How Sukuk (Islamic Bonds) Differ from Conventional
BondsDefinition of SukukAn Islamic financial certificate, similar
to a bond in Western finance, that complies with Sharia, Islamic
religious law. Because the traditional Western interest paying bond
structure is not permissible, the issuer of a sukuk sells an
investor group the certificate, who then rents it back to the
issuer for a predetermined rental fee. The issuer also makes a
contractual promise to buy back the bonds at a future date at par
value.Sukuk represents undivided shares in the ownership of
tangible assets relating to particular projects or special
investment activity. A sukuk investor has a common share in the
ownership of the assets linked to the investment although this does
not represent a debt owed to the issuer of the bond.In the case of
conventional bonds the issuer has a contractual obligation to pay
to bond holders, on certain specified dates, interest and
principal. In contrast, under a sukuk structure the sukuk holders
each hold an undivided beneficial ownership in the underlying
assets.Consequently, sukuk holders are entitled to a share in the
revenues generated by the Sukuk assets. The sale of sukuk relates
to the sale of a proportionate share in the assets.Since the
beginning of 2000, sukuk have become important Islamic financial
instruments in raising funds for long-term project financing. The
first sukuk were issued by Malaysia in 2000, followed by Bahrain in
2001. Since then sukuk have been used by both the corporate sector
and states for raising alternative financing. While sukuk issuance
was affected by the global financial crisis, since 2011, sukuk have
been growing in popularityDefinition of Conventional Bonds A debt
investment in which an investor loans money to an entity (corporate
or governmental) that borrows the funds for a defined period of
time at a fixed interest rate. Bonds are used by companies,
municipalities, states and U.S. and foreign governments to finance
a variety of projects and activities.Bonds are commonly referred to
as fixed-income securities and are one of the three main asset
classes, along with stocks and cash equivalents.Rewarding Investors
for SukukWith sukuk, the future cash flow from the underlying asset
is transferred into present cash flow. Sukuk may be issued for
existing assets or for assets that will exist in the future.
Investors who purchase sukuk are rewarded with a share of the
profits derived from the asset. They dont earn interest payments
because doing so would violate sharia. Repurchasing Sukuk at
MaturityAs with conventional bonds, sukuk are issued with specific
maturity dates. When the maturity date arrives, the sukuk issuer
buys them back (through a middleman called a Special Purpose
Vehicle).However, with sukuk, the initial investment isnt
guaranteed; the sukuk holder may or may not get back the entire
principal (face value) amount. Thats because, unlike conventional
bond holders, sukuk holders share the risk of the underlying asset.
If the project or business on which sukuk are issued doesnt perform
as well as expected, the sukuk investor must bear a share of the
loss.Most sharia scholars believe that having sukuk managers,
partners, or agents promise to repurchase sukuk for the face value
is unlawful. Instead, sukuk are generally repurchased based on the
net value of the underlying assets (each share receiving its
portion of that value) or at a price agreed upon at the time of the
sukuk purchase.In practice, some sukuk are issued with repurchase
guarantees just as conventional bonds are. Although not all sharia
scholars agree that this arrangement complies with Islamic law, a
product called sukuk ijara may come with a repurchase
guarantee.Ensuring Sharia Compliance with SukukThe key
characteristic of sukuk the fact that they grant partial ownership
in the underlying asset is considered sharia-compliant. This ruling
means that Islamic investors have the right to receive a share of
profits from the sukuks underlying asset.Putting Bonds and Sukuk
Side-By-SideWhen you have the basics about how conventional bonds
and sukuk work, its time to put them next to each other. This table
offers a quick look at the key ways in which these investment
products compare.
Distinguishing Sukuk from Conventional BondsConventional
BondSukuk
Asset ownership
Bonds dont give the investor a share of ownership in the asset,
project, business, or joint venture they support. Theyre a debt
obligation from the issuer to the bond holder. Sukuk give the
investor partial ownership in the asset on which the sukuk are
based.
Investment criteria Generally, bonds can be used to finance any
asset, project, business, or joint venture that complies with local
legislation. The asset on which sukuk are based must be
sharia-compliant.
Issue unit Each bond represents a share of debt. Each sukuk
represents a share of the underlying asset.
Issue price The face value of a bond price is based on the
issuers credit worthiness (including its rating). The face value of
sukuk is based on the market value of the underlying asset.
Investment rewards and risks Bond holders receive regularly
scheduled (and often fixed rate) interest payments for the life of
the bond, and their principal is guaranteed to be returned at the
bonds maturity date. Sukuk holders receive a share of profits from
the underlying asset (and accept a share of any loss incurred).
Effects of costs Bond holders generally arent affected by costs
related to the asset, project, business, or joint venture they
support. The performance of the underlying asset doesnt affect
investor rewards. Sukuk holders are affected by costs related to
the underlying asset. Higher costs may translate to lower investor
profits and vice versa.
References Investopedia. Definitaion. Retrieve from
http://www.investopedia.com/terms/s/sukuk.asp Definition of sukuk
(Islamic bonds). Retrieve from
http://lexicon.ft.com/Term?term=sukuk-%28Islamic-bonds%29
Investopedia. Definitaion. Retrieve from
http://www.investopedia.com/terms/b/bond.asp Dr. Faleel Jamaldeen.
Islamic Finance for Dummies. Retrieve from
http://www.dummies.com/how-to/content/how-sukuk-islamic-bonds-differ-from-conventional-b.html
