By: Elwaleed M. Ahmed

For an Islamic market to exist in the proper manner, it must have all of the relevant products that assist the growth and expansion of the Islamic finance market. In a modern economic system, the issuance and trading of bonds are important means of investment. An Islamic financial system therefore needs to include, right from
the early stage, the development of an Islamic capital market. This is not just to provide an alternative source of financing, but also to create broader and more diverse Islamic financial instruments for investors. Shariah compliant structures in the Islamic finance industry, such as the various Sukuk structures that have evolved over time, provide investment opportunities and meet the financing needs of businesses and investors who believe and comply with the Islamic Shariah principle.

 

We will not go into the detailed definition and fundamentals of Sukuk as these have been widely covered by Islamic Finance News. Sukuk is Shariah compliant due to its nature of being backed by a specific, tangible asset throughout its entire tenure. Hence, the Islamic Sukuk becomes a vital avenue for infrastructure projects to tap fresh funds. This adds value to the funds available in the local economy. Furthermore, Sukuk, or Islamic bonds, have been established as a profitable instrument and hold great potential in the Islamic finance market. The Sukuk market is growing strongly and their attraction as an alternative to the conventional methods of saving and investment appeals to a mounting investor base. Sukuk issuances are indisputably a new development in global capital market; it is one of the fastest growing sectors in Islamic finance. 

Unique features
The issuance of sukuk is a significant mechanism for raising money in the capital markets. Unlike other Islamic banking vehicles, Sukuk have unique characteristics and offer significant benefits. For example, they are tradable in secondary markets because they are backed by real assets and they are assessed for quality by international rating agencies, as are all other conventional financial instruments before their issuances. In addition they provide regular periodic income streams during the investment period with easy and efficient settlement and a possibility of capital appreciation. 

Moreover, Sukuk are becoming more popular, not just as a means for the government to raise financing through sovereign issues but also as a way for companies to obtain funding. We already understand that the importance of Sukuk lies in its ability to transfer fixed assets into liquidity without the need to go into long legal complications for investors. In addition, Sukuk can transform an asset’s future cash flow into present cash flow and can be issued on existing as well as specific assets that may become available at a future date. As such, Sukuk is an excellent structure for infrastructure or project finance as it enables governments or corporations to raise funds for a specific project and concurrently generate returns from the assets created for the Sukuk holders.

Sukuk offers an attractive yield because repayments are not dependent on the cash flows of the borrowing company but from a future IPO of strategic government sovereign issues or from a corporate Sukuk. The unique structure of Sukuk, with IPO rights, has captured the attention of the capital markets.

Another interesting feature of the Sukuk is that, it not only guarantees wider global investors audience but also provides, in most instances, lower prices to issuers and is considered a source of cash flow and finance for the originator.

Secondary Market
Even though the Sukuk market is developing rapidly, the market lacks liquidity. Sukuk holders tend to keep Sukuk until maturity and most Sukuk issued to date are in the hands of large institutions. The Sukuk assets are essentially “unavailable” for the average private investor. Therefore, active trading is constrained due to the limited number of issuances and the fact that most investors hold on to these certificates owing to a lack of alternative instruments in this asset class. On the other hand, many experts believe that the secondary market for Sukuk will become reality only when corporate Sukuk issuances increase in global markets.  

Until recently, there have not been sufficient Sukuk transactions in the market to create an appropriately diversified asset portfolio for a secondary market to exit. For a Sukuk secondary market to flourish, there must be a widespread Sukuk issuance that could lay the groundwork for the emergence of Islamic capital markets and Sukuk issuances requires a critical mass. Some experts estimate that this critical mass is about US$400 billion worth of issuances, amounting to some 270 individual issuances worldwide. Another factor that will lead to Sukuk secondary market growth, is to move away from sovereign to corporate Sukuk. Corporate Sukuk is a way to raise capital for projects which the company is committed. It can also be used to refinance conventional debts.

There is also a need for Islamic borrowers to list their deals outside their home jurisdictions. This will make secondary trade easier from a regulatory point of view for foreign investors. The consequences of widespread Sukuk issuance and cross-border Sukuk sales will be greater harmonization in the way that Sukuk are structured and laying the groundwork for the emergence of Sukuk secondary markets.

Comparison
Sukuk are similar to asset-backed conventional bonds, but instead of a fixed annual interest rate, payouts to investors over the life of the bond are derived from leases, profits or sales of tangible assets such as property, equipment or a joint-venture business.  

Contrary to the position of a conventional bond, which is a contractual debt obligation entitling the holder to receive interest and principles on specified dates, a Sukuk holder is entitled both to the share in the revenues generated by the Sukuk assets and to the share in the proceeds of the realization of the Sukuk assets. On the other hand, Sukuk holders are also under an obligation to maintain the asset and to bear losses. In contrast, the holders of conventional bonds do not have these obligations and are only entitled to receive interest.

Like conventional bonds, Sukuk certificates can be negotiated and traded freely in the market. But the tradability of Sukuk certificates is strictly contingent upon the nature of the underlying asset during the term of Sukuk, since the sale and purchase of debt is not permissible under Islamic Shariah. In addition, Sukuk investors have an implicit right of information on the use of their funds and the nature and performance of the underlying assets, which is not usually the case in conventional bonds. This can serve to give the investors assurance that their funds are being used for the intended purpose. Moreover, the fact that Sukuk are asset-backed gives investors reasonable assertion that they will be able to retrieve a major part of their investment if the issuer defaults (Sukuk investors have an undivided share in the ownership of the Sukuk assets).

Basic Sukuk Instruments in Islamic Finance
There are a number of different ways to structure Sukuk, depending upon the type of underlying assets and the specific financing needs of the issuing entity. The following are the basic Sukuk instruments in Islamic finance: Mudarabah (Profit/Loss-Sharing or investment partnership), Murabahah (cost plus or purchase and resale), Musharakah (joint venture), Ijarah (Islamic lease agreement) and Istisnah (pre-delivery financing and leasing).  

Under the Ijarah structure, the first contract of Ijarah (leasing/renting) precedes a second Bai (purchase) contract. Islamic leasing creates a great potential for securitization, because lease finance is easier to practice as it involves less documentation and takes less time to conclude a deal. Unlike lending, it does not need collateral and no thorough enquiries into the creditworthiness of the lessee are needed. This is due to the physical presence of a tangible asset, the subject of the lease.

Istisnah is a structure suited for long term project financing. It is a contractual agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery or a future payment and future delivery. Istisnah is often used for financing manufacturing projects, plants, real estate projects – residential, hotels, commercial buildings – and infrastructure projects – bridges, roads and highways.

Challenges facing the Sukuk issuance market
Like all financial instruments, Sukuk are also subject to a number of risks. The rapid growth of Islamic finance globally has given rise to many structural challenges facing the industry. The lack of standardization is hindering liquidity. It prevents investors from knowing what risk they are assuming when they invest and increases the costs associated with sukuk issuance.  

Moreover, the Shariah board in the Middle East and elsewhere that approves Islamic Sukuk for sale to Muslims holds slightly different interpretations about what is acceptable, making Islamic investor nervous about buying bonds from outside their jurisdiction. Sukuk may involve challenging procedures to structure because they require extensive and costly advice – both legal and religious – in addition to diverse sets of skill and resources to make it work. Therefore, corporations and banks shy away from such structures because of the legal risks and the potential costs of pioneering such instruments.

Moreover, since Sukuk trading sizes tend to range in the millions of dollars, they are out of reach for all but the wealthiest Muslim investors. In addition, anyone who buys into a Sukuk typically buys it and holds it. Moreover, difficulties in defining rates of return on these instruments have also constrained the development of the money and inter-bank market.

Conclusion
Islamic products must compete with conventional products if they are to penetrate non-Islamic markets. Islamic products cannot exist only because of faith. Efforts to develop new financial products that embody the virtues of Islamic banking needs to be intensified. Only then would Islamic financial instruments evolve into distinct, innovative and cutting-edge products. The development of an active and vibrant Sukuk market is of fundamental importance to the continuing development and growth of the Islamic finance industry. Even though sovereign, institutional, and corporate issues are now common, there is much scope for innovation in the use of Sukuk to expand the Islamic capital market. As building confidence in the Sukuk market is fundamental for the development of Islamic finance, it is essential to regulate and modernize the systems that determine the operations of Sukuk products.  

Another consideration is that, Islamic financial services and products are generally well suited to meet the demands of the modern world in terms of rules, regulations and systems. Adopting common policies on certain financial instruments and best practices for their supervision and accounting are critical for future market and industry development in the context of global competitiveness. A sustained strong growth in the Sukuk market can be expected, given the increasing standardization of Sukuk documents in the market place, which will drive costs of issuing Sukuk down. A sound, well-functioning Islamic financial system can pave the way for regional financial integration. It can also contribute to regional economic and social development by financing economic infrastructure and creating job opportunities.

The author is a legal consultant and the head of the Foreign Affairs Department at Kuwaiti Lawyer Firm in Al-Jabria, Kuwait. He advises on Islamic investment transactions, international commercial transactions and corporation and business law. He can be contacted by email: elwaleed@kuwaitilawyer.com