Sukuk

SUKUK (ISLAMIC BOND) AT A GLANCE

The purpose of this write-up is to answer frequently-asked questions on Sukuk and its benefits.

  1. What is Islamic finance?

It is a financial system comprising institutions, (such as Sukuk) and services that operate according to Islamic law known as Shariah under the principle of Islamic commercial laws. It involves the means by which corporations or governments raise capital and the forms of investments that are made in accordance with Shariah. Just as the conventional financial systems, Islamic financial system comprises of deposit- taking banks, fund managers, investment firms, and insurance companies (takaful). This entitles are governed both by Islamic law and the conventional finance industry’s rules and regulations.

Islamic finance aims at ensuring or is based on the principle of ‘justice and equity’ for all parties involved in a transaction.

  1. What is Shariah

An Arabic word, meaning Islamic law, it refers to the legal system governing believers of the Islamic faith and derived from four (4) main sources: the Holy Qur’an, The Sunnah (practices of the prophet Muhammad), Ijma (consensus among religion scholars) and Qiyas (Analogical Reasoning). It acts as a code for living that all Muslims should adhere to.

  1. What is Sukuk?

An Arabic word referring to investment certificates or note which evidence proportionate interest in ownership of tangible assets, usufructs and services or investment in the assets of particular projects or special investment activity that adhere to principles of Shariah.

The basic principle behind Sukuk, popularly known as Islamic or Shariah complaint “Bond”, is that the holder has an undivided ownership right on a particular asset and is therefore entitled to the return generated by the asset.

As a component of Islamic finance, Sukuk is a non interest based investment and financing instrument but its application is not restricted to Muslims as it conforms to ethical standard and justice.

  1. What is the origin of Sukuk?

The application of Sukuk is not a recent phenomenon; it is as old as Islam. Prior to the modern period, Islamic communities used Sukuk as ‘papers’ to represent financial commitments that originate from trade and other economic transactions. The first Sukuk transaction took place in Damascus, Syria in the 7th century AD.

Modern resurgence of Sukuk has been propelled by renewed recognition of the concept by the Islamic FIQH Academy of the Organization of Islamic Countries (OIC) and the Accounting and Auditing Organization of Islamic Financial Institutions (AAOIF).

These institution are standard setting organizations in the Islamic finance industry and have enabled Sukuk structure to be developed leading to the first successful insurance of Sukuk by the Malaysian Government in 1983.

The rationale behind the creation of Sukuk is to provide an alternative to conventional bond in a Shariah complaint manner.

  1. What are the principles guiding the use of Sukuk?

Financing and investing in Sukuk must comply with Islamic law and ethical standards referred as Shariah principles as follows:

  • Project to be funded from Sukuk must be beneficial and not be harmful to the society such as dealings on alcohol.
  • Any transfer of asset/property should be through a valid contract.
  • The activity for which the transaction is based must be permissible in Shariah and based on mutual consent.
  • Transaction must be free of unlawful conditions in the form of deceit, fraud, uncertainty/ambiguity that might lead to destruction or loss
  • Transaction should be free of speculation and gambling
  • Interest is forbidden/prohibited
  • Sukuk must be backed by or be based on some underlying assets.
  • The Sukuk assets must be a well defined (specifications), physical existing (location) and known property with commercial value (revenue generating) (e.g. land, building, machinery) and owned by the seller
  • Return to Sukuk holders are , as much as possible, generated form the revenue or cash flows of the underlying assets such as rent, profit or disposal
  • Asset can be tangible or intangible e.g. marketing rights, concession agreement etc.
  • For any Sukuk to be tradable , there must be 1/3 of its asset in tangible form
  1. What are the differences between Sukuk and Conventional Bond?

Key differences between Sukuk and Conventional bonds are as follows:

Consideration Sukuk Conventional Bonds
Ownership Represents the investor’s ownership interest in the underlying Sukuk asset, business, enterprise or project which entitles them to receive a share of the income generated Evidence an interest bearing debt the issuer owes to the bondholders

 

Underlying asset The asset on which Sukuk are based must be Shariah-compliant. Used to finance any asset, project or business
Pricing Priced according to the value of the assets backing them Pricing is based on credit rating i.e. the credit worthiness of the issuer without any specific asset to be relied upon
Returns to investors Returns on Sukuk can increase in value when the underlying assets increase in value Returns from bonds are based on fixed interest
Sales When you sell Sukuk, you are selling ownership in the assets backing them in case of issuer’s default, Sukuk holders will possess the asset and they can sell it to other buyers or keep it as an asset. The sales of bonds is the sale of debt
Guarantee on returns The initial investment (principal) isn’t guaranteed as the Sukuk holder may or may not get back the entire principal (face value) amount because the Sukuk holder share the risk (loss) of the underlying asset. Guarantee the return of the principal when redeem at maturity, regardless of whether the business is profitable or otherwise
Share of returns are Sukuk holder are entitled to share in the revenue generated by the Sukuk assets as well as being entitled to share in the proceeds of the realization of the Sukuk assets The bond holder has no beneficial right over the asset constructed from the bond proceeds

 

Nature of investment Sukuk is a hybrid instrument in that

It combines both equity (shares in ownership of underlying asset/project) and debt features (fixed periodic payments/coupon payments)

It is debt instrument

 

  1. What are the similarities between Sukuk and conventional bond?
  • As with conventional bonds, Sukuk are issued with specific maturity dates.
  • They are both tradable securities i.e. they can be sold to a willing buyer.
  • Both securities can be rated for the purposes of insurance
  1. What is a specific for vehicle (SPV) in Sukuk transaction?

An SPV is a company incorporated for the purpose of financing a Sukuk called project originated by an obligor i.e. company or government seeking to raise fund.

  1. What are the Categories of Sukuk?

Sukuk can be categorized as follows:

  • Product-based: the AAOIFI which issues standards on accounting auditing, governance, ethical, and Shariah standard has laid down 14 different types of Sukuk. The common ones include ijara (lease) Sukuk, murabaha (cost-plus-profit margin sale) Sukuk, Musharakah (profit & loss bearing partnership) Sukuk, istisna (construction/manufacturing financing) Sukuk and Salam (sale with spot payment but differed delivery) Sukuk.
  • Issuer-based: issuer including sovereign, company and financial institution can raise funds through insurance of sovereign, sub-national or corporate Sukuk respectively.
  1. Structure of Sukuk?

Sukuk structuring typically involves the packaging of pools of Shariah-compliant asset/project which has to be reviewed and approved by Shariah adviser to ensure compliance with Shariah. Sukuk are structured based on the specific contract of exchange of the Shariah-compliant assets. Such contracts can be made through the sale and purchase of an asset based on immediate, installmental or deferred payment, leasing of specific assets or participation in joint-venture businesses.

The issuer of funding objectives dictates which structure to adopt. Each structure may be used singly or combined with another in line with the underlying commercial and contractual basis for the Sukuk.

  • Ijara (lease) Sukuk

Ijara is a contract where a party purchases and lease out a specific asset (e.g. equipment, parcels of land, buildings) required by client for a rental fee. The duration of the rental fee are agreed in advance in the contract entered into between the lessor (Asset Owner) and lessee (Beneficiary) and ownership of the asset remains with the lessor.

Ijara Sukuk are securities representing ownership of assets that are linked to a lease contract. Lease rentals are the source of returns to the investors in this contract. Ijara Sukuk can be traded in the secondary Sukuk market at a price determined by the demand and supply of the product.

  • Murabaha (cost-plus-profit margin sale) Sukuk

Murabaha is basically a sales contract whereby goods are sold at a price which includes the purchase price plus a margin of profit agreed upon by both parties concerned. The price is paid in cash or installments.

Murabaha Sukuk are certificates of equal value issued for the purpose of financing the purchase of goods through murabaha so that the certificate holders become owners of murabaha commodity. The proceeds from the Sukuk are used to purchase and take little of the commodities from a supplier/vendor and sell to the Sukuk originating entity at the cost plus a reasonable profit payable in future. This true sale transaction entails the seller disclosing in advance to the buyer profit to be made in the transaction. The murabaha contract is widely used as a short-term financing instrument.

  • Musharaka (profit & loss sharing partnership) Sukuk

Musharaka means a partnership arrangement between two or more parties to finance a business venture whereby all parties contribute capital either in the form of cash or in kind for the venture. Any profit derived from the venture will be distributed based on pre-agreed profit sharing ratio, but a loss will be shared on the basis of capital contribution.

Musharaka Sukuk is a project/business equity financing where the certificate holders, via an SPV become part ownership of the project while the originating entity is the other partner. The structure of musharaka requires both parties to provide financing in cash or in kind to the project, share the profit/return based on the agreed sharing ratio or loss based on the proportionate capital contribution to the project. The certificates are tradable in the secondary market.

  • Mudaraba (profit sharing &loss bearing partnership) Sukuk

Mudaraba is a partnership contract between provider (Rabb al-Mal) and an entrepreneur (Mudarib) whereby the capital provider would contribute capital to an enterprise or activity that is to be managed by the entrepreneur. profits generated by that enterprise or activity are shared in accordance with the percentage specified in the contract, while losses are to be burn solely by the capital provider unless the losses are due to misconduct, negligence or breach of contracted terms.

Mudaraba Sukuk are trust certificates issued to finance project or business activity funded with Sukuk proceeds but managed by the originating entity on behalf of the Sukuk holders. The profit generated from the project/business activities is shared between SPV (for Sukuk holders) and originating Entity acting as an entrepreneur based  on the pre-agreed ratio while in the case of loss, it is borne completely by the Sukuk holders as providers of the finds.

  • Istisna (construction/manufacturing financing) Sukuk

Istisna involves the sale of a specified asset, with an obligation on the part of the seller to manufacture/construct it using his own materials and to deliver it on a specific date in return for a specific price to be in one lump sum or installments.

Istisna Sukuk are certificates issued with the aim of mobilizing funds for the advance funding of real estate construction and manufacturing large asset such as power plants. The Sukuk proceeds are used to fund contractor or manufacturer during the construction of the asset. The investor via SPV acquire title to that asset and upon completion either immediately pass title to the obligor on agreed deferred payment terms or lease the asset to the developer under a hybrid contract of istisna-ijara Sukuk. This Sukuk is tradable only after delivery.

  • Salam (sale with spot Payment but deferred delivery) Sukuk

Salam is the sale of a specific commodity with define quantity and quality which will be deliver to the purchaser on a fixed date in the future against an immediate advance full payment price.

Salam Sukuk are certificate of equal value issued for the purpose of mobilizing Salam capital so that the goods to be deliver on the basis of Salam come to the ownership of the certificate holders. It is most commonly used in the agricultural sector.

  1. What is asset-backed Sukuk?

Asset-backed Sukuk involve granting the investor (Sukuk holder) a share of tangible asset or business venture along with a corresponding share of the total risk in line with his level of investment.

In this structure, there is a true sale of transaction, where the originator sells the underlying assets to an SPV as trustees that hold these assets and issue the Sukuk back on them. The buyer of Sukuk doesn’t have recourse to the originator if there are payment defaults.  All of the risk and rewards of ownership passes to the SPV. The Sukuk holders must assume any losses in case of impairment of Sukuk assets.

Assets remain under the ownership of investors throughout the maturity period and returns are linked to performance of the assets. In the event of default, Sukuk holders have recourse to assets. If the returns fail to arise, the Sukuk holders suffer the losses. Examples of asset backed Sukuk include Musharaka and Mudaraba.

  1. What is Asset-Based Sukuk?

Asset-based Sukuk entails the issuer purchasing the underlying assets and them investing trading or leasing them on behalf of the investors (Sukuk holders), using the funds raised through the issued certificates (Sukuk). This structure, most often, takes the form of the sale lease to the originator and is embedded with a binding promise from the originator to repurchase the underlying assets at maturity.

In this structure, the Sukuk holders can only require the originator to purchase the underlying assets. As such, the Sukuk holders have an unsecured debt claims against the originator embodied in the payment of the purchase price following an execution of the binding purchase promise. This implies that Sukuk holders don’t have full recourse to the underlying assets and the underlying assets are not used as collateral.

Asset-based Sukuk grant only beneficial ownership to the Sukuk holders, so that in case of default, the investor would be left without any claim on these assets. This makes this type of Sukuk more akin to the debt or bonds. Examples of assets based Sukuk include Murabaha, Salam and Istisna.

  1. How is income earned from investing in Sukuk?

The return provide to Sukuk holders by the SPV come in the form of profit from a sale rental or a combination of both.

  1. Who can invest in Sukuk?
  • Households – individuals and families (local and foreign residents)
  • Small businesses – traders, merchants, professionals firms etc
  • Associations and unions – professional bodies, cooperative societies, student union Governments, Trade Unions, Town Unions, Chambers of Commerce etc
  • Religious Bodies –churches, Mosques etc
  • Educational Institutions – primary, Secondary and Tertiary
  • Corporate entities – Banks, Insurance companies, Pension funds, Funds and Asset Managers etc
  • High network INDIVIDUALS
  • Governments –Government agencies, states and local governments
  • Supernational Institutions – World Bank, IMF, UN, ADB etc
  1. What are the benefits of Sukuk?
  • Domestic issuer (sovereigns and corporations) can use Sukuk instrument to tap funding from international market with huge investor base and thereby attracting direct foreign investment (DFI).
  • Insurance of Sukuk can attract domestic investment capital which is invested according to Islamic principles.
  • Sukuk, as an investment product, appeals to faith-based investor as well as conventional investors who are seeking liquid, diversified and attractively priced instruments with stable returns
  • Sukuk ensures that every financial activity is backed by real economic activity and thus promotes financial stability and real economic development.
  • Sukuk as investable product serve as liquidity management tool for banks and other Islamic financial institution.
  • The tradable nature of Sukuk enable investor to liquidate their investments with ease whenever the need arises and as a result, enhances market liquidity
  • Sukuk investment is relatively free from default risk
  • Income from Sukuk investment is tax-free in advance markets
  • Sukuk certificate qualify as collateral for interest-free borrowing
  • Sukuk pricing is competitive to other financing mode
  • Low cost of financing because it carries low burden of debt
  • Sukuk, as an asset class provides an alternative investment opportunity for the ethically conscious populace and otherwise
  • Sukuk provides an alternative source of funding development and expansion projects
  • When project based, Sukuk can generate jobs.
  • Insurance of Sukuk depends on the domestic bond market in order to promote economic growth
  • Sukuk structures mandate accountability to finance providers, thus it will promote better governance on corporate and institutional levels
  • Investment in Sukuk has a social and an ethical benefit to the wider society beyond “pure return”
  1. What are the risks of issuing or investing in Sukuk?

Some of the varied risks that can affect Sukuk include:

  • Interest rate risk – Sukuk certificates are exposed indirectly to interest rate fluctuations. Investment profit is tied to benchmarked interest rate and most Sukuk issue has fixed payment. Thus when the market interest rate rises, Sukuk value drops.
  • Liquidity risk – Sukuk certificate tend to be held until maturity due to the absence of well-structured and sufficiently liquid secondary market.
  • Shariah negligence risk – a risk of loss of asset value resulting from failure/negligence of issuer to adhere with the rules and principles of Shariah throughout the duration of Sukuk insurance.
  • Credit risk – adverse changes in market rates will unfavorably affect the credit worthiness of the issues.
  • Foreign exchange risk – unfavorable exchange rate fluctuations will invariably have an effect on the assets in the Sukuk pool and in the currency of denomination in which the Sukuk funds are accumulated.
  • Market risk – risk of fall in asset value.
  • Assets risk – loss/damage of the underlying asset.
  • Default risk – this is risk related to the ability and desirability of the buyer/ debtor to pay the debt as at when due. It involves the probability that an asset or loan becomes irrecoverable due to a default or delayed settlements. It is also related to delivery of sub-standard goods/projects or delay by the supplier as against the contract’s specifications.
  • SPV specific risks – possible failure/negligence of SPV to reimburse the Sukuk holders.
  • Exit risk – the inability of the SPV to dispose the asset/business at the end of the contract.
  1. What is sovereign Sukuk?

A certificate evidencing ownership of an asset or its usufructs issued by an SPV backed up by the Sovereign entity

  1. What is Sub-national Sukuk?

It is a certificate evidencing ownership of an asset or its usufructs issued by an SPV backed up by the state government.

  1. What is corporate Sukuk?

A certificate evidencing ownership of an asset or its usufructs issued by an SPV backed up by a company

  1. What is supernatural Sukuk?

A certificate evidencing ownership of an asset or its usufructs issued by an SPV backed up by a supernatural institution

  1. Who are the participants in the Nigerian Sukuk market?

Generally, participants in the Sukuk market in Nigeria include:

  • Sovereigns
  • Sub-nationals
  • Corporate bodies
  • Supranationals (international finance institutions)
  • SPV
  • Shariah Advisers
  • Stockbrokers
  • Issuing Houses
  • Solicitors
  • Underwriters
  • Trustees
  • Fund Managers
  • Rating Agencies
  • Banks
  • Auditors/reporting Accountants
  • Investors (Local & Foreign)
  • Regulators
  1. What are the potential projects to be financed from Sukuk?

Prospective issuers of Sukuk may invest the Sukuk proceeds in the following projects areas: Agriculture, Roads, Air Transport, Rail Transport, Power, Petroleum Refining, Mass Housing, and Education, Health facilities, Water and sanitation etc

  1. How do I buy Sukuk?

Interested person can buy Sukuk during public offer through capital Market Operators registered by the securities and Exchanges Commission or on recognized and registered Exchanges through a stockbroker.

  1. Can I sell Sukuk before maturity date?

Yes. Most Sukuk can be sold through stockbrokers.

  1. Which countries have issued Sukuk?

Today, over 20 countries in Europe, Asia, Middle East and Africa have issued either corporate or sovereign Sukuk with Malaysia and United Arab emirates at the forefront.

Other countries include Bahrain, Indonesia, Iran, Qatar, Kuwait, Pakistan, Saudi Arabia, Singapore, Somalia, and turkey, Brunei, UK, Hong Kong, Egypt, Ivory Coast, Senegal, Gambia, South Africa and Nigeria.

  1. What is the current state of global Sukuk market?

The global Sukuk market continues to witness remarkable growth since after the 2008 global financial crisis. Annual insurance have grown from $15 billion in 2008 to almost $120 billion in 2014. Most of the Sukuk insurance recorded over subscription. For instance, UK’s  Sovereign Sukuk sale in 2014 attracted effective demand worth  an increase by 11.5 times. Outstanding volume of Sukuk hit  billion in 2015 from 587 instruments.

The growth of Sukuk market has been largely driven by liquidity in gulf countries; its focus on socially responsible investment, its innovative asset backed funding structures, and government’s support through regulation and issuances.

  1. Have Sukuk been issued in Nigeria?

Yes. A sub-national Sukuk worth about million (N11.4 billion) was issued by Osun State in 2013 and plans to issue a Sovereign Sukuk are ongoing.

  1. What are the growth potentials of the Nigerian Sukuk?

With population of about 170 million and significant Muslim population estimated at over 50%, Nigeria is a home to far more Muslims than all the leading Sukuk markets of Malaysia, Saudi Arabia, UAE, Kuwait and Qatar put together. In addition, Nigeria, estimated as the largest economy in Africa with a Gross Domestic Product of about  billion, has larger economy than them, with the exception of Saudi Arabia.

  1. Who regulates the Nigeria Sukuk Market?

Securities and Exchange Commission (SEC), Nigeria regulates sovereign, sub-national (State) and corporate Sukuk markets.

  1. What are the existing laws guiding Sukuk transaction?

In Nigeria, Sukuk transaction is regulated through the framework provided under the Investment and Securities Act 2007 and SEC’s guidelines on Sukuk. Others are guidelines of reputable local and international institutions including CBN, Islamic Financial Services Board (IFSB) and AAOIFI.