What Is a Sukuk?
A sukuk is an Islamic financial certificate, akin to a bond in conventional finance, that abides by Islamic religious law commonly known as Sharia. Since the traditional interest-paying bond structure is not permissible, the issuer of a sukuk essentially sells a certificate to an investor group, using the proceeds to purchase an asset in which the investor group has direct partial ownership interest. The issuer also makes a contractual promise to repurchase the bond at a future date at par value.
Key Takeaways
- A sukuk is a Sharia-compliant financial instrument used in Islamic finance.
- Sukuk involves a direct asset ownership interest, whereas conventional bonds are interest-bearing debt obligations.
- Both sukuk and bonds provide payment streams to investors, but income derived from a sukuk cannot be speculative to remain halal.
Understanding Sukuk
With the growing prominence of Islamic finance, sukuk have surged in popularity since their first issuance in Malaysia in 2000, followed by Bahrain in 2001. In today’s financial landscape, sukuk are used by both Islamic corporations and state-run organizations worldwide, gaining an increasing share of the global fixed-income market.
Islamic law prohibits “riba,” or interest, making traditional Western debt instruments non-viable for investment or capital-raising within Islamic finance. To address this, sukuk link the returns and cash flows of debt financing to a specific asset being purchased, effectively distributing the benefits from that asset. This enables investors to work around Sharia prohibition while still enjoying the returns from debt financing. However, financing through sukuk is limited to identifiable assets.
Therefore, sukuk represent aggregate and undivided shares of ownership in tangible assets related to a specific project or investment activity. Sukuk investors do not own a debt obligation from the bond issuer but instead hold a piece of the asset linked to the investment. Thus, sukuk holders receive earnings generated by the associated asset, distinguishing them from traditional bondholders.
Sukuk vs. Traditional Bonds
Sukuk and conventional bonds share some similar characteristics but also possess essential differences:
Similarities
- Both provide investors with regular payment streams.
- Sukuk and bonds may be issued to investors to raise capital for firms.
- Both are considered stable investments compared to equities.
Key Differences
- Sukuk entails asset ownership, whereas bonds represent debt obligations.
- The value of a sukuk can appreciate if the backing asset appreciates, while bond yields depend primarily on interest rates.
- Sukuk must finance halal assets, unlike bonds which may finance non-Sharia-compliant businesses or speculative activities.
- Sukuk valuation is based on the value of the backing assets, while bond prices are largely influenced by their credit rating.
Sukuk Example: Trust Certificates
The most common form of sukuk is a trust certificate. Governed by Western law, this sukuk structure is nuanced: the organization raising funds creates an offshore special purpose vehicle (SPV). The SPV issues trust certificates to qualified investors and channels the investment proceeds toward a funding agreement with the issuing organization. In return, investors earn a portion of the profits linked to the asset.
Trust certificates sukuk require the establishment of an SPV in a jurisdiction that allows such trusts. If an SPV and trust certificates can’t be created, an alternative structure can be implemented. In this scenario, an asset-leasing company is created in the country of origin, purchasing the asset and leasing it back to the organization needing financing.
Related Terms: Islamic Banking, Sharia Law, Bonds, Riba, Fixed Income.
References
- Securities and Exchange Commission of Nigeria. “Sukuk (Islamic Bond) At A Glance”.
- Boutti, Rachid. “Sukuk and Bond Performance in Malaysia”. *International Journal of Economics and Finance,*vol. 6, no. 2, 2014, pp. 226-234.
- Bahrain Bourse. “Sukuk Brochure”, Page 5.
- TMF Group. “The Global Islamic Finance Market: Part 1, Sukuk Bonds”.
- Islamic Finance Foundation. “Why Muslims Reject Interest (Riba)”.
- The Association of Corporate Treasurers. “What Are Sukuk, and How Do They Work?”
