Course: Sukuk Management (5449)
Semester Autumn 2021
Level: Associate Degree
Assignment no 1.
Question no 1.
Q1 Explain the concept of sukuk Discuss and evaluate sukuk market in Pakistan with examples.
A sukuk is an Islamic financial certificate, similar to a bond in Western finance, that complies with Islamic religious law commonly known as Sharia. Since the traditional Western interest-paying bond structure is not permissible, the issuer of a sukuk essentially sells an investor group a certificate, and then uses the proceeds to purchase an asset that the investor group has direct partial ownership interest in. The issuer must also make a contractual promise to buy back the bond at a future date at par value.Understanding Sukuk. With the rise of Islamic finance, sukuk have become extremely popular since 2000, when the first such products were issued in Malaysia. Bahrain followed suit in 2001. Fast forward to current times, and sukuk are used by Islamic corporations and state-run organizations alike around the globe, taking up an increasing share of the global fixed-income market.
Islamic law prohibits what’s known as “riba,” or what we understand as “interest” in the West. Therefore, traditional, Western debt instruments cannot be used as viable investment vehicles or ways to raise capital for a business. To circumvent this, sukuk were created in order to link the returns and cash flows of debt financing to a specific asset being purchased, effectively distributing the benefits of that asset. This allows investors to work around the prohibition outlined under Sharia and still receive the benefits of debt financing. However, because of the way that sukuk are structured, financing can only be raised for identifiable assets.
Thus, sukuk represent aggregate and undivided shares of ownership in a tangible asset as it relates to a specific project or a specific investment activity. An investor in a sukuk, therefore, does not own a debt obligation owed by the bond issuer, but instead owns a piece of the asset that’s linked to the investment. This means that sukuk holders, unlike bond holders, receive a portion of the earnings generated by the associated asset.
Sukuk vs. Traditional Bonds
Sukuk and conventional bonds do share similar characteristics, but also have important key differences:
Both provide investors with payment streams.
Bonds and sukuk are issued to investors and may be used to raise capital for a firm.
Both are considered to be safer investments than equities.
Sukuk investors receive profit generated by the underlying asset on a periodic basis while bond investors receive periodic interest payments.
Sukuk involves asset ownership while bonds are debt obligations۔
If the asset backing a sukuk appreciates then the sukuk can appreciate whereas bond yield is strictly due to its interest rate.
Assets that back sukuk are halal whereas bonds are often riba and may finance non sharia compliant businesses or fuel speculation.
Sukuk valuation is based on the value of the assets backing them while a bonds price is largely determined by its credit rating.
Sukuk Example: Trust Certificates
The most common type of a sukuk comes in the form of a trust certificate. These certificates are also governed by Western law, however, the structure of this type of sukuk is more nuanced. The organization raising funds first creates an offshore special purpose vehicle (SPV). The SPV then issues trust certificates to qualified investors and puts the proceeds of the investments toward a funding agreement with the issuing organization. In return, the investors earn a portion of the profits linked to the asset.
Sukuk structured as trust certificates are only applicable if the SPV can be created in an offshore jurisdiction that allows such trusts. This is sometimes not possible. If an SPV and trust certificates can’t be created, a sukuk can be structured as an alternative civil-law structure. In this scenario, an asset-leasing company is created in the country of origin, effectively purchasing the asset and leasing it back to the organization in need of financing
Q2 What are the various expected benefits of investment funds in sukuk market? Discuss with examples.
Benefits of Sukuk
Among benefits of Sukuk we can refer to these: Sukuk is tradable capital market product providing medium to long-term fixed or variable rates of return. It is assessed and rated by international rating agencies, which investors use as a guideline to assess risk/return parameters of a Sukuk issue. It has regular periodic income streams during the investment peri- od with easy and efficient settlement and a possibility of capital apprecia- tion of the Sukuk. Finally, Sukuk are liquid instruments and tradable in secondary market
Sukuk can play an important part in the development of an Islamic market and banking system. The main advantage of sukuk is to comply with Sharia while boosting the standard of living in Islamic society and developing these societies’ economies. However, sukuk also bring several other important benefits.
Sukuk provide an ideal way of financing large projects for the public good that would otherwise not be possible. There are many economic activities or projects that are out of reach of individuals, companies, or, in the case of various developing Islamic economies, governments. In these cases, sukuk are perfect for financing these projects without falling into interest-based debt. This makes sukuk an important avenue for redistribution of wealth and achievement of social justice. The use of sukuk to fund large projects means that investors in sukuk are incentivized to help economies develop by creating and producing rather than by consuming or manipulating others. Islamic finance is based on principles of fairness and justice which are achieved by avoiding Riba.
Investors on the secondary market that are looking for investments that can be liquidated easily will find that sukuk are ideal. Thanks to the secondary market for Islamic securities, investors can sell their securities and obtain the cost of their certificates. If the projects that back their sukuk certificates have generated profits, this results in a quick return in investment. This means that Islamic financial instruments are well suited for fund management. Banks or institutes can use part of their funds to purchase Islamic securities and then sell them on the secondary market when liquid assets are needed. Sukuk are well suited for smart management of risk. Uncertainty is a big part of investment. Islamic securities can be issued with varying degrees of risk and yield, allowing investors to choose a portfolio best suited for their risk management profiles. It is important to note that risk in sukuk is more difficult to manipulate artificially than is the case in other types of securities. This is because the value and risk of sukuk is always related to real assets with provable, tangible value, rather than on artificial manipulation of debt and credit ratings.
sukuk is an Islamic equivalent of a bond. It’s a financial certificate that represents ownership of certain assets. When companies or governments aim to raise money for certain projects, they’ll issue a sukuk and use the investment proceedings to buy assets. In return, investors will receive periodic payments and principal investment when the sukuk matures.
Sukuk are considered Shariah-compliant because they don’t involve interest payments (as conventional bonds do). Instead, the payments come from profit-sharing or rental of the assets.
You want consistent income
A sukuk provides regular payments (i.e. on a yearly, semi-annually or quarterly basis) to its investors. These payments are fixed and pre-determined, which makes sukuk a good investment if you need predictable income on a regular basis.
If you invest in a sukuk fund, the fund manager may distribute these payments to you in the form of monthly, quarterly, semi-annual or annual dividends.
- You need to lower the risk in your portfolio
As you grow older, you may need to lower your risk by increasing the proportion of low-risk investments in your portfolio. That’s because older investors have less time to recover if their portfolios experience huge losses. Investing in sukuk can help you lower the risk in your portfolio, as sukuk are less volatile than other asset classes like equities. This helps to protect your portfolio when markets are volatile.
- You need to preserve your capital
If you need to cash out your investments soon – say, you’re expecting to retire in a few years – you should focus on capital preservation. This means preserving your investments and avoiding losses.
Investing in sukuk is a good way to preserve your capital. Unlike equities, where prices can go up or down, the value of a sukuk will not change, unless you sell it on the secondary market (i.e. to other investors) for a different price. If you wait for the sukuk to mature, you will receive your principal investment.
A sukuk’s returns can depend on its credit rating. A sukuk with a lower rating is deemed to be riskier, but will offer higher payouts. A sukuk with higher ratings is less risky, but will offer lower payouts.
If you invest in a sukuk unit trust fund – that is, a fund that pools together money from many investors to buy a group of sukuk – the fund may manage its yield and volatility by buying sukuk with different ratings and maturities.
For example, the Principal Islamic Lifetime Sukuk Fund by Principal Asset Management aims to gain a higher-than-average income over the medium to long-term. To do so, it invests in a diversified portfolio of sukuk and other Shariah-compliant investments. Here’s how the fund has performed since its inception:
Q3 What are the various types of sukuk securities operated in the financial market in Pakistan? Discuss with examples..
There are five main types of bonds:
Treasury, savings, agency, municipal, and corporate.
Each type of bond has its own sellers, purposes, buyers, and levels of risk vs. return.
If you want to take advantage of bonds, you can also buy securities that are based on bonds, such as bond mutual funds. These are collections of different types of bonds.
One of the differences between bonds and bond funds is that individual bonds are less risky than bond mutual funds.
US Treasury Bonds
The most important bonds are the U.S. Treasury bills, notes, and bonds issued by the Treasury Department. They are used to set the rates for all other long-term, fixed-rate bonds. The Treasury sells them at auction to fund the operations of the federal government.
These bonds are also resold on the secondary market. They are the safest, since they are guaranteed by the United States government. That means they also offer the lowest return. They are owned by almost every institutional investor, corporation, and sovereign wealth fund.
Treasury Inflation-Protected Securities are Treasury bonds that protect against inflation
Savings bonds are also issued by the Treasury Department. These bonds are meant to be purchased by individual investors. They are issued in low enough amounts to make them affordable for individuals. I bonds are like savings bonds, except they are adjusted for inflation every six months.
Quasi-governmental agencies, like Fannie Mae and Freddie Mac, sell bonds that are guaranteed by the federal government.
Municipal bonds are issued by various cities. They are tax-free but have slightly lower interest rates than corporate bonds. They are slightly more risky than bonds issued by the federal government. Cities occasionally do default.
Corporate bonds are issued by all different types of companies. They are riskier than government-backed bonds, so they offer higher rates of return. They are sold by the representative bank.
There are three types of corporate bonds:
Junk bonds or high-yield bonds are corporate bonds from companies that have a big chance of defaulting. They offer higher interest rates to compensate for the risk.
Preferred stocks are technically stocks, but they act like bonds. They pay you a fixed dividend at regular intervals. They are slightly safer than stocks in case of a bankruptcy. Holders get paid after bondholders but before common stockholders.
Certificates of deposit are like bonds issued by your bank. You essentially loan the bank your money for a certain period of time for a guaranteed fixed rate of return.
Types of Bond-Based Securities
You don’t have to buy an actual bond to take advantage of its benefits. You can also buy securities that are based on bonds. They include bond mutual funds, which are are collections of different types of bonds.
One of the differences between bonds and bond funds is that individual bonds are less risky than bond mutual funds. Assuming that there are no defaults, the holder of an individual bond gets his principal sum intact upon the instrument’s maturity. With bond funds, the investor risks losing his principal should prices fall.
Bond securities also include bond exchange-traded funds (ETFs). They perform like mutual funds, but they don’t actually own the underlying bonds. Instead, ETFs track the performance of different classes of bonds. They pay out based on that performance.
Bond-based derivatives are complicated investments that get their value from the underlying bonds.1 They include the following:
Options give a buyer the right, but not the obligation, to trade a bond at a certain price on an agreed-upon future date. The right to buy a bond is called a “call option.” and the right to sell it is called the “put option.” They are traded on a regulated exchange.
Futures contracts are like options, except they obligate participants to execute the trade. They are traded on an exchange.
Forward contracts are like futures contracts, except they are not traded on an exchange. Instead, they are traded over-the-counter either directly between the two parties or through a bank. They are customized to the particular needs of the two parties.
Mortgage-backed securities are based on bundles of home loans. Like bonds, they offer rates of return based on the value of the underlying assets.
Collateralized debt obligations (CDOs) are based on auto loans and credit card debt. They also include bundles of corporate bonds.
Asset-backed commercial paper is a one-year corporate bond package. The value is based on that of underlying commercial assets. These include real estate, corporate fleets, or other business property.
Interest rate swaps are contracts that allow bondholders to swap their future interest rate payments. They occur between a holder of a fixed-interest bond and one holding a flexible-interest bond. They are traded over-the-counter.
Total-return swaps are like interest rate swaps, except the payments are based on bonds, a bond index, an equity index, or a bundle of loans.
- 4 Discuss and evaluate the guidelines for issuing sukuk securities prescribed by Organization of Islamic Countries.
In this section we deal with this subject that one of the above mentioned forms of Sukuk is more similar to bonds and one of them is more similar to shares. As mentioned before, Sukuk are in two forms of asset-based and asset-backed. In the first type, original capital is guaranteed via tan- gible or intangible assets of the issuer; and, the profit payable to inves- tors is not necessarily stemmed from a specified asset. However, in terms of the second type, both repayment of original capital and income be- longing to the investor is directly resulted from underlying asset ( it should be noted that in terms of the repayment, it is possible if the asset exists and is not destroyed on the maturity date).
14 Therefore, holders of the second type of Sukuk share also the loss. Moreover, in this type due dates for payment of profits are not predetermined; whereas, in the first type a specified amount of profit is paid to the Sukuk holders on certain time intervals, in the second type of Sukuk, the amount of profit de- pends on earnings resulted from the asset. 15In fact, original capital and profit belonging to asset-based Sukuk is guaranteed; while, original capi-tal and profit belonging to the holders of asset-backed Sukuk is not guar- anteed and they share both the loss and profit. To the same reason, structures of first and second type of Sukuk have been resembled to bonds and stocks, respectively. It should be noted that, shareholders divide the remaining parts of the company’s assets among themselves in proportion to their shares, due to the stock’s structure. Meanwhile, in case the originator becomes bankrupted in process of issuance of asset- backed Sukuk, holder has objective right as to the assets specifically used for such issuance (priority against other creditors); however, because the Sukuk holders will be affected by the loss of the same specific asset in the case of being destroyed or discounting of that asset, these securities may be considered similar to the stocks. Each of Sukuk types, e.g. lease- based Sukuk may be of asset-backed or asset-based type. In asset-based
Sukuk, holders are considered as beneficial owners; and, in terms pay- ment of profits is failed, they are entitled to refer to the originator.
By beneficial ownership, we mean some elements of the “ownership right” package such as the right to use the profit from the asset belong- ing to the beneficial owner; even though, the legal ownership belongs to another person. Therefore, these securities hold a value independent of underlying asset and are considered beyond title deeds. Their meaning is closer to the concept of common bonds; while, they do not represent or prove any specific asset. In asset-backed Sukuk, holders are owners of the asset and in case the originator fails to pay the profit, they are entitled to collect their debts from the asset. 16Theoretically, Islamic financial system is mostly considered as an asset-backed financial system; connect- ing each financial claim to a real asset related thereto. In Islamic financial system, each financial claim is considered as a dependent claim, returns or performance of which depends on return or performance of a real undertaken asset.17 Practically, issuing the most prevailing type of Sukuk e.g. lease-based Sukuk is based on asset-based system, payment of prin- cipal and profit is guaranteed and it resembles the structure of bonds in non-Islamic countries. Although holders of bonds are not theoretically sharing loss with the originator and they just receive profit; in case of issuance of Islamic securities, the risk imposed on the holders is re- moved with the help of insurer institutions and their function is identical to that of bonds, in practice. In non-Islamic countries, asset-backed se-curities resemble guaranteed debt, i.e. the company puts its own assets (such as financial claims) as a support for loan payment. As a result holders of asset-backed securities have to pay more attention to those assets backing a loan, rather than overall assets of the business. 18In asset-backed Sukuk, in case the originator becomes bankrupted,
holders of Sukuk have priority against other creditors because their secu-rities represent their objective right towards the asset backing the issu- ance of those securities. 19Asset-based Sukuk were foreseen because the issuers were not willing to sell the asset and investors were not ready to accept the risk resulted from asset-backed ownership; they were demand-ing documents similar to bonds, with fixed incomes. It seemed necessary for the asset-backed to be sold to investors, transforming them to bene- ficial owners; while the legal ownership still belonging to the issuer. This way, investor would just share the profit stemmed from the asset; which, this kind of ownership is not accepted by Sharia. 20 However, supposing issuance of asset-backed Sukuk, it should be cited that in fact there is still no difference between the two structures (asset-backed Sukuk and bonds); that is, in both cases and if the project is not profitable or the assets are lost, the loss is borne by the investor. The difference is that, in terms of Sukuk, possible dishonoring is already included in the contract concluded between investor and issuer. So, the economic result is the same even if legal analyses in terms of Sukuk may be based on consisten- cy of wills and also sharia. This way, the only difference between asset-backed Sukuk with bonds in conventional term is that Sukuk holders share the loss and profit through contract, in which the buyers of this type of securities explicitly exempt the issuer from payment of profit, in case of bankruptcy.
On the contrary, nonpayment of profit resulted from bankruptcy in terms of conventional bonds depends on an implicit provision. That is, buyers of bonds as reasonable and normal human beings implicitly ac-cept incapability of the issuer to pay the principal or profit in case of bankruptcy; and, knowingly they buy the bonds. So, we may not differ-entiate between asset-based and asset-backed Sukuk, in terms of eco- nomic effects. Again, it should be noted that in Islamic economy and financing, asset-based securities also make the philosophy of these mar- kets to become realized. The reason is that, ownership is a credit-based. Securities (securitizat- ion) in Terms of Sukuk
The purpose of this section is to clarify securitization process in Sukuk structure. As we know, conversion of assets to securities makes those commodities, claims, or credits incapable of becoming cash, or thosewhich are potentially unusable, to become convertible to securities and also transferrable, accordingly.
Conversion of assets to securities enables minor investors to buy small parts of the asset without being enforced to pay entire price of the overall asset for its purchase. Contrary to guaranteed debts, converting assets to securities means transfer of ownership of the asset to a SPV, which the latter subsequent- ly sells his related right over the assets to the investors, against cash payment. In fact, converting the assets to securities is an organized pro- cess upon which, loan interests or other receivables and claims are pack- aged and underwritten; then, they would be sold in form of asset-backed securities. The process enables investors to allocate the capital more effi- ciently and find access to variable resources with less cost, primarily.
Then, the process leads to liquidity or improving it. In other words, conversion to securities is a process during which, the assets belonging to the owner or the originator will be extracted from the balance sheet.
In turn, financing would be made by those investors who buy a tradable financial instrument; the instrument represents such a debt, with no ref- erence being made to the first lender. Process of converting the assets to securities makes the companies’ procedure of investment, more efficient.
In the process, when the company’s assets are backing issuance of secu- rities or Islamic securitiesand the asset is converted to securities; securi- ties become valuable and could be transacted in primary and secondary markets. The asset may be the company’s loan or mortgage assets. In Islamic financing system, generally in process of converting assets (including mortgage loans) to securities, the company or institution in need of financing establishes a SPV, SPE, or SPC and sells to it those of its assets which have perspective cash flows. The SPV issues asset- backed securities to provide money required for the purchase of afore- mentioned assets and the securities are sold to all of the investors. Then, the latter pays to the originator, the fund obtained from selling the secu- rities, for purchase of financial assets. Those investors, who have bought asset-backed securities, obtain profit from cash flows stemmed from financial assets of SPV.
Q5 Explain the concept of mudarabah sukuk Discuss the process of mudarabah sukuk with examples.
Mudarabah means a form of partnership where one partner provides funds, while the other provides skill, expertise and management. 14.39 “Mudharib/Mudarib” means a working partner, who provides entrepreneurship, skill and management under a Mudarabah agreement as distinct from the Rub-ul-Mal who provides the finance.
Companies have increasingly looked to Sukuk issuances as a Shari’a compliant method to raise finance for their growing financial needs. Sukuk attracts investors in the region and internationally who are keen to invest in Shari’a compliant instruments. Unlike bonds, Sukuk are structured as asset based certificates which represent an interest (typically ownership or usufruct rights) in the underlying assets. The most popular Sukuk structures include the Sukuk Al Ijara, based on a lease finance structure, Sukuk Al Mudaraba based on a joint investment structure and Sukuk Al Musharaka based on a partnership structure. One of the key debates centres around the issue of sharing of losses between the investors and the issuers. In a conventional bond issuance, the issuer is responsible for the payment of interest and principal to the bondholders without any correlation to the performance of the issuer’s underlying business. However, in equity linked Sukuk structures such as the Sukuk Al Mudaraba and Sukuk Al Musharaka, there are restrictions both from a legal perspective as well as from a Shari’a perspective on guaranteeing the principal and profit elements.
In Islamic finance, Mudarabah is a distinct type of partnership, wherein one partner provides the capital to an entrepreneur (another partner) for investing in a commercial initiative, with the objective of sharing profit from the commercial entity. The entrepreneur then undertakes the activities and management of the entity and the profit is shared between the partners in a predetermined quantum, while loss is borne by the investing partners. The investing partner will not interfere in the day-to-day management, but may specify certain conditions related to managing the capital. In other words, he may be referred to as a silent partner.
In Mudarabah, the profit distribution must be pre-determined by both the parties and will be solely dependent on the profit accrued, which is independent of the capital invested in the commercial entity. The Shariah law does not indicate the percentage distribution of profit and will be at the discretion of both parties. Either party, in accordance with the terms and conditions given, can terminate a Mudarabah contract at any time.
Interest-bearing loans are prohibited under Islam’s Sharia law.
In Islamic finance, murabaha financing is used in place of loans.
Murabaha is also referred to as cost-plus financing because it includes a profit markup in the transaction rather than interest.
A seller and buyer agree to the cost and the markup, which are then paid in installments.
In a murabaha contract of sale, a client petitions a bank to purchase an item on their behalf. Complying with the client’s request, the bank establishes a contract setting the cost and profit for the item, with repayment typically in installments. Because a set fee is charged rather than riba (interest), this type of loan is legal in Islamic countries. Islamic banks are prohibited from charging interest on loans according to the religious tenet that money is only a medium of exchange and has no inherent value; so banks must charge a flat fee for continuing daily operations.
Many argue that this is simply another method of charging interest. However, the difference lies in the structure of the contract. In a murabaha contract for sale, the bank buys an asset and then sells the asset back to the client with a profit charge. This type of transaction is halal or valid, according to Islamic Sharia/Sharīʿah.
Issuing conventional loans and charging interest on them are considered interest-based activities, which are haram (prohibited) according to Islamic Sharīʿah.
Murabaha and Default
Additional charges may not be imposed after a murabaha due date, which makes murabaha default an increasing concern for Islamic banks. Many banks believe defaulters should be blacklisted and not allowed future loans from any Islamic bank as a method of decreasing murabaha default. Even if it is not expressly mentioned in the loan agreement, this arrangement is permissible in Sharia. If a debtor is facing a genuine hardship and cannot repay a loan on time, respite may be given as described in the Quran. However, the government may take action in cases of willful default. Defaults under murabaha arrangements have become a problem for companies operating under Islamic law and there has been no clear consensus on how to deal with them.
Use of Murabaha
The murabaha form of financing is typically used in place of loans in diverse sectors. For example, consumers use murabaha when purchasing household appliances, cars, or real estate. Businesses use this type of financing when purchasing machinery, equipment, or raw materials. Murabaha is also commonly used for a short-term trade, such as issuing letters of credit for importers.
A murabaha letter of credit is issued on behalf of an applicant (importer). The bank issuing the letter of credit agrees to pay an amount of money in compliance with the terms described in the letter of credit. Because the bank’s creditworthiness replaces that of the applicant, the beneficiary (exporter) is guaranteed payment. This benefits the exporter because the bank assumes the payment risk. Following the murabaha contract provisions, the importer is required to repay the bank for the cost of goods plus a profit markup Amounts.
Example of Murabaha
Bilal would like to buy a boat that sells for $100,000 from Billy’s Boat Shop. To do so, Bilal would contact a murabaha bank, that would buy the boat from Billy’s Boat Shop for $100,000 and sell it to Bilal for $109,000, to be paid in installments over a three year period. The amount Bilal pays is a fixed amount to a bank that owns the asset and there is no interest charge involved. Also, if Bilal defaults on any payments, there are no additional charges that he would incur. The additional amount Bilal pays over the cost price from the boat shop is in effect a 3% loan, but because it is offered as a fixed payment without any additional costs, it is allowed by Islamic law.