IBF #04 - Sukuk

The Islamic Securities Guidelines (issued by the Securities Commission) defines Sukuk as: A document or certificate that represents the value of an asset;

The Shariah Standard 17 under the Auditing and Accounting Organisation for Islamic Financial Institutions (AAOIFI) applies Sukuk to Investment Products: Certificates of equal value representing, after closing of subscription, receipt of the value of the certificates and putting to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity.

Sukuk

• Undivided beneficial ownership in the underlying assets, entitled to share in the revenues generated by the Sukuk assets as well as being entitled to share in the proceeds of the realization of the Sukuk assets.
• Sukuk represent ownership in existing and/or well defined assets.
• Sale of a Sukuk represents a sale of a share of assets, business activity or project.
• The subject of the contract in Sukuk is a contract based on lease or a defined business undertaking between the Sukukholders and the originator.
• The underlying Sukuk assets, business or project must be Shariah compliant in nature.

Bond

• A contractual debt obligation, the issuer is required to pay interest and principal to bondholders on certain specified dates.
• Bonds represent pure debt on the issuer.
• Sale of a bond basically represents sale of a debt.
• Bonds basically create a Lender/Borrower relationship i.e. a contract whose subject is purely earning money on money.
  

Sukuks and Bonds are totally different instruments, serving different purpose, with different mechanics and goals. It would be erroneous to structure a Sukuk based on the conventional platform and norms. One must always look at structuring a Sukuk purely from the Islamic perspective and this includes contracts, legal documentations, pricing and the operational mechanics/modus operandi.

What are the factors that will make issuers and investors choose Sukuk over Bonds? From my observation, the decision is made mostly based on cost and price considerations. The attractiveness of Sukuk as compared to bonds in the Malaysian market is mainly due to the various incentives given by the authorities, especially tax exemptions/allowances. However, Sukuks are often structured to fit the conventional Bond model in the pursuit of mandates from clients.

Valuation:
Sukuk valuation at any point should be done based on market value; therefore both at issuance and dissolution, the Sukuk must reflect the market value of the underlying assets (except for Musharakah or Mudharabah where the value at issuance reflects the amount of equity injected into the venture). The same is true during an event of default and investors should expect to receive trhe market value of the asset and not a predetermined amount (principal) when a default occurs.

Role of the authorities:
The authorities that govern the financial markets play a very important and crucial role in developing the Sukuk market. Incentives should not stop at tax breaks but must also include providing the right platform for the Sukuk. Platform means the infrastructure, guidelines, rules and regulation, pricing and trading mechanism. Investor as well practitioners’ continuous education is of utmost importance, being a developing science, Islamic banking faces new challenges and new developments all the time.

Above all, the market, both the sell and buy sides must be fully aware of and understand what Sukuk and Islamic finance is all about. It is not about taking a conventional debt instrument; execute a few more legal documents and giving it an Arabic name.