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The Potential and Risk of Sukuk 2011
1.0 Introduction
In the modern economy, debt market and bonds are an integral part of the financial sector and
effectively supplement the funds provided by the banking sector. From the conventional
perspective, bonds can be defined as a long-term contract under which a borrower agrees to
make payment of interest and principal, on specific dates, to the holders of the bonds. (Brigham,
E. C. and Ehrhardt, M. C., Financial Management, 11th ed., 2005)
According to Longman, bonds are actually certificates or documents of debt issued by a
government or an organization for an amount of money they borrow from the bondholders,
promising them that it will pay back the money it has borrowed, usually with interest. (Longman,
Business English Dictionary, 2000)
1.1Introduction of Sukuk
Sukuk, plural of ‘Sakk’ means “legal instrument, deed or check”. Sukuk 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 descrived as an asset-based
investment, as the investor owns an undivided interest in an underlying tangible asset which
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 the Sukuk notes are used to invest in an underlying asset,
a trust is declared over that particular asset and thereby the certificate holder will own 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 (Mohamed Z., Azmi & Associate, 2010)
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The Potential and Risk of Sukuk 2011
1.2History of Sukuk
In classical period Islam sakk (sukuk) & ndash; which is cognate with the European root
"cheque" (which itself derives from Persian)- meant any document representing a contract or
conveyance of rights, obligations or monies done in conformity with the Shariah. Empirical
evidence shows that sukuk were a product extensively used during medieval Islam for the
transferring of financial obligations originating from trade and other commercial activities.
The essence of sukuk, in the modern Islamic perspective, lies in the concept of asset
monetization - the so called securitization - that is achieved through the process of issuance
of sukuk (taskeek). Its great potential is in transforming an asset & future cash flow into
present cash flow. Sukuk may be issued on existing as well as specific assets that may
become available at a future date. (aibim.com)
1.3History Sukuk in Malaysia
The roots of Sukuk in Malaysia are embedded in the Islamic banking and financial system. It
began in 1973 with the establishment of Tabung Haji (Pilgrims Fund), the country’s first
Islamic financial institution.
A decade later, Bank Islam Malaysia became the first full-fledged Islamic commercial bank
in Malaysia. In 1993, the government took another bold step and introduced the Interest
Free Banking Unit (IBU), which is an Islamic window within existing commercial banks. IBU
allows the parallel existence of conventional and Islamic banking systems in a bank.
The Islamic money market was established in 1994 as the final major requirement for a
complete Islamic banking system. It currently serves as a place to trade Islamic financial
instruments. In addition, the establishment of a National Shariah Council, a single source of
2
The Potential and Risk of Sukuk 2011
reference to advice on the legality and compliance of Islamic financial instrument
transactions with the Shariah, streamlined the development process.
The first Sukuk issuance in Malaysia was for Shell MDS in 1990. A syndicate of financiers
arranged a Bai Bithaman Ajil transaction of RM75 million (US$22 million) for a tenure of five
years, and another RM50 million (US$14.73 million) for eight years.
The next notable development was the RM300 million (US$88.42 million) Sukuk issuance by
Petronas Dagangan in 1994. The first Sukuk in Malaysia to be rated, it was assigned a long-
term AA1 rating by Rating Agency Malaysia (now known as RAM Rating Services) in
February 1994. It was also the first Islamic instrument to be listed on the Kuala Lumpur
Stock Exchange (now Bursa Malaysia).
The Islamic financial market is one of the fastest-growing capital pools, and is quickly being
drawn into the mainstream of the financial system. The Malaysian Sukuk market has
successfully outgrown its infancy phase.
The viability of Islamic finance is no longer an issue as the success of the domestic Sukuk
market within a short period is testimony of the widespread acceptance of Islamic financing
principles in the country. In Malaysia, Sukuk constituted 34.24%, or RM212.11 billion
(US$62.5 billion) of RM619.53 billion (US$182.58 billion) total outstanding debt securities as
at the 30th June 2008.
Sustaining such growth requires a good legal and price discovery mechanism to enable
market participants to be updated on valuation levels and their rights. In this regard,
Malaysia has a good legal framework in place, which has shown its impartiality. However,
the issue of valuation remains a grey area.
In marking-to-market using market price, the last transacted price of the instrument is taken.
Market price is reliable only in an efficient market where information infrastructures are
3
The Potential and Risk of Sukuk 2011
established and liquidity is sufficient. In the bond and Sukuk markets, less than 1% of bonds
is traded on a daily basis.
Furthermore, bonds and Sukuk that were traded may encounter the next trade only after
several weeks or months. Hence, the last traded price may no longer reflect the bond’s true
value as certain pricing factors, such as interest rate and credit environment, have lapsed.
Due to the low level of liquidity in the bond and Sukuk markets compared to the equity
market, the ability of players to obtain market prices is extremely difficult.
Moreover, the “non-independence” of traditional sources of bond and Sukuk prices in
Malaysia, as well as the lack of a comprehensive set of rules and regulations regarding the
origination and usage of generated bond and Sukuk prices, create a situation of information
asymmetry between market players.
Despite the market growing to a substantial size, the ability of market players to obtain
independent pricing as well as to compare and evaluate the portfolio performance of fund
managers comes close to impossible. To eliminate this impediment to the bond and Sukuk
markets, the Securities Commission of Malaysia (SC) decided to create a new capital
market infrastructure: the bond pricing agency.
2.0 Types and Principles of Sukuk and Bonds
2.1Types of Sukuk and Bonds
2.1.1 Types of Sukuk
Sukuk can be of many types depending on the type of Islamic modes of financing
and trades used in its structuring. The following are the common types of Sukuk:
4
The Potential and Risk of Sukuk 2011
2.1.1.1 Sukuk Ijarah
This is one of the most common Sukuk issuance types, especially for project
finance. Sukuk Ijarah is a leasing structure coupled with a right available to
the lessee to purchase the asset at the end of the lease period. The
certificates are issued on stand-alone as sets identified on the balance sheet.
The rentals rated of return on these Sukuk can be fixed or floating depending
on the agreement. The cash flow from the lease including rental payments
and principle repayments are passed through to inventors in the form the
lease including rental payments and principle repayments are passed through
to investors in the form of coupon and principle payments. The Sukuk Ijarah
provides an efficient medium-to-long term mode of financing.
2.1.1.2 Sukuk Mudharabah
This is an agreement made between a party, who provides the capital and
another party (an entrepreneur), to enable the entrepreneur to carry out
business projects, which will be on a profit sharing basis, according to
predetermined ratios agreed on earlier. In the case of losses, the losses are
born by the provider of the finds only. Sukuk Mudharabag are used to
enhance public participation in big investment projects.
2.1.1.3 Sukuk Musharakah
These are investment Sukuk that represent ownership of Musharakah equity.
The structure of musharakah requires that both parties provide financing to the
projects. In case of losses, both parties will lose 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, or to finance a business activity on the
basis of partnership contrats.
2.1.1.4 Sukuk Istisna’
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The Potential and Risk of Sukuk 2011
This type of Sukuk has been used for the advance of funding for real estate
development, major industrial projects or latge items of equipment such as
turbines, power plants, ships or aircraft (construction / manufacturing financing)
(Mohamed Z., Azmi & Associate, 2010).
2.1.2 Types of Bonds
Bonds can be of many types depending on the type of conventional bonds modes of
financing and trades used in its structuring. The following are the common types of
Bonds:
2.1.2.1 Zero-coupon Bond
Zero coupon bonds are bonds that do not pay interest during the life of the
bonds. Instead, investors buy zero coupon bonds at a deep discount from
their face value, which is the amount a bond will be worth when it "matures"
or comes due. When a zero coupon bond matures, the investor will receive
one lump sum equal to the initial investment plus the imputed interest, which
is discussed below.
The maturity dates on zero coupon bonds are usually long-term—many don’t
mature for ten, fifteen, or more years. These long-term maturity dates allow
an investor to plan for a long-range goal, such as paying for a child’s college
education. With the deep discount, an investor can put up a small amount of
money that can grow over many years.
(http://www.sec.gov/answers/zero.htm)
2.1.2.2 Government Bond
A debt security issued by a government to support government spending,
most often issued in the country's domestic currency. Government debt is
money owed by any level of government and is backed by the full faith of the
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The Potential and Risk of Sukuk 2011
government. Federal government bonds in the United States include: the
savings bond, Treasury bond, Treasury inflation-protected securities (TIPS),
and others. Before investing in government bonds, investors need to assess
several risks associated with the country such as: country risk, political risk,
inflation risk, and interest rate risk.
Lending to a national government in the country's own sovereign currency,
government bonds, are free of credit risk, because the government can raise
taxes or simply print more money to redeem the bond at maturity. But this
does not mean risk-free. (http://www.investopedia.com)
2.1.2.3 Corporate Bond
A debt security issued by a corporation and sold to investors. The backing for
the bond is usually the payment ability of the company, which is typically
money to be earned from future operations. In some cases, the company's
physical assets may be used as collateral for bonds.
Corporate bonds are considered higher risk than government bonds. As a
result, interest rates are almost always higher, even for top-flight credit quality
companies. (http://www.investopedia.com)
2.1.2.4 Municipal Bond
Municipal bonds (also known as “munis”) are attractive to many investors
because the interest income is exempt from federal income tax and in many
cases, state and local taxes as well. In addition, munis often represent
investments in state and local government projects that have an impact on
our daily lives, including schools, highways, hospitals, housing, sewer
systems and other important public projects.
(http://www.investinginbonds.com/learnmore)
2.2Principles of Sukuk and Bonds7
The Potential and Risk of Sukuk 2011
2.2.1 Principles of Sukuk
2.2.1.1 Requirement of underlying asset
Under `uqud mu`awadhat or contracts of exchange (such as bai` bithaman
ajil, murabahah, istisna` and ijarah), an asset, whether tangible or intangible,
must be made available for sukuk to be issued subject to the following:
The underlying asset and its use must comply with the requirements of
Shariah.
An encumbered asset, such as an asset charged to a financial institution, or
an asset that is jointly-owned with another party, can only be used as
underlying asset provided the issuer has obtained consent from the chargee
or joint-owner.
Where receivables are used as the underlying asset, they must be mustaqir
(established and certain) and transacted on cash basis (on spot).
2.2.1.2 Asset pricing
Sukuk under`uqud mu`awadhat involves the sale and purchase of underlying
assets. When the investors purchase the underlying assets, the purchase
price must comply with the following SAC pricing guidelines:
The purchase price should not exceed 1.51 times of the market value of the
asset.
In cases where the market value of a particular asset could not be
ascertained, a fair value or any other value must be applied.
2.2.1.3 Ibra’ (Rebate)
Provision for ibra’ may be stipulated in the primary legal document provided
that such provision shall not be part of the pricing section.
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The Potential and Risk of Sukuk 2011
Through the application of ibra’, variable rate mechanism may be applied to
sukuk BBA, murabahah and istisna` which may be benchmarked to the
prevailing market rates.
2.2.1.4 Ta`widh (Compensation)
Ta`widh is permissible under both `uqud mu`awadhat and `uqud ishtirak only
in the event of delay in payment. However, under `uqud ishtirak, ta`widh is
limited to the failure of the issuer/obligor to distribute the realised profit on
time. Ta`widh does not apply to expected profit.
The rate of ta`widh should be as prescribed by the SAC from time to time and
is available on the Islamic Capital Market section of the SC website.
2.2.2 Principles of Bonds
2.2.2.1 All projects in the bond bill must be accomplished and must be completed
within the scope and within the budget as identified in the bond bill.
2.2.2.2 The additional 5% in funding that is intended to cover project management
costs and inflationary increases should be reserved in a separate line item in
each individual capital improvement project’s budget. The 5% will be held in
reserve, and should not be included in the dollar amounts available for
design, construction, contingencies, or equipment.
2.2.2.3 Only the General Assembly has the authority to alter the project list, including
any deletions.
2.2.2.4 All bond projects are equally important and no project should be inordinately
impacted by inflation simply because of its place in the overall sequence.
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The Potential and Risk of Sukuk 2011
2.2.2.5 Each campus and affiliate should have an official project description and cost
estimate for each bond project. As needed, each campus should consult with
the Office of State Construction in the North Carolina Department of
Administration to define the project scope and estimated cost. Information
used to develop the official scope and cost estimate should be consistent with
the UNC Capital Study.
2.2.2.6 Each campus and affiliate, in conjunction with the Office of the President,
should prepare a spending plan to fully implement the bond bill package. At
the appropriate time and after consultation with the Board of Governors,
modifications can be considered to transfer savings achieved from projects
expedited in the early years of the plan to projects planned for the out-years
to mitigate inflationary impacts or other necessary changes.
2.2.2.7 In cases where a bond project will use not-state funds to supplement funds
appropriated in the bond bill, funds authorized in the bond bill should be spent
first, unless this is found to be inconsistent with other state policies or
procedures.
2.2.2.8 Funds included in the bond bill, as a Reserve for Repairs and Renovations
and Cost Overruns, will be placed in a reserve in the Board of Governors’
capital improvement budget code. The Board of Governors will determine use
of these reserve funds, subject to approval of the Director of the Budget.
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The Potential and Risk of Sukuk 2011
3.0 The differentiate between Sukuk and Bonds
Beside Sukuk is followed by Islamic finance terms and Bond is followed by conventional finance
term, there have many other different in order to show sukuk is not only term
Sukuk Bonds
Sukuk represent ownership stake in an
underlying asset.
Sukuk are financial fixed income certificates
that are permissible within the provisions of
Islamic Sharia law as they are raised on
trading in, or construction of, specific and
identifiable assets [rather than being
interest based like bonds].
The income from Sukuk is related to the
original legal contract that governs the
relationship between the Sukuk provider
and the customer [owner of the Sukuk].
A bond represents the issuer’s pure debt.
Bonds are securities in the form of a debt
that will be paid back before a certain date,
termed the date of maturity, in addition to
interest [on this debt]. In short, a bond is a
debt security in which borrowed money is
repaid along with interest at a fixed rate.
Bonds also include a fixed rate of interest
regardless of loss or gain
*Sources: http://www.asharq-e.com/news.
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The Potential and Risk of Sukuk 2011
4.0 Potential of Sukuk
The global Islamic financial sector has witnessed an encouraging growth over the last decade
and is currently estimated to be at around US$1trillion. It is predicted to be the world’s fastest-
growing financial sector for the coming years with an estimated global potential of US$4trillion.
Sukuks have turned out to be an important driver to raise finance under the Islamic mode of
financing. In today’s business practice, the term Sukuk means a claim similar to that
represented by a trust certificate. In essence, the Sukuk is a financial instrument that sits above
a Shari’ah-compliant underlying structure which generates an income for the holder of the
instrument. Islamic finance has many qualities that could lend themselves to securitization as a
means of raising funds. Shari’ah compliant tools must have asset-driven returns for example,
which is a notable feature of securitization. (http://www.sukuk.me/news/articles/73/Global-
sukuk-markets.html)
4.1The Development of Islamic Finance Industry
The growing role of Islamic finance in mobilizing and channeling funds to productive
investment activities across borders contributes to more efficient allocation of funds across
borders and facilitates international trade and investment. Greater diversification of risk also
contributes towards promoting international financial stability. The more recent development
in Islamic finance is the growing significance of the Sukuk market to become an increasingly
important component of the Islamic financial system. Five major trends are having a
significant bearing on the future development of the global Sukuk market.
Firstly, the bond market is now becoming key to meeting the funding requirements for both
the public and private sectors in emerging market economies. This is particularly the case
for the Middle East and Asia, which are among the fastest-growing regions in the global
12
The Potential and Risk of Sukuk 2011
economy. This includes financial needs of the private sector following the privatization and
implementation of infrastructure projects. The development of the Sukuk market will provide
opportunities for the corporate sector, the government agencies, multinational corporations
(MNCs) and multinational development institutions to raise funds through the issuance of
Sukuk to meet their financing requirements. The Sukuk market also serves as an important
platform, complementing the conventional bond market in enhancing the effectiveness and
efficiency for the mobilization and allocation of funds within the domestic financial system,
as well as in the international financial system.
Secondly, while there has been growing interest in the issuance of Sukuk by corporations,
sovereigns and MNCs, the demand for Sukuk significantly exceeds the supply. Today, the
global Sukuk market, denominated in international currencies, is estimated to exceed
US$50 billion. Although the size of the market is modest by global standards, the Sukuk
market is experiencing remarkable growth, increasing at an average rate of growth of 40% a
year.
The significant demand for Sukuk has also been spurred by the high levels of surplus
savings and reserves in Asia and in the Middle East. This has been reinforced by increased
liquidity in the international financial system in search of higher returns and greater
diversification of risk. Since the issuance of the first sovereign global Islamic Sukuk by the
government of Malaysia in 2002, there has been a series of other issues by the
governments of the United Arab Emirates, Qatar, Bahrain and Pakistan. An increased
number of multilateral agencies have also issued Sukuk to finance development projects. In
addition, both government agencies and the corporate sector have considered the Sukuk
market as an attractive financing instrument.
Thirdly, there are a great number of global players such as investment banks, Islamic banks
and securities firms that are involved in the issuance of Sukuk in the international financial
markets. A large number of western banks are also providing Islamic financial services
13
The Potential and Risk of Sukuk 2011
taking advantage of the opportunities and to provide customized products and services to
their customers.
Fourthly, the established international financial centers have also shown interest in
promoting the development of the Sukuk market including enacting the appropriate
legislative provisions. These developments would augur well for the development of the
Sukuk market.
Finally, the regulatory and supervisory paradigm continues to evolve. Indeed, the recent
decade has witnessed significant global shifts in the approach to regulation and supervision
across many countries. In addition, the harmonization of standards and practices is also
important. The establishment of the international standard setting organizations, such as the
Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organization for
Islamic Financial Institutions (AAOIFI), to formulate appropriate prudential and accounting
standards that not only facilitate the process of harmonization but also contribute to the
strengthening of the Islamic financial system. IFSB has already formulated the prudential
treatment for Sukuk investment by the Islamic financial institutions as stipulated in the
capital adequacy standards.
The Islamic finance industry is growth rapidly with the current positioning which, in Middle
East and North Africa have 204 million Muslims from GCC countries like, UAE, Iran and
Egypt where this is 13% of total Muslim population in the world. GCC countries (excluding
Oman) have 17 commercial banks offering Islamic banking and the AUM is USD100 billion.
In South East Asia have 16 million Muslims in Malaysia and 195 million Muslims in
Indonesia and 13% of total Muslim population in the world. Malaysia has AUM USD31 billion
and the Islamic money market in Malaysia ranging from USD8 – 12 billion monthly. There
had issued 60% of the world’s Sukuks in 2006.
14
The Potential and Risk of Sukuk 2011
Have also 439 million Muslims in India, Pakistan and Bangladesh and 16 million Muslims in
United Kindom, United State, Germany and France where it accounted for 41% of the total
Muslim population in the world. (Overview of Islamic Finance, Grail Research, 2007.)
This can be seen comparison of the sukuk market in Malaysia ad the biggest issuer in the
world and sukuk market in the United Kindom to see how far the development of the global
sukuk market.
4.1.1 The Potential of Sukuk Market in Malaysia
Significant progress has been achieved in the development of the Malaysian Sukuk
market. In 2007, Malaysia accounted for about two-thirds of the global Sukuk
outstanding, amounting to about US$47 billion. Malaysia not only represents the
largest Sukuk market in terms of outstanding size, but also in terms of number of
issuance.
In developing the Sukuk market, Malaysia provides a total solution for Sukuk
activities by offering a complete Sukuk issuance and trading platform, supported by
four elements: a wide range of Islamic instruments, strong legal and regulatory
infrastructure, sound Shariah governance framework and talent supply. These
elements are also further strengthened by Malaysia’s comprehensive Islamic
financial system with all the key components of the financial system comprising the
Islamic banking, Takaful, Islamic money and capital markets that are now at an
advanced stage of development. These different parts of the Islamic financial
system not only facilitate the issuance and the distribution of the papers but also
create a strong demand for Sukuk by providing a broad investor base.
There is also a variety of Islamic instruments in the Sukuk market in Malaysia that
include currency swaps and Islamic forward contracts available to facilitate hedging
and other risk management activities. The Malaysian Sukuk market is also
15
The Potential and Risk of Sukuk 2011
supported by appropriate rules and regulations, and by the pool of experienced
global and domestic players as well as the legal and accounting professionals
including legal and tax consultancies, as well as documentation in the issuance and
trading exercise.
Malaysia aim to be as an international Islamic Financial Center (MIFC) , thus
develop Malaysia into a center for the origination, distribution and trading of Sukuk
to provide further impetus to the development of an increasingly vibrant and
progressive bond market in Malaysia as well as in the Asian region. This would
reinforce the international dimension of the Sukuk market in Malaysia by providing
linkages with international issuers and investors. To deepen and widen the bond
and Sukuk markets, Malaysia has further liberalized the foreign exchange
administration rules to allow multilateral financial institutions, MNCs and other
national corporations to issue both ringgit and non-ringgit denominated instruments
in capital market. Malaysia also has in place the financial infrastructure and
facilitative rules that contribute towards efficient price discovery and shorter time to
market, thus providing an efficient platform for Sukuk issuance and trading
activities. The established legal, regulatory and Shariah framework in the Islamic
financial infrastructure in Malaysia is reinforced by the supporting financial
infrastructure, including the settlement and bond information system.
To facilitate an efficient Sukuk issuance process in Malaysia, an MIFC one-stop
center is being established as a single contact point for efficient delivery process to
facilitate the issuance of Sukuk. To further facilitate this process, there is no
restriction on the ability to use international rating services, on the ability to hedge
positions and on the ability to swap issuance proceeds into foreign currency.
As part of ongoing efforts to position Malaysia as an attractive gateway for the
issuance of Sukuk, a number of legal and regulatory requirements are further
customized to reduce the cost of Sukuk issuance. Profits and dividends received by
16
The Potential and Risk of Sukuk 2011
non-resident investors from holding of ringgit and non-ringgit Islamic instruments
issued in Malaysia are exempted from withholding tax. Special Purpose Vehicles
(SPVs) for Islamic financing purposes via the Islamic capital market are not subject
to the administrative procedures under the Income Tax Act 1967. In addition,
companies that establish these SPVs are given a tax deduction on the issuance
cost of the Islamic securities incurred by the SPV. The issuance cost for all Islamic
securities approved by the Securities Commission is also eligible for tax deduction.
Finally, there is a stamp duty exemption for 10 years on instruments relating to
Islamic securities under the MIFC. These initiatives have positioned Malaysia as a
competitive and attractive Sukuk market in the global arena.
Malaysia has also put in place an efficient platform for trading of bonds including the
Real-time Electronic Transfer of Funds and Securities System (RENTAS), Fully
Automated System for Issuance/Tendering (FAST), and Bond Information and
Dissemination System (BIDS) to provide post-trade transparency and market
liquidity on par with developed markets. Malaysia also has a payment system link
with the Hong Kong Monetary Authority on US dollar settlements, while Malaysian
government securities can be cleared with Euroclear.
Finally, a conducive environment for innovation has been put in place. In 2006, the
Malaysian market continued to generate innovative products with the launch of
Sukuk using Mudarabah, Musharakah and Ijarah. Landmark issuances, such as the
exchangeable Sukuk Musharakah by Khazanah Nasional, marked the world’s first
issue of its kind, incorporating full convertibility features common to conventional
equity-linked transactions.
4.1.2 The Potential of Sukuk Market in United Kingdoms
A recent report from Ernst & Young (E&Y)2 shows that between 2007 and 2009
sukuk are still largely originated from Malaysia and the GCC. Issuance from other
17
The Potential and Risk of Sukuk 2011
jurisdictions such as Indonesia is increasing, but at this point in time still negligible.
Figure 1 below shows how the issuance compares geographically. (E&Y Islamic
Funds and Investments Report, 2009)
The exact potential size of the market is difficult to determine, mainly as a result of
the fact that the instrument is still relatively new and the number of European listed
issues is still fairly low. However, given the characteristics defined in the previous
section, 69% of the investment professionals that have responded to the survey have
indicated that they would consider investing in a European Sukuk issue.
Like any other bond, the issue would have to fit within the overall portfolio and meet
the investment requirements associated with, among others, issuer, credit quality
and size. The total demand depends on the investor and is often associated with a
percentage of the issue size or a percentage of their total holding. The fact that the
market is still relatively young has an impact on the perceived risk levels and
available liquidity which are in turn reasons to approach investing in a Sukuk with
caution.
The potential demand is currently still difficult to assess due to the fact that the
market is still relatively young and the total outstanding amount of Sukuk is small
compared to the overall bond market. However, where a few years ago the majority
of respondents would not have heard of Sukuk, we found that in excess of 85% of
the respondents have heard about the instrument and in excess of 50% has invested
in them. (European Sukuk Issue, 2010)
18
The Potential and Risk of Sukuk 2011
5.0 Risk of Sukuk
5.1Risk-Rewards Sharing
The development of Islamic Financial products that provides impetus to the economic
machinery of a country are no doubt a pleasant initiative. Whether the new Ijara’h based and
Murabaha – based trading contracts have led the Islamic financial institutions to introduce
Islamic financial dealings in banking, or the fine tuning of these and other transactions to
ensure Sharia’h compliance, these are welcome signs. Sukuk as equity scrips simply, open
huge possibilities to explore and adapt, with the Sharia’h permissibility (of course, inclusive
of fair play and justice to the parties involved). Though currently operating mostly at
institutional and sovereign level, with the volumes of transactions breaking the previously set
records, quite often, these can also be utilized for small scale investment needs, if the
operational costs can be met easily. Sukuk have the flexibility to mould the financial
requirements and investment opportunities according to the Sharia’h requirements, as well
as meeting the requirements of investments (demand and supply side). More importantly,
these instruments have provided an alternate choice to the market in the form of non-debt
based ( like Ijarah sukuk) and equity –based and other quasi-equity investments that can
also be availed productively However, in the conventional finance perspective , many of the
sukuk structures are still considered as an “Islamic Debt structure”, especially in regulatory
treatment. (Jabeen Z. & Javed M. T., 2007)
5.2Relative Risk Of Sukuk Over Bonds
The governments bonds are always considered to be safe, liquid and in terms of return they
provide a lower yield. The sukuks are growing fast along with the government and
conventional bonds. The sukuks invest money as per Shariah principles in halal businesses
as such they are safer when compared to the conventional bonds. When empirically
analysed for sukuks’ riskinessthe results reveal that they are m oderately risky than
government bonds and less risky than conventional bonds. As risk and return are positively
correlated the sukuks provide a lower return. These results support the popularity of the
19
The Potential and Risk of Sukuk 2011
sukuks though yield is less due to their less risky nature. All these results imply that the
sukuks are more apt investment for risk averters, whether they follow Islam or any other
religion. Investors who choose bond market for investment will be normally risk averse else
they will go to stock market which is more risky and with better YRs. (Ramasamy R.,
Munisamy S., M. Helmi M. H., 2011)
5.3Risk Assessment of Sukuk
The market for Sukuk certificates continues to grow and an important facet of this growth is
the increased number of sovereign issuances typified by those issued by Malaysia, Bahrain
and Qatar and, interestingly, Saxony-Anhalt in Germany. These certificates are appealing to
global investors without having too much bearing on the underlying ‘Islamicity’ of the
certificates. Accordingly, Islamic secondary markets receive a boost because such
sovereign issuances and the subsequent attraction of global investments encourage
increased corporate confidence in their private issuances. Nevertheless, Ijarah Sukuks
continue to prevail as the most popular manifestation of Sukuk certificates. This is largely in
part to their unambiguous Shari’ah conformity and familiar leasing formulae. However,
leasing contracts on underlying real estate properties cannot single-handedly support the
growing diversity of Sukuk investors. With increased global investors there will be a myriad
of investment needs and thus other avenues of Sukuk issuances should be implemented to
satisfy these demands. Istisnaa, Mudarabah and Musharakah certificates are established as
part of the AAOIFI standard and can be garnered to offer a plethora of Sukuk structures.
The recent Sukuk issuance by the Islamic Development Bank serves as an excellent case
study in this regard with their Shari’ah compliant diversity of investments.
With the rapid emergence of Sukuk markets, risk management considerations have also
come to the vanguard of the industry. Novel financial instruments bring with them original
financial risks. An analogous situation represented itself in conventional financial markets in
the early 80s with the emergence of interest rate derivatives to hedge against the financial
risks of bonds. With the globalization of financial markets and increased convergence of
Islamic finance and conventional markets, indirect interest rate effects as well as other
20
The Potential and Risk of Sukuk 2011
financial risks will necessitate the development of Islamic financial risk management
techniques. Derivatives are inherently against Shari’ah considerations because of the
uncertainty associated with them that amounts to Gharar. However, we have discussed the
possibility of extending the functions of embedded options to fit the needs of Sukuk
certificates and Shari’ah considerations. This facility provides a debt structure framework
that helps replicate the functions of traditional instruments and in turn benefit from the
convexity gains of these instruments. Neftci and Santos (2003) identify two major hurdles in
emerging markets for acquiring convexity gains. Firstly, there are no markets for liquid
interest rate derivatives. Secondly, interest rate fluctuations lead to significant increases in
credit risk and lower the bond’s price. Accordingly, investors in emerging markets suffer from
the negative effects of volatilities but cannot benefit from the positive effects. Such benefits
have been garnered in conventional emerging markets such as Brazil where interest rate
volatilities in the 90s warranted a protective cushion against these fluctuations in the form of
puttable and callable bonds. These debt structures can be transferred to the Sukuk
issuances in accordance to outstanding Shari’ah concerns. (Tariq A. A., 2004)
5.4Sukuk vs. Eurobonds: Value-at-Risk Different
The market for Sukuk2 has grown tremendously in recent years, from less than $8 billion in
2003 to $50 billion by mid-2007. Sukuk provide sovereign governments and corporations
with access to the huge and growing Islamic liquidity pool, in addition to the conventional
investor base. The structure of Sukuk is now well established in several corporate and
sovereign/supranational issues in the international bond markets.
Sukuk are in many aspects similar to conventional Eurobonds. Sukuk are also considered to
serve as security instruments that provide a predictable level of return (fixed or floating);
they are traded in the secondary market albeit less than conventional bonds; they are
assessed and rated by international rating agencies; and are mostly cleared under
Euroclear (listed in Luxemburg). The convergence between Islamic and conventional
21
The Potential and Risk of Sukuk 2011
finance, particularly in the case of Sukuk, is gaining momentum as foreseen by several
scholars (Mirakhor 2007).
This said, there are certain differences between conventional bonds and Sukuk. A bond
represents the issuer’s pure debt, while Sukuk represent ownership stake in an underlying
asset. For example, an Ijarah (lease) contract that is often used to structure sovereign
Sukuk creates a lessee/lessor relationship which is different than a lender/borrower
relationship. Investor protection mechanisms for Sukuk remain largely untested. Taxation
could also become an issue for certain investors where the legal basis for taxation of Islamic
securities is not legislated in the home country (Thuronyi, 2007). (Cakir S. & Raei F., IMF
Working Paper, 2007.)
22
The Potential and Risk of Sukuk 2011
6.0 Conclusion
Sukuks can be used very effectively
23
The Potential and Risk of Sukuk 2011
Reference
1. E&Y Islamic Funds and Investments Report 2009
2. Cakir S. & Raei F., IMF Working Paper, 2007
3. European Sukuk Issue, 2010
4. http://www.bloomberg.com/news/2011-10-07/malaysian-islamic-banking-assets-rise-15-percent-
to-123-billion.html
5. http://cms.sb24.com/modules/news/EnglishNews/news10.html?uri=/en/index.html
6. http://cms.sb24.com/modules/news/EnglishNews/news10.html?uri=/en/index.html
7. http://www.mifmonthly.com
8. http://www.sc.com.my
9. Ramasamy R., Munisamy S., M. Helmi M. H., Global Journal of Management and Business
Research, 2011
10. Tariq A. A., Managing Financial Risks Of Sukuk Structures, 2004
11. Jabeen Z. & Javed M. T., Sukuk-Structures An Analysis Of Risk-Reward Sharing And Wealth
Circulation, 2007
24
The Potential and Risk of Sukuk 2011
Appendix
12. 2010 LIST OF SUKUK APPROVED BY SC
Qtr No. Issuer Shariah Principle Size of Issues
(RM mil)
Q1 2010 1. Haluan Gigih Sdn Bhd Musharakah 240.00
2. Lafarge Malayan Cement Berhad Murabahah 350.00
Q2 2010 1. Cagamas Berhad Ijarah, Wakalah, Bai
Bithaman Ajil
5,000.00
2. CJ Capital Sdn Bhd Musharakah 114.00
3. Kencana Petroleum Berhad Mudharabah 250.00
4. LBS Bina Group Berhad Mudharabah, Murabahah 135.00
5. Maju Expressway Sdn Bhd Musharakah 550.00
6. New Pantai Expressway Sdn Bhd Bai Bithaman Ajil 74.00
7. Padiberas Nasional Berhad Musharakah 750.00
Q3 2010 1. AmIslamic Bank Berhad Musharakah 3,000.00
2. Bank Pembangunan Malaysia
Berhad
Tawarruq 2,000.00*
3. Celcom Transmission (M) Sdn Bhd Ijarah 4,200.00
4. Malaysia Airports Capital Berhad Ijarah 3,100.00
* Combined issue size limit of RM2.0 billion with Conventional Commercial Papers
Programme
Q4 2010 1. Aman Sukuk Berhad Musharakah 10,000.00
2. Alluvium Berhad Ijarah 615.00
3. Gamuda Berhad Musyarakah, Murabahah 800.00
4. KNM Group Berhad Musharakah 1,500.00
5. Konsortium Lebuhraya Utara-Timur
(KL) Sdn Bhd
Musharakah 820.00
6. Point Zone (M) Sdn Bhd Murabahah 500.00
7. Senai-Desaru Expressway Berhad Ijarah 5,580.00
8. TTM Sukuk Berhad Commodity Murabahah 750.00
25
The Potential and Risk of Sukuk 2011
Table 1: Top 20 Corporate Issuers as on June 2010 (RM billion)
Issuer CBs Sukuks Con. MTN
Islamic MTN Total
Cagamas — — 9.30 8.85 18.15
Khazanah — 13.20 — — 13.20
Binariang GSM — 3.17 — 8.28 11.45
Project Lebuhraya — 6.57 — 3.68 10.25
Prasarana 5.11 2.00 — 2.00 9.11
Maybank 6.10 2.50 — — 8.60
Rantau Abang Capital Bhd — — — 8.00 8.00
Malakoff Corp — 1.70 — 5.60 7.30
KL International Airport 1.60 4.76 — — 6.36
AM Bank 1.60 — 4.33 — 5.93
Value Cap 5.10 — — — 5.10
1 Malaysia Development Bhd. — — — 5.00 5.00
Jimah Energy Ventures — — — 4.77 4.77
Tanjung Bin — — — 4.59 4.59
Bank Pembangunan Malaysia 1.00 — 2.60 0.90 4.50
Putrajaya Holdings — 1.70 — 3.65 5.35
YTL Power International 2.20 — 1.70 — 3.90
Tenaga Nasional 1.50 2.15 — — 3.65
Danga Capital — — — 3.60 3.60
RHB Bank 0.60 — 3.00 — 3.60
Total 24.81 37.75 20.93 58.91 142.40
Total Outstanding 63.48 70.47 45.48 89.40 294.65
Top 20 as % of Outstanding 39.10% 53.60% 46.00% 65.90% 48.30%
Source: Bank Negara Malaysia Fully Automated System for Issuing/Tendering (FAST).
Types of Sukuk
Description of
Sukuk structure Credit Risk
Rate of return (Interest rate
risk) FX risk Price risk Other risks
Zero coupon
Sukuk Istisna’, Murabahah debt certificates –
Unique basis of credit risks exist, see, Khan and
Very high due to fixed rate, remains for
If all other conditions are similar, FX risk
Price risk relates to the prices of the
Liquidity risk is serious as far as thenon-tradable
26
The Potential and Risk of Sukuk 2011
non-tradable Ahmed (2001)
the entire maturity of
the issue
will be the same for all cases of Sukuk. However, those Sukuk which are liquid or which are relatively short term in nature will be less exposed. The composition of assets in the pool will also contribute to the FX risk in different ways. Hence this can be very useful tool to overcome the FX risk by diversifying the pool in different
currencies.
underlying commodities and assets in relation to the market prices. Ijara Sukuk are most exposed to this as the values of the underlying assets may depreciate faster as compared to market prices. Maintenance of the assets will play an important part in this process. Liquidity of the Sukuk will also play an important part in the risk. Salam is also exposed to serious price risks. However, through parallel contracts these risks can be
overcome
Sukukare concerned. Business risk of the issuer is an important risk underlying Sukuk as compared to traditional fixed incomes.
Shari’ah compliance risk is another one unique in case of Sukuk. Infrastructure rigidities, i.e., non-existence of efficient institutional support increases the risk of Sukuk as compared to traditional fixed incomes, see Sundararajan, &
Luca (2002)
Fixed Rate
Ijara Sukuk
Securitized Ijara, certificate holder owns part of asset or usufructs and earns fixed rent -
tradable
Default on rent payment, fixed rate makes credit risk more
serious
Very high due to fixed rate, remains for the entire maturity
of the issue
Floating Rate
Ijara Sukuk
Securitized Ijara, certificate holder owns part of asset or usufructs and earns floating rent indexed to market benchmark such as LIBOR –
tradable
Default on rent payment, floating rate makes default risk lesser serious – see
previous case
Exists only within the time of the floating period normally
6 months
Fixed rate Hybrid/ Pooled
Sukuk
Securitized pool of assets; debts must not be more than 49%, floating rate possibility exists
– tradable
Credit risk of debt part of pool, default on rents, fixed rate makes credit
risk serious
Very high due to fixed rate, remains for the entire maturity
of the issue
Musharakah Term Finance
Sukuk (MTFS)
Medium term redeemable musharakah certificate based on diminishing musharakah – tradable as well
as redeemable
Musharakah has high default risk (see Khan and Ahmed 2001), however, MTFS could be based on the strength of the entire balance
sheet
Similar to the case of the floating rate. This is however, unique in the sense that the rate is not indexed with a benchmark like LIBOR, hence least exposed to
this risk
27
The Potential and Risk of Sukuk 2011
Salam Sukuk
Securitized salam, fixed-rate and non-
tradable
Salam has unique credit risk (see Khan and Ahmed
2001) Very high due
to fixed rate
28