Index and the Sukuk Index by HSBC and Dubai International Financial Exchange (DIFX).

However, the tradability of sukuk is still not as efficient or liquid as the bond market, the key reason being that the sukuk market is much smaller and there is a lack of shorter-term sukuk for banks’ treasury departments to invest to meet their short-term obligations. As the market matures, deepens and becomes bigger – with more sukuk being listed on stock exchanges and being rated – the secondary market for sukuk will get stronger and more liquid.

A STRONG FUTURE FOR SUKUK

Sukuk issues are an increasingly popular way for governments and large corporations to raise sharia-compliant capital for large infrastructure projects such as energy plants, airports and roads, as well as real estate projects and businesses. Similarly, sukuk issues provide banks with an investment instrument that can facilitate treasury management and inter-bank liquidity, deploying ‘excess’ capital to earn a sharia-compliant, predictable and relatively low-risk return. For investors, too, sukuk can form a useful part of a diversified sharia-compliant investment strategy, typically combining a fixed-income profile and the ability to trade on recognised secondary markets.

As Figure 6.4 illustrates, the number of sukuk issued and the capital raised have increased impressively over a number of years. In 2013 there was a decline on 2012, driven by fewer large new issuances of sukuk in 2013 and the ‘fixed-income market’ overall slowing down due to investors being uncertain/anxious about the monetary policy of the United States in particular and the impact on interest rates. Despite this, the potential growth of sukuk is significant, with more and more countries looking to use this as a source of funding.

Figure 6.4 Global aggregate sukuk historical trend, 1996–2013

Source: Thomson Reuters Zawya.

Economic growth and government spending commitments are likely to boost sukuk issues in markets such as Malaysia, GCC and Turkey where Islamic finance is relatively established and growing. Saudi Arabia and Abu Dhabi have significant spending plans, while Dubai’s preparations for the 2020 World Expo and Qatar’s plans for the 2022 FIFA World Cup are all likely to lead to new sukuk issues, either directly by the respective sovereign governments or by related entities. Oman, which has not previously been a major issuer, has also indicated it will use sukuk instruments to fund infrastructure projects over the next few years.

Following the successful launch of the first sovereign sukuk outside of the Islamic world by the UK government in June 2014, Luxembourg and Hong Kong have recently taken steps to legislate for sukuk deals, while at the time of writing several Sub-Saharan African countries were reportedly considering issuances.

Issuers are also likely to be attracted by evidence of increasing market efficiency. Structuring costs have fallen significantly, while the time taken to construct a deal has fallen from as much as six months to a few weeks.

CONCLUSION

All in all, the future for the sukuk market looks strong and its importance to the Islamic finance industry is central. As mentioned at the start of this chapter, sukuk have had a leading positive impact on the global expansion and attraction of the Islamic finance industry, and can have a material impact on the world economy. They are helping Muslim and non-Muslim nations to raise capital to support infrastructure projects – in the process putting excess liquidity to good use, creating more jobs and enhancing living standards.

¹ Thomson Reuters Zawya, ‘Sukuk Perceptions and Forecast Study 2014’.

² Ibid.

³ Ibid.

⁴ Retakaful is the mechanism by which takaful entities (Islamic insurance entities) mutually cover each other for some of the risks they carry in their respective takaful entities. In essence it is very similar to the concept of reinsurance as applied to conventional insurance.

⁵ Thomson Reuters Zawya, ‘Sukuk Perceptions and Forecast Study 2014’.