The answer lies, putting Islamic motive aside, partly because investment in sukuk gives some sort of relief to investors when it is said that sukuk are less volatile as compared to conventional bonds since they are basically asset-backed and not just a mere securitization of future cash flow in the form of debts payable in future as practiced in conventional securitization.
In sukuk, when an investor purchases the certificates, he in fact purchases an undivided share or interest in the underlying assets which back the sukuk issuance. In order to comply with Shariah requirements these assets must be essentially tangible assets, and the position of the investor must be one of a full owner throughout the tenure of the sukuk. Ownership in this contact must means full ownership as understood in Shariah law that confers all rights and privileges to the relevant owner who, on his part, is entitled to receive whatever income that can be generated by the asset including possible rise in its value.
However a pertinent issue would arise if sukuk structure does not take Shariah guideline seriously for example when sukuk are structured based on methods used in conventional securization which is typically a lending by investors to the seekers of fund in the capital market. Sukuk are not debt instruments simply because they are essentially backed by real tangible assets as opposed to debts or receivable as is the case with conventional bonds. This major difference leads to a different outcome; since sukuk are not based on debts, returns of investment to the relevant investors cannot be viewed in the context of fixed incomes because what the investors would received depends largely on the real performance of the underlying asset. Therefore to talk of sukuk as fixed income instruments is both misleading and inaccurate.
Even in the context of Sukuk al-Ijarah where the anticipated returns to investors are likely to flow from rental streams, investors cannot be guaranteed of fixed incomes based on such streams that in themselves cannot assured. It may happen that the relevant underlying tenancies or leasing contracts need to be terminated earlier due to some misfortune or natural calamities or the asset may be lost or destroyed due to faults of no one. Under these kinds of circumstances, the right of the investors to the payment of the stipulated returns or income could not be continued and nothing could be done in term of the manager’s liability. In fact the contract itself will become frustrated due to the reasons. Furthermore, a future income stream as previously described cannot under the Shariah law be securitized in the first place as it constitutes a non-established liability on the part of the tenants. It will become established only when the tenants have utilized the period of leasing, but have yet to pay the necessary rental to the owner of the assets.
Given the fact that sukuk are basically financial instruments used for investment purposes, the issue of risk for return is central to the operation of the sukuk. Investors who buy them are expected, as owners of the underlying assets, to be ready to face risk of loss or diminution of their capital or value of the purchased assets. In line with this, the issuer is not duty bound to guarantee any payment of fixed income to the investors be it in the form of regular dividend or capital gain emanating from any possible increase in the value of the underlying assets. What the issuer must do however is to provide an undertaking to exercise his level best to manage the investment so that it is profitable, in which case the parties will share the realized profit based on an agreed ratio. Any form of guarantee that covers capital protection or payment of certain fixed rate return or dividend runs counter to the Islamic theory or notion of risk for return principle.
One issue that has been recently raised is related to the way sukuk were structured in the past few years when it was discovered that in many cases, the issuers normally made non-revocable undertaking to repurchase the sukuk at certain prices fixed in advance in case of default or non-adherence to the term of the issuance. This kind of undertaking that creates an obligation on the part of the issuer when the triggering events do take place will undoubtedly lead to a guarantee of capital that is not in line with the Shariah requirement.
However this point needs further clarification to clear the doubt that has been lingering around about the shariah compliance aspect of these sukuk. Any undertaking to repurchase made on the basis of possible breach or wrongdoing or negligence on the part of the issuer, who is possibly a fund or project manager (sukuk Mudarabah) or even a partner in an Islamic partnership (sukuk Musharakah), will not violate any shariah principle because as per the Shariah, the manager is to be held liable for any loss resulting from either his negligence or wrongdoing or both.
In other words, the insertion of such an undertaking is just to reemphasize a shariah rule pertaining to the possible liability of the manager/issuer in case of negligence or wrongdoing. If however, the undertaking seeks to cover the investor more that what he is entitled to under the Shariah law i.e to cover for the manager’s liability even though there is no fault on his part, then this will trigger a Shariah compliance issue.
In the context of obligation to repurchase in the event of default as is commonly provided in Sukuk documents, if default here means inability to pay returns or dividend as agreed, this condition/undertaking needs to be further clarified to refer only to cases where such inability is due to the issuer’s negligence or wrongdoing. From Shariah perspective once negligence or wrongdoing is committed, the issuer or manager by that account has changed his Shariah status from that of a trustee (whose liability is based on fault) to one of a wrongdoer who by thus is under the duty to repay the investors their investment capital. In order to discharge this duty, the relevant assets must be liquidated or sold for value, and the money be paid back to the investors.
Whatever the outcome of the present discourse on the Shariah compliance aspect of sukuk, one thing that must be understood by all is that the notion of risk for return or no pain no gain is there in the Shariah to be implemented in practice and not just be treated as a mere theory repeated time after time. Furthermore if Islamic finance is to be conducted truly on the basis of Shariah guidance, then it is incumbent on all parties involved to subscribe sincerely to the relevant rule both in form and substance.
The Global Sukuk Report 2008 by Global Investment House cited that the amount raised by sukuk, or Islamic bonds, totalled $15.1 billion US Dollars last year, compared with $33.1 billion in 2007. At the same time however, the number of sukuk issued worldwide increased from 129 to 165 in 2008.
The impact of the global financial downturn has only recently begun to be felt in the Gulf region. Consequently, the Global Investment House report recorded that the majority of sukuk were issued in the first three quarters of 2008, with only 26 sukuk issued in the final three months - an indication of the correlation with the impact of the global economic slowdown on the region.
At the same time, the market for sukuk issuance, and Islamic finance instruments in the Gulf was noted to be growing. The Gulf Cooperation Council (GCC) was the largest issuer of sukuk last year, followed by Malaysia.
"The Islamic bond market is still concentrated in the GCC region and Malaysia, in terms of dollar amount. GCC countries accounted for 55.5 per cent of the dollar amount issued, while Malaysia accounted for 36.3 per cent," according to the report's findings.
The market share for sovereign issued sukuk is also increasing, with 73 sovereign sukuk issued in 2008, compared to 32 in 2007, an indication of the growing importance of the debt instrument to raise government funds.
Over half of Gulf states are already issuing sovereign sukuk, with the UAE leading the way.
In 2008, the UAE was the second largest market for sukuk raising, with Dh19.5 billion raised from 10 issues.
This was marginally behind Malaysia, which raised Dh20 billion. The only other country to have raised over $1 billion from sukuk was Saudi Arabia, out of a total of ten states which issued sukuk last year.
Wow, the statement itself is full of controversy – well, let me tell you what actually happened.
There was an article initially carried by Bloomberg, a financial news agency, specifically attributed the fall-off in sukuk last year due to a fatwa issued in early 2008 by the Bahrain-based Accounting & Auditing Association for Islamic Financial Institutions (AAOIFI) essentially deeming the majority of issuance thus far non-shariah-compliant and setting out a stricter series of principles necessary for religious acceptability.
AAOIFI’s doubts first hit the headlines in late 2007 when the body’s influential scholar and chairman Sheikh Mohammed Taqi Usmani told a conference that some 85% of outstanding sukuk failed the shariah-compliance test on the basis that they were asset-based rather than asset-backed - with the issuer undertaking to pay back the face value of the bond on maturity and without the buyers truly owning the underlying asset - mimicking a conventional bond through a guaranteed return and a lack of the profit and loss-sharing required under Islamic financial tenets.
A more detailed pronouncement was published by the AAOIFI board in February, the first point of which covered this area, stating that ownership of the relevant assets were required to be legally transferred to the sukuk-holders. The fatwa ruled unacceptable the extension of “loans” from the borrower to the investors to make up for any shortfall in the return on the assets - in effect offering an assured rate of return - while barring guarantees to repurchase the bonds for a nominal value at maturity, except in the case of the ijara, or leaseback, structure.
AAOIFI also called for closer scrutiny by shariah boards of the documentation detail of particular issues, rather than accepting the nominal structure at face value - a development that has for some time been advocated more broadly among conservatives in the Islamic banking community, complaining that overstretched or inexperienced scholars are frequently misled by issuers and their financial advisers over the true shariah-compliance of a transaction’s contractual framework.
The statement ended with an explicit exhortation for a return to basic principles: “The (AAOIFI) shariah board advises Islamic financial institutions to reduce their involvement in debt-related operations and to increase true partnerships based on profit and loss-sharing in order to achieve the objectives of shariah.”
I was reading a book on Corporate Finance just now and suddenly I remembered about sukuk. However, not many of us know how it works, therefore, I decided to give a brief introduction of sukuk.
Sukuk is the Arabic name for a financial certificate but can be seen as an Islamic equivalent of bond. However, fixed income, interest bearing bonds are not permissible in Islam, hence Sukuk are securities that comply with the Islamic law and its investment principles, which prohibits the charging, or paying of interest.
Shariah requires that financing should only be raised for trading in, or construction of, specific and identifiable assets. Trading in indebtedness is prohibited and so the issuance of conventional bonds would not be Shariah compliant. Thus all Sukuk returns and cashflows will be linked to assets purchased or those generated from an asset once constructed and not simply be income that is interest based. For borrowers to raise compliant financing they will need to utilise assets in the structure (which could be equity in a ‘tangible’ company). It’s worth noting that Equity financing is Shariah compliant and fits well with the risk/return precepts of Islam.
The Problem with Interest or Riba
As Shariah considers money to be a measuring tool for value and not an asset in itself, it requires that one should not be able to receive income from money (or anything that has the genus of money) alone. This generation of money from money (simplistically interest) is Riba, and is forbidden. The implications for Islamic financial institutions is that the trading/selling of debts, receivables (for anything other than par), conventional loan lending and credit cards are not permissible.
The Problem of Uncertainty or Gharar
This principle is widely understood to mean uncertainty in the contractual terms and/or the uncertainty in the existence of an underlying asset in a contract and this causes issues for Islamic scholars when considering the application of derivatives. Shariah also incorporates the concept of Maslahah or Public benefit, denoting that, if something is overwhelmingly in the public good, it may yet be transacted and so hedging or mitigation of avoidable business risks, may fall into this category but there is still much discussion yet to come.
Controversy
Sukuks are widely regarded as controversial due to their perceived purpose of evading the restrictions on Riba. Conservative scholars do not believe that this is effective, citing the fact that a Sukuk effectively requires payment for the time-value of money. This can be regarded as the fundamental test of interest.
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