Bond markets are important components of capital markets. Bonds are fixed income securities that promise the holder a specified set of payments. In effect, a bond investor has lent money to the bond issuer. In return, the issuer of the bond promises to pay interest and repay the principal on maturity. Islamic bond (Sukuk): Islamic bonds or Sukuk, as they are commonly called in current Islamic finance circles, are on the constant rise in the global capital market, especially in the Middle East and Malaysia.
Islamic Sukuk are being structured, managed and floated for the same economic and religious reasons as necessitated the establishment of interest-free banking and finance institutions ie to meet the requirements of those investors who want to invest their savings in an Islamically approved manner.
As a matter of principle, interest-based transactions and certain unlawful business activities are absolutely ruled out in the Islamic mode of financing. However, this does not mean that the door of debt financing, or more specifically the possibility of bond issuance and trading is closed to Islamic finance. Considering the fact that bond issuance and trading in bonds are important means of investment in the modern financial system, Muslim jurists and economists are striving to find the Islamic alternative.
Therefore, in order to meet the various demands of the investors a variety of bonds based on the acceptable modes of contracts in the Islamic law have been devised and issued during the last few years. We thus already have the mudarabah bonds, the musharakah bonds, the ijarah bonds, the istisna' bonds, the salam bonds, and the murabahah bonds.
The basic difference between conventional bonds and Islamic bonds (sukuk) lies in the way they are structured and floated. In the conventional system of bond issue and trading the element of 'interest' is at the centre of all transactions. Islamic sukuk, on the other hand, are structured in such a way that the issue is based on an exchange of approved asset for some financial consideration that allows the investors to earn lawful profits from transactions. Approval of the assets and the contract of exchange must be in line with shari'ah principles.
The issuance of Islamic Sukuk thus requires an exchange of a Shari'ah-compliant underlying asset for a financial consideration through the application of various Islamic commercial contracts. The equity-based nature of mudarabah and musharakah sukuk exposes investors to the risks connected with the performance of the project or venture for which the financing is raised.
In contrast, issuance of Sukuk on principles of ijarah (leasing) and murabahah (cost plus sale) yields deterministic receivable and hence warrants predictable and somewhat fixed returns for the prospective investors. Given the typical nature of sukuk issue, it is necessary that the structure of Islamic sukuk be reviewed and approved by shari'ah advisors to ensure that the structures are in compliance with Islamic principles.
An important issue related to Islamic Sukuk structuring is its eligibility for trading in both primary and secondary markets. For liquidity purposes bond trading in the secondary market is crucial. Debt certificates (bonds) that are not backed by an asset are not allowed to be sold in a secondary market according to the majority of Muslim scholars.
This is so because, in this situation, the Sukuk will represent claim on debt and, according to the majority of Muslim jurists, debt cannot be traded except at par. Thus trading of a debt certificates that are not backed by an asset at fluctuating market rates in the secondary market will represent sale of dayn (debt) and according to the Islamic law dayn cannot be traded except at face value since any difference in value will be tantamount to riba.
According to Islamic law, in order to be eligible for trading in primary as well as secondary markets, a bond must assume the role of al-mal or property. A bond certificate supported by an asset is transformed into an object of value and, therefore, qualifies to become an object of trade whereby it can be purchased and sold in both the primary and secondary market at fluctuating market prices like any other article of trade. As an article of trade, the investor can sell the bonds to the issuer or even to the third party if a secondary market for Islamic bonds exists.
Assets securitization, therefore, is essential for the Islamic bond issue. By the term securitization we mean the process of pooling assets, packaging them into securities, and making them marketable to investors. It is a process of dividing the ownership of tangible assets, usufructs, or both into units of equal value and issuing securities as per their value.
The underlying asset, contract and payment mechanism while being commercially viable have to be aligned with the requirements of the shari'ah.
ISLAMIC SUKUK MARKET: Islamic Sukuk issue is a new but emerging phenomenon in global financial markets. During the last few years a variety of Islamic bonds (Sukuk) have been structured and floated on the global capital markets. The Islamic Sukuk market is still small but growing fast. The list of sovereign issuers has grown to include Bahrain, Qatar, Lebanon, Turkey, Malaysia, the UAE and Pakistan in addition to the Jeddah-based Islamic Development Bank. Corporate issuers have also started to tap this market.
The value of Islamic Sukuk in the gulf states approached approximately US $4 billion in 2004. In Malaysia, the Islamic debt market has experienced rapid growth since its emergence in the 1990s. The issuance of Islamic bonds has expanded steadily at an average growth rate of 33.7% since 1995. In 2003, the total funds raised via the issuance of Islamic bonds amounted to RM 8.1 billion, constituting 19% of the total funds raised in the bond market.
Historically, the first successful issuance of Islamic bonds was initiated by the Malaysian Government in 1983 with the issuance of the Government Investment Issue or GII. The main objective of this issuance was to facilitate the management of assets in the Islamic banking system.
The issuance of GII is based on the Islamic concept of Gard Hasan (benevolent loan) or non-interest bearing loans. The Central Bank of Kuwait also issued interest-free bonds to finance the repurchase of properties held by nationals other than Gulf Co-operation Council states. Iran has also introduced the concept of participation bonds on a mudarabah basis.
The success of the numerous Islamic sukuk issuances experiment world-wide opened up an alternative source of funding, which is now tapped by many countries and corporations.
SOME RECENT EXAMPLES:
-- In January 2005 the Government of Pakistan (GOP) floated ijarah sukuk in the international market. The size of the Sukuk was increased, following the investors' overwhelming interest, reflected in the $1.2 billion offerings of which GOP accepted $600 million. The sukuk have a five-year maturity period ending 2010. The sukuk are priced at 220 points over the six month London Inter bank Offered Rate (LIBOR).The sukuk investors will receive profit yielded by approved investments of the GOP.
In order to comply with Islamic shari'ah, the sukuk will be fully backed by state-owned assets, including the 400-kilometers Islamabad-Lahore Motorway. GOP has formed Pakistan International Sukuk Company Ltd (PISCL) that will issue trust certificate, through lease agreement.
The periodic payments on certificate will be described as "rentals on assets" or ijarah rather than interest, so that the sukuk remain Islamic shari'ah compliant.
In 2004, the Department of Civil Aviation, Dubai, awarded the world's largest finance package - a $750 million sukuk al ijaa issue - to the Dubai Islamic Bank, to raise funds for Phase II of the expansion of Dubai International Airport. Overwhelming investor interest has led to the Dubai Department of Civil Aviation increasing the size of its sukuk issue to $1 billion.
The $1 billion sukuk will have a five year maturity period with a semi-annual coupon and has been priced at .45 percent above the six month dollar LIBOR rate.
In the UAE, the National Central Cooling Co (Tabreed) has raised $100 million via a corporate sukuk, the first such issue listed in Luxembourg.
In one of the biggest offerings in Bahrain, the government came out with a $250 million Government Islamic Securities in May 2003. It was the largest-ever offering by the Bahrain government since it launched the Islamic sukuk program in September 2001.
The sukuk, which carries a maturity period of five years, carries a rental return of 60 basis points over the six-month LIBOR. The sukuk is backed by an ijarah lease on the country's airport.
Islamic Development Bank Bond, the first Global Bond issued by a multilateral institution through Special Purpose Vehicle (Solidarity Trust Service Ltd) for D 400 million.
Qatar Global Sukuk, the second Sovereign Global Sukuk for $700 Million. It is based on al Ijarah.
In 2004 the German state Saxony-Anhalt became the first state government in Germany and Europe to issue a sub-sovereign bond under Islamic ijarah principles. The €100m bond does not offer interest payments to its investors. Saxony-Anhalt issued the five-year, AAA-rated bond in early August. Co-managers for the deal were US banking giant Citigroup and the Kuwait Finance House. Sources at the co-managers said the Islamic bond was fully subscribed.
They added that 60% of the issue went to investors in Bahrain and the United Arab Emirates and the other 40% to investors in Europe, particularly France and Germany. The bond is based on ijarah principles.
The Bahrain Monetary Agency (BMA) issues short-term bonds based on the basis of salam contracts. In December 2004 the monthly issue of Sukuk al-Salam has been oversubscribed by more than three times. Subscriptions worth $74.5 million were received for the $25 million issue.
The issue has a maturity of 91 days and expected return is 2.4%. The salam sukuk are issued by the BMA on behalf of the Government of the Kingdom of Bahrain.
In June 2000, Malaysia Global Sukuk were issued on behalf of Government of Malaysia for $600 Million. It was based on al-Ijarah.
In 2002 the Government of Malaysia issued the world's first dollar-dominated Islamic global bond, a $600 million five-year deal structured as a sukuk and managed by HSBC.
SOME COMMON TYPES OF ISLAMIC SUKUK:
I. IJARAH SUKUK: Ijarah (leasing) is a contract according to which a party purchases and leases out equipment, real state, etc required by the client for a rental fee. The duration of the rental and the fee are agreed in advance and ownership of the asset remains with the lessor.
IJARAH SUKUK: Ijarah sukuk are the most popular type of the Islamic sukuk and are of particular interest to a broad range of investors representing both the conventional and Islamic investors alike. The ijarah concept is one of the more popular concepts among issuers of global Islamic sukuk.
This is reflected by the strong reception and success of global Islamic sukuk. All these sukuk were reviewed and endorsed by the Global Shari'ah Supervisory Committee (SSC) of the International Financial Market (IIFM) Board.
Ijarah sukuk are securities of equal denomination of each issue, representing physical durable assets that are tied to an ijarah contract as defined by the shari'ah. The basic feature of ijarah sukuk is that they represent leased assets, ie without relating the sukuk holders to any common organisation, company or institution.
Since these sukuk represent the undivided pro-rata ownership of the underlying asset, they are freely tradable at par, premium or discount in both primary and secondary markets as determined by market forces.
STRUCTURE OF IJARAH SUKUK: If a corporation requires, for example, $50 million for the purchase of land, real asset, equipment, aircraft etc it can issue ijarah sukuk equalling that amount in small denominations, say $10,000 each. The firm then either purchases the asset on behalf of the sukuk holders or transfers the ownership of the already acquired asset to certificate holders who will be the real owners of the asset.
The asset is then leased back to the firm and the lease proceeds from the asset is distributed to the sukuk holders as dividend. For the issuance of the certificate the ijarah certificate issuer transfers the ownership of the asset to a Special Purpose Vehicle (SPV), then sells investor shares in the SPV. The returns on the certificates which come from leasing out the assets owned by the SPV, could be either fixed or floating.
Then the expected returns are fixed and can be treated as predictable as coupon on a conventional bonds. Ijarah sukuk can be issued through a financial intermediary (bank) or directly by the users of the lease assets. A third party can also guarantee rental payments, and since the yield is predetermined and the underlying assets are tangible and secured, the ijarah certificate can be traded in the secondary market.
CASE EXAMPLES: Tabreed trust certificate : National Cooling Company (Tabreed) (UAE) has issued $100 million Islamic ijarah sukuk in 2004. The issuer's initial assets were created through the sale of plant(s) by the Company.
The plants thus transferred were then leased back to Tabreed through a lease agreement, and the lease proceeds from these assets will be distributed to the bondholders. In this sale and lease back arrangement, the issuer will act as the trustee on behalf of the certificate holders.
The Tabreed sukuk are issued in minimum denominations of $10,000 and are subject to a minimum investment of $100,000 initially. However, the certificates are transferable in lots worth $10,000. Tabreed sukuk are the first of its kind listed in Luxembourg.
The Tabreed sukuk maturing in 2009 carries a fixed 5.5 per cent coupon, a return based on principles approved by Islamic scholars.
MURABAHA SUKUK: Technically, the term murabahah refers to sale of goods at a price covering the purchase price plus a margin of profit agreed upon by both parties concerned. Murabaha sukuk are issued on the basis of murabahah sale for short-term and medium term financing. Let us take an example. Suppose the required commodity in murabahah is too expensive for an individual or a banking institution to buy alone eg 50 million dollars for an oil refinery. This requires the participation of many financiers.
The financing of the project could be mobilised on an understanding with the would-be ultimate owner that the final price of the refinery would be 70 million dollars to be repaid by instalments over five years. The various financiers may share the 20 million dollars murabahah profit in proportion to their financial contribution to the operation.
In a murabahah sukuk the certificate represents a monetary obligation from a third party or dayn arising out of a murabahah transaction. This implies that the certificate represents dayn and, according to the Islamic law, it cannot be traded except at face value since any difference in value will be tantamount to riba. Thus as a principle murabahah-based sukuk can be sold only in the primary market.
This, of courses limits the scope of a murabahah sukuk issue since for liquidity consideration a sukuk must be eligible for trading in both primary and secondary markets. To overcome this obstacle, Islamic finance experts have devised a way out. They suggest that if the security represents a mixed portfolio consisting of a number of transactions then this portfolio may issue negotiable certificates.
MUDARABAH SUKUK: Mudarabah or muqaradah means an agreement between two parties according to which one of the two parties provides the capital for the other to work with on condition that the profit is to be shared between them according to an agreed ratio.
Muqaradah sukuk are based on the conclusion of a lawful mudarabah contract with the capital provided by one party and labour by the other, while the shares of the profit are determined beforehand by a definite proportion of the total.
Accounting and Auditing Organisation for Islamic Financial Institutions' (AAOIFI) Shari'ah standard no 18 defines the arrangement of mudarbah sukuk as follows:
" The issuer of the certificate is mudarib, the subscribers are the capital owners and the realised funds are the mudarabah capital. The certificate holders own the assets of the modaraba operation and share the profit as per agreement. The certificate holders, being the capital providers, bear the loss if any".
The mudarabah sukuk give its owner the right to receive his capital at the time the sukuk are surrendered, and an annual proportion of the realised profits as mentioned in the issuance publication. This financial instrument has earned the approval of the Islamic Fiqh Academy of Organisation of Islamic Conference (OIC) {Decision 65/1/7, seventh session, 1992}.
Accordingly, such sukuk may be issued by an existing company (which acts as mudarib) to investors (who act as silent partners, or rabb al-mal) for the purpose of financing a specific money-making project or function separable from the company's general activities.
The profits of this separate activity are split according to agreed percentage. The contract may provide for future retirement of the sukuk at their then market price, and often provides that a specific percentage of the mudarib's profit share is paid periodically to the sukuk-holders to retire their investment in stages.
MUSHARAKAH SUKUK: Musharakah sukuk based on the musharakah contract are somewhat similar to mudaradah sukuk. The only major difference is that the intermediary-party will be a partner of the group of subscribers represented by a body of musharakah sukuk holders in a way similar to a joint stock company, while in mudarabah the capital is only from one party. It should be noted that almost all the criteria applied to mudarabah sukuk are also applicable to the circulation of musharakah sukuk.
AAOIFI's shar'iah standard No 18 defines the arrangement of musharakah sukuk as follows:
" The issuer of the certificate is the inviter to a partnership in a specific project or activity. The subscribers are the partners in the musharkah contract. The realised funds are the share contribution of the subscribers in the musharakah capital. The certificate holders own the assets of partnership and are entitled to profit, if any."
Zero coupon bonds: Zero coupon bonds are bonds sold at a discount. Such bonds , which pay no interest to the holders, are issued at a substantial discount and repaid at par on maturity. A bond without a coupon rate issued a price of 67 and repaid at par 100 in three years would generate for the holder a yield of approximately 14% per annum.
EXAMPLE OF KHAZANA (ZERO COUPON) ISLAMIC BOND (MALAYSIA): The khazana bonds are government guaranteed issued by the Malaysian Government on a zero coupon basis. As stated earlier, debt certificates issue is valid only when an asset supports it.
For the securitization of khazana bonds the concept of bai' al-ina is implied. In bai al-inah asset securitization, the financier purchases an asset from the issuer and sell it back to the same party at a credit price. This purchase-back agreement will ensure that the issuer will receive the money in cash while the financier will be paid a prefixed amount in a future date. Debt payment will be made in by instalment through bond issues. The difference between cash and credit will be the profit.
To illustrate the basic feature of the Khazanah Islamic bonds, let us suppose that through the bidding process, a RM1000 bond at par value is sold at RM 800 per unit. For one million unit issues, the market value of the securitized asset is therefore RM 800 million while the buy-back price is 1billion. The return to investors is 200 million.
However, some objections have been raised against the Islamic zero coupon bonds because of its structure on the ground that such a transaction will result in bay' al inah and bay'al-dayn bi al-dayn traded at a discount which are considered as prohibited transactions by the majority of Muslim jurists. Some scholars of Malaysia have, however, allowed such deal. They refer to the ruling of Shafi'ite school wherein it is held that sale of debt is permissible. However the Islamic Fiqh Academy has unanimously voted for the prohibition of bai'-al-dain.
From the above it is clear that debt financing through Islamic sukuk issue is an effective means of resource mobilisation. The successful experiences in the Middle East, Pakistan and South East Asia show that Islamic sukuk have provided an avenue for Islamic investors to invest in shari'ah compliant investment schemes.
Islamic sukuk are attracting large investor volume with subscriptions exceeding expected issuance, even in big issues as is the case with the Government of Pakistan and Dubai Civil Aviation's issues.
In a recent forum on Islamic Finance in Dubai ( 13-15 March 2005) Dr Mohamaad Khalfan bin Kharbash, the UAE Minister of Financial and Industrial Affairs, clearly advocated that in line with the development of Islamic Banking, the growth of Islamic finance means sukuk.
The Minister also emphasised that the contributions from the non-Islamic institutions to Islamic issues have reached about 60 per cent of the amount issued.
However, this phenomenon requires more attention and effort from financial experts and Muslim religious scholars. Keeping in view the requirements of the modern financial system and the soaring market demand for Islamic sukuk, it is important that Muslim financial experts and jurists must intensify their efforts to explore the different forms of Islamic sukuk based on the acceptable types of Islamic commercial contracts.
(The writer is Economics Professor at the College of Islamic Banking, World Al Lootah University, Dubai.)
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