Recent modernization of Islamic finance has changed the dynamics of the industry. Demand for Sukuk or Islamic securities has increased in the last few years as the instrument has gained universal acceptance as a feasible alternative to conventional products.
Sukuk has developed as one of the most significant mechanisms to raise financing in the market through Islamically acceptable structures.
Sukuk, the plural of “Sakk”, means “legal instrument, deed, check”. It is the Arabic name for a financial certificate but may also be considered as Shariah-compliant “bonds”. Although Sukuk is generally referred to as Islamic bonds, it is better described as an asset-based investment as the investor owns undivided interest in an underlying tangible asset that is proportionate to his investment.
The claim embodied in Sukuk is not simply a claim to cash flow but an ownership claim. Monies raised by the issuance of Sukuk notes are used to invest in an underlying asset; a trust is declared over that particular asset, thereby giving the certificate holder a beneficial interest in that asset in proportion to his investment. Therefore, the investor is entitled to the benefits that entail including a proportion of the return generated by that asset.
There are some similarities between Sukuk and conventional bonds. For instance, it has a fixed term maturity, bears a coupon (profit) and is tradable on the normal yield price.
However, Sukuk is structured such that the issuance is not an exchange of paper for money consideration with interest, as per conventional bonds. It is based on an exchange of approved asset for some financial consideration that will allow the investor to earn profits from the said transaction.
Another aspect that differentiates Sukuk from an investor’s perspective is its asset backed nature. Contrary to the default in the payment of conventional bonds and investors losing all their wealth, the built-in safety aspect of Sukuk being asset backed reasonably assures investors of their ability to retrieve a major part of their investment even if things go terribly wrong since they will be having an undivided share in the ownership of the Sukuk assets.
Benefits and features of Sukuk
These include:
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Regular periodic income streams during the investment period with easy and efficient settlement and a possibility of capital appreciation of the Sukuk.
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Liquid instruments, tradable on the secondary market.
Types of Sukuk
Sukuk can be of many types, depending on the mode of financing and trades used in its structuring. Common ones include
(1) Sukuk Ijarah
This is usually issued for project finance. Sukuk Ijarah is a leasing structure wherein the lessee has the right to purchase the asset at the end of the lease period. The certificates are issued on standalone assets identified on the balance sheet.The rental rates of return on the Sukuk can be fixed or floating, depending on the agreement. The cash flow from the lease including rental payments and principal repayments passes to investors in the form of coupon and principle payments.
The Sukuk Ijarah provides an efficient medium-to-long term mode of financing.
(2) Sukuk Mudharabah
This constitutes an agreement between a party who provides the capital and an entrepreneur to enable the latter to carry out business projects, which will be on a profit-sharing basis and according to predetermined ratios agreed upon earlier. Losses are to be borne by the provider of the funds only. Sukuk Mudharabah are used to enhance public participation in big investment projects.(3) Sukuk Musharakah
These are investment Sukuk that represent ownership of Musharakah equity. The structure requires that both parties provide financing for the project. If losses are incurred, both parties will have to bear the burden in proportion to the size of their investment.Sukuk Musharakah are used to mobilize funds to establish new projects or to develop an existing one. They can also be used to finance a business activity on the basis of partnership contracts.
(4) Sukuk Istisna
This has been used for the advancement of funds for real estate development, major industrial projects or large pieces of equipment such as turbines, power plants, ships or aircraft (construction/manufacturing financing).The Islamic financial institution funds the manufacturer or the contractor during the construction of the asset, acquires title to that asset and up on completion either immediately passes title to the developer on agreed deferred payment terms or, possibly, leases the asset to the developer under Sukuk Ijarah.
Zureena Mohamed is a senior associate at Azmi & Associates. She can be contacted at +603 2118 5030.