There are several types of sukuk and which are classified on the bases of the different Islamic modes of financing used to arrive at their respective structures, types and nature of the underlying assets, as well as their commercial and technical features. The structures include murabaha, mudaraba, salam, istisna, ijarah and musharaka. Based on underlying assets, they are classified as asset based and asset backed sukuk. Sukuk segment of the Islamic capital market industry has gained considerable attention of writers due to its growing popularity as an avenue for raising capital by corporate entities among other seekers of funds. This chapter discusses issues related to sukuk such as its evolution and meaning, types and valuation, how it is different from conventional bond, benefits from its usage and the challenges involved, as well as various sharia explanations on sukuk features as currently utilised.
Meaning of Islamic Bonds
There are different accounts of history on the origin of sukuk. In some literature, it was reported that the history of sukuk can be traced back to as far back as during the era of the second caliph, Umar b. al-Khattab (A.D. 634–644). In another literature, the word sukuk has been recognised to be in existence during the period of Caliph Mu’awiyah (A.D. 661–680). Furthermore, it was also reported that the sale of sukuk was recorded in the era of Marwan b. al-Hakam (A.D. 684–685), but the practice was objected to by some of his companions and was therefore outlawed .
The use of the word “sukuk” can be traced back to traditional Islamic literature as a word used in place of certificate for goods or foodstuffs (“Sakk al-bada’i”). Sukuk stands for the plural of the word sakk, and which means “legal documents, deed, and check”. In another perspective, Sukuk or sikak is the plural of “sakk” which means to strike or to hit; the meaning is related to strike one’s seal on a document. It also means a “legal instrument, deed, check“. The word is literally translated as a ‘written document’.
The word originates as an Arabic name for certificates related to financial dealings but it can be seen as an Islamic equivalent of the conventional bonds and has been defined variously in the literature. Firstly, it is defined as a system of paying the wages of government officers who would later exchange such certificates in line with their day-to-day consumption of goods or foodstuffs.
Secondly, it is defined as “Certificates of equal value representing individual shares in ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity”.
Thirdly, Islamic Financial Services Board defines sukuk as “Sukūk (plural of sakk), frequently referred to as “Islamic bonds”, are certificates with each sakk representing a proportional undivided ownership right in tangible assets, or a pool of predominantly tangible assets, or a business venture (such as a mudārabah). ”
Finally, sukuk can be defined as a commercial paper that provides investors with ownership in underlying assets. It is asset backed trust certificates evidencing ownership of an asset or its usufruct. Its additional feature is that it has a stable income and complies with the principle of shariah.
In all the above definitions, the central theme seen is that sukuk represents a financial transaction in which assets are pooled and certificates representing interests in the pool are issued to investors. Thus, sukuk is used to mobilise resources, and it is beneficial to investors in one hand and fund users in the other hand, through its provision of liquidity to corporations and other users of funds. It is noteworthy here from the definitions that though sukuk represent a share of the ownership of underlying assets or projects, they are negotiable or tradable. However, it is not tradable, if it creates any debt obligations. In addition to their compliance with sharia principles, the main features that differentiate sukuk from conventional bonds are their link to the underlying asset. Furthermore, the remuneration of the sukuk holders is not based on debt and interest payments of the issuer, but it depends on the income generated by the sukuk underlying asset.
Benefits and challenges of Sukuk
Benefits of Sukuk
There are varying perspectives on values inherent in the utilisation of sukuk by corporate as well as public institutions. Some of the benefits have been highlighted as follows:
- The use of sukuk represents a way of raising financial resources for large companies including multinational corporations, multinational development institutions and government agencies that require enormous resources that is difficult to be met by individual investors singly. sukuk funds generation is a veritable vehicle in the drive for resource mobilisation that is consistent with Islamic legal injunctions and maqasid al-shari’ah.
- For many investors, a major concern is whether there are diversified sources of income available from different investment outlets, and which at the same time can be liquidated without difficulty to meet needs as they arise. This legitimate concern is addressed if sukuk is utilised, as there are openings in the secondary market for trading in the sukuk where investors can sell their current holdings in full or in part, for cash including earnings where it is a profitable one.
- A major fault line usually associated with conventional financing is its unfair means of allocating returns from business efforts. This anomaly is effectively corrected by the use of sukuk, which carries a more equitable method of distributing wealth as all investors are carried along in fair manner and based on actual profits made. Note that there is broader scale of wealth circulation in this arrangement as opposed to the restrictive conventional means of raising finance.
- Islamic Banks and other financial institutions sometimes have difficulty in managing their liquidity situations as they are limited by sharia constraints. With sukuk issuance by corporate entities, an avenue is created for them. For the corporate entities, their need for large scale financing is met by the banks that may have vast resources trapped in excess liquidity.
- Public Private Partnership (PPP) which has been used in raising required financing for infrastructure provision and development could have potential for its sustenance with the utilisation of sukuk as a source of finance. There are also many possible benefits of utilising sukuk financing to many parties. To the originators, the benefits are seen in respect of reduced cost of funds occasioned by higher ratings, access to capital markets, bringing alternative and diversified funding sources, possibilities of reduction of risks, and possible tax relief on capital. Similarly, investors can derive benefits in terms of provision of safe harbour investment, an appropriate risk-reward relationship that ensues a fair profit sharing arrangement, and enhanced liquidity.
- Forward lease sukuk which is not widely known and used source of funding has the potential for uplifting economic developmental activities through infrastructure financing attributes it possesses.
Challenges of Sukuk
- Of course some challenges trail the issuance and utilisation of sukuk in corporate entities. The first challenge is related to viability of an economy that involves the private sector in the production of public infrastructure and public goods. Thus where there are fault lines in the overall activities in the economic landscape, such as high interest rates and inflation rates, such permeates to issuance and performance of sukuk.
- Another challenge for full utilisation of benefits associated with sukuk is the concern about the capacity of the public sector to establish a sound legal framework that would attract the private sector participation. In the private sector investors’ perspective, the existence of a clear and consistent legal framework is a precondition for participation.
- A further challenge facing the sukuk in Islamic corporate entities is related to their use in a context regulated by conventional laws. Current evidences that abound indicate that majority of the laws in various jurisdictions are at variance with Shari’ah provisions and thus do not favor Islamic finance. Furthermore, lack of consensus on Shari’ah compliance along with contingent matters that may surface with the application of conventional laws to sukuk, this could have combined effect of creating and enhancing apprehension among the investors.
- Assets that are tradable in the secondary market for sukuk are limited in number. This is as a result of the fact that those assets are sharia compliant and thus fresh issuers have limited supply of underlying assets and have to wait for maturity of the underlying assets before such new issuances can be made. This is unlike conventional bond issuances which do not have underlying assets as basis for issuance.
- Again, there is the challenge of standardisation of sukuk in its documentation and structures, and also standardisation in Shari’ah principles.
The views expressed in this article are the author’s own and do not necessarily reflect Saray Consultancy’s editorial stance.