SUKUK

Introduction
Bonds are important part of overall financial system.
Well developed bond markets ensures stable financial
system as it minimize over-reliance on financing from
the banking sector.
The development of the bond market allows for
access to funding with the appropriate maturities, thus
avoiding the funding mismatches. It also allows for the
diversification of risks by issuers and investors.

Sukuk- Introduction

Dealing in Bonds is not permissible according to

Shariah because of two aspects.
Firstly, they represent a portion of Debt payable by
the issuer. Earning any kind of profit falls under the
category of RIBA as defined in the Hadith

Every loan that draws any premium is Riba.

Introduction

Second aspect pertain to the trading of Bonds.

Shariah prohibits trading of debts (Bai Dayn) as it
involves Gharar.

Introduction

Sukuk are developed as alternative of Bonds.

A Sukuk represents proportionate actual or
beneficial ownership in an Asset or a Pool of
identified assets.
For a defined period the Risk and Return
associated with such Assets belong to Sukuk
holders which makes their return permissible for
the holder.

Introduction
Trade of such Sukuks is permissible, because it will be
equivalent to the sale/ purchase of holders
proportionate share in the assets.
However, trading of Murabahah and Salam Sukuks is
not permissible.

Sukuk- International Overview

Sukuk are gaining popularity as alternative source of funding.
Growth has been fuelled by strong demand for Shariah compliant
assets.
Malaysia and Middle East have emerged as key Sukuk centers
Also issued in Germany, Britain, japan, Philippines , Pakistan, etc.
Ijarah concept is the most popular amongst issuers of global Islamic
securities

Global Sukuk Issuance (Billion dollars)

Global Sukuk Issuance

Sukuk versus Conventional Bonds

Sukuk
Conventional Bonds
1. Income is generated 1. Income is derived
from assets
from debt instrument.
2. Return is expected
3. Negotiability is
restricted to specific
types of Sukuk

2. Return is interest and

pre-determined.
3. Negotiable financial
paper

Sukuk
4. Sukuk issuer is a
seller of assets
5. Sukuk holder is an
owner of assets
6. Seller-Buyer
relationship
7. Business risk-return
relationship

Conventional Bonds
4. Bond issuer is a
borrower
5. Bond holder is a
lender
6. Lender-borrower
relationship
7. Issuer guarantees
the payment of face
value and periodic
interest

Sukuk
8.Major risk lays with
underlying assets

Conventional Bonds
8.Major risk is with issuer
credit risk

9.Return is expected
from the underlying
assets

9.Interest payment is an
obligation

10.Return of investors
capital cannot be
guaranteed

10.Issuer is obligated to
return investors capital
(face value)

Sukuk- Types

The issuance of Sukuk requires an exchange of a

Shariah compliant underlying asset for a financial
consideration through the application of various
Islamic commercial contracts such as the
Mudarabah, Musharakah, Ijarah, Istisna, Salam and
Murabahah.
The equity-based nature of Mudarabah and
Musharakah Sukuk exposes investors to the risks
connected with the performance of the project for
which the financing is raised.

Sukuk- Types
In contrast, issuance of Sukuk on principles of Ijarah
and Murabahah yields deterministic receivable and
hence result in predictable and somewhat fixed
returns for the prospective investors.

What does an originator looks for?

Capital relief
Managing Assets liability
Off balance sheet funding
Reducing concentration risk
Direct access to capital Markets
Improved RoA / RoE

Sukuk Al Ijarah

Sukuk Al Ijarah

Ijarah is an Islamic alternate of conventional leasing.

Issuing certificates of ownership of assets, leased to
a particular customer is known as Sukuk Al Ijarah or
simply Ijarah Sukuk.
Ijarah Sukuk concept is one of the most popular
concepts among issuers of global Sukuk.
A simple process is explained next.

Sukuk- Sukuk Al Ijarah

If a Company requires, for example, 500 million for

the purchase of land, real asset, equipment etc it can
issue Ijarah sukuk equaling that amount in small
denominations, say 500,000 each.
After collection of funds from the investors the
company either purchases the asset on behalf of the
Sukuk investors or transfers the ownership of the
already acquired asset to sukuk holders usually by
establishing a Special Purpose Vehicle (SPV), which
owns the underlying assets.

SPV Structuring
Characteristics of the SPV
qBankruptcy remoteness
qThinly capitalized
qFormed for specified purpose; no other activities
undertaken
qDoes not add to the costs to the transaction Capital
efficient and tax efficient

Legal structure dependent on the regulatory and

legal environment in respective country

SPV Structuring
Alternative Payment structures
Pass through structure SPV remits any funds
collected completely and immediately to the investors
Pay through structures
q

SPV has discretion to re-invest the funds and pay investors

accordingly to a predetermined schedule

Conduits vehicle set up for the multiple

issuance
q

Typically credit card and Commercial Papers ( in US

and Europe)

Sukuk Al Ijarah

The investor or sukuk holders owns the asset held

by SPV as Trustee in the form of Sukuk. The asset
is then leased to the firm and the lease proceeds
from the asset is distributed to the sukuk holders as
return/dividend.
The returns on the sukuk certificates could be
either fixed or floating. As the expected returns
(pre-determined rental payments) are fixed and can
be treated as predictable like the coupon payments
of a conventional bond.

Sukuk Al Ijarah
Ijarah sukuk can be issued through a financial
intermediary, a bank or a brokerage house or
directly by the users of the leased asset. A third
party can also guarantee rental payments.
Since the yield is predetermined and the underlying
assets are not liquid but tangible and secured, thus
the Ijarah certificate can be freely traded in the
secondary markets at par, premium or discount.

Sukuk Al Ijarah
Structure

ABC
Ltd.
(Corporate)

ABC Ltd. wishes to purchase a new asset and plan to

raise finance through issuance of Sukuk.

Supplier

Supplier of the Asset is

identified and negotiations is
finalized by ABC Ltd.
ABC
Ltd.

Supplier

ABC
Ltd.

Issuer
SPV
(LLC
100%
owned
ABC Ltd.)

SPV is created by ABC Ltd. as a limited liability

Company.

SPV issues certificates and receives proceeds which

are used to purchase asset from the supplier

Supplier
Payment made to
Supplier
Title is transferred to
SPV

ABC
Ltd.

Issuer
SPV
(LLC
100%
owned
ABC Ltd.)

Investors

SPV holds Asset as

Trustee and leases the
plant to ABC Ltd. as per
rules of Ijarah
SPV holds
Plant/
Asset as
Trustee

ABC
Ltd.

SPV leases
Plant to ABC
Ltd. on
Ijarah

Issuer
SPV

Investor

ABC Ltd.
(Lessee)

Issuer
SPV

Periodic Lease Rentals

Investors

Semi-annual coupon
distribution amounts

ABC Ltd. (Lessee) pays periodic rentals to SPV for

tenors & amounts matching the coupon & tenor of the
Sukuks

Exercises the purchase undertaking.

Asset transferred to ABC Ltd.

ABC Ltd.
(Lessee)
Pays the
exercise price at
dissolution

Issuer
SPV

Investors
Redeems the
Trust Certificates
at dissolution

ABC Ltd (Lessee) give the SPV an irrevocable purchase

undertaking to purchase the Asset at maturity.
Exercise Price = Initial Purchase Price of Asset + service costs.
Asset is transferred back on maturity, upon payment of the
Exercise Price to the SPV / Sukuk Holders.

Sukuk-Sukuk Al Ijarah
Important Conditions
Ijarah Sukuk represents the holder's proportionate
ownership in the leased asset.
The holder will assume the rights and obligations
of the owner/lessor to the extent of his ownership.
As owner the holder will have the right to enjoy a
part of the rent according to his proportion of
ownership in the asset.

Sukuk-Sukuk Al Ijarah
Important Conditions
In the case of total destruction of the asset, holder
will suffer the loss to the extent of his ownership.
SPV rules in some countries do not allow SPV to
hold actual tangible assets, therefore, the asset is
shown on the books of the client itself instead of
SPV.

Sukuk-Sukuk Al Ijarah
Essential Condition
Its essential that the Ijarah Sukuk are designed to
represent real ownership of the leased assets, and not only a
right to receive rent.

Sukuk-Sukuk Al Ijarah
Innovation in Pakistan
In Pakistan essentialy the same structure has
been used to develop Sukuks based on
Diminishing Musharakah.

Sukuk-Sukuk Al Ijarah
Innovation in Pakistan

There are two basic differences in Diminishing

Musharakah Sukuks:
Underlying Assets is jointly owned by investors and
issuer according to specified percentage.
Ownership is also transferred periodically to the
issuer.
Ijarah is essential part of a Diminshing Musharakah
transaction under Shirkatul Milk.

Sukuk Al
Murabaha

Sukuk al-Murabaha
Murabaha is basically the sale of goods at a price
comprising the purchase price plus a margin of profit
The margin of profit must be negotiated and agreed
upon by both parties to the transaction

Sukuk al-Murabaha structure

Investors

6.Sale price
+ profits

2. Sukuk issues
and Sukuk proceeds
3. Spot payment

Issuer SPV
3. Commodity
1.Master
agreement

4. Murabaha
Commodity

4. Deferred payment

Borrower

Commodity
supplier

Overview of Structure
Issuer SPV issues sukuk, which represent an undivided ownership interest
in an underlying asset or transaction. They also represent a right against
Issuer SPV to payment of the Deferred Price.
The Investors subscribe for sukuk and pay the proceeds to Issuer SPV
(the Principal Amount). Issuer SPV declares a trust over the proceeds
(and any commodities acquired using the proceeds and thereby acts as
Trustee on behalf of the Investors.
Originator (as Purchaser) enters into a murabaha agreement with Trustee
(as Seller), pursuant to which Trustee agrees to sell, and Originator agrees
to purchase, certain commodities (the Commodities) from Trustee on
spot delivery and deferred payment terms. The period for the payment of
the deferred price will reflect the maturity of the sukuk. Trustee purchases
the Commodities from a third party Commodity Supplier for a Cost Price
representing the Principal Amount for spot payment.

Commodity Supplier makes spot delivery of the Commodities to

Trustee in consideration for the Cost Price.
Trustee (as Seller) on-sells to Originator the Commodities upon
delivery from Commodity Supplier in accordance with the terms
of the murabaha agreement
Originator (as Purchaser) makes payments of deferred price at
regular intervals to Trustee (as Seller). The amount of each
deferred price instalment is equal to the returns payable under
the sukuk at that time.
Issuer SPV pays each deferred price instalment to the Investors
using the proceeds it has received from Originator.

Required Documentation
Document
Murabaha Agreement

Sale and Purchase

Agreement

Parties
Summary / Purpose
Originator (as Purchaser) Trustee (and the Investor)
and Trustee (as Seller) sells Commodities to
Originator on spot
delivery and deferred
payment terms.
Documents the terms of
the murabaha sale
transaction as well as
terms of payment of
deferred price.
Trustee (as Buyer) and Commodity Supplier sells
Commodity Supplier (as Commodities to Trustee
Supplier)
on spot delivery and spot
payment terms

Related Structures/Structural Developments

Sharia prohibits the trading of debt receivables, particularly
when doing so at a discount may give rise to interest (riba).
As discussed earlier, this limits the negotiability of sukuk
certificates issued under the sukuk al-murabaha structure
as such certificates essentially represent entitlements to
shares of debt receivables from the purchaser of the
underlying murabaha, and this structure has thus been less
commonly used in recent times.

Despite the global downturn in sukuk issuance in 2008,

issuances based on the sukuk al-murabaha structure
increased by nearly 60%4 . Whilst sukuk al-murabaha
issuances still only account for a small fraction of the
total value of the sukuk market, the increased number of
issuances suggest that the structure is still favoured for
smaller deals, where the Investors are more likely to be
buy-to-hold investors hence more immune to
uncertainties over negotiability

Sukuk al-Istisna

sukuk al-istisna often combines an istisna arrangement

with a forward lease arrangement whilst the istisna is
the method through which the investors can advance
funds to an originator, the ijara provides the most
compatible payment method to those investors.

Sukuk al-Istisna structure

Sukuk holders
(investors)

1.Sukuk
proceeds

5. Distribution of
returns

4.Monthly
Payments

2.Payments

Contractor/builder

End buyer

SPV
3. Title to assets

4. Title to assets

1. SPV issues Sukuk to investors and receive proceeds

2.Sukuk proceeds are used to pay the contractor/
builder to build and deliver the future project
3.Title to assets is transferred to the SPV
4.Property/project is leased or sold to the end buyer.
The end buyer pays monthly installments to the SPV
5. The returns are distributed among the Sukuk holders

Sukuk al-Istisna characteristics

Issued with the aim of mobilizing the funds
required for producing products owned by the
certificate holders
The issuer of these certificates is the manufacturer
(supplier/seller)
The subscribers are the buyers of the intended
product
The certificate holders own the product and are
entitled to the sale price of the certificates

Sukuk Al
Musharakah

Sukuk-Sukuk Al Musharakah
Musharakah is a mode of financing against which
Sukuks can be issued.
If a comapany required financing for any of its
project through Musharakah it can issue Sukuks
against which investors would provide funding as
per the rules of Musharakah.

Sukuk-Sukuk Al Musharakah
Every Sukuk would represent holder's
proportionate ownership in the assets of the
Musharakah.
Once the majority of the cash amount is
converted into fixed assets, these Musharakah
Sukuk can be treated as negotiable instruments
in the secondary market.

Sukuk-Sukuk Al Musharakah
Important Conditions
Profit earned by the Musharakah is shared
according to an agreed ratio between the Issuer
and Investors at an agreed ratio.
Loss is shared on pro rata basis.
Profit & Loss is shared between the investors as
per investment ratio only.

Sukuk-Sukuk Al Musharakah
Important Conditions
To ensure tradability of the Sukuks following
condition should be adhered to:
All the assets of the Musharakah should not be
in liquid form.
At least 20% of the value of Portfolio should be
invested in non-liquid assets.

Sukuk-Sukuk Al Musharakah
Musharakah Sukuks can be used for number of
purposes including:
Construction of Projects and factories
Expansion Projects
Working Capital Finance

Sukuk al-Musharaka structure

Originator/
Corporate
1.Physical
asset
contribution

3b.Periodic profits
+incentive fees

0&5. Musharaka Arrangement

+Undertaking to buy Musharaka
shares of the SPV on a periodic
basis

Investors

Musharaka

2b. Sukuk
proceeds

3a.Periodic profits

2a. Sukuk
proceeds

SPV
4. Periodic distribution of profit

1.

Sukuk al-Musharaka structure

The Originator/Corporate contributes some

specific assets and management skills

2. a&b The Sukuk issuer (usually a SPV) contributes

the investors Sukuk proceeds
3. a&b The Originator/Corporate runs the JV,
operates the assets and invests the funds. It
distribute the profits
4. Sukuk holders are entitled to the Issuers rights in
the JV whatever they are
5. The Corporate irrevocably undertakes to buy at a
pre-agreed price the Musharaka shares of the SPV

Sukuk-Other types
Sukuks are also issued under hybird structures
where number of Islamic modes of finance are
used to issue a single Sukuk.
Under these structures each of Islamic mode is
applied at different intervals to cater to different
requirements of the issuer.
.

Sukuk-Standardization
AAOIFI has also issue Shariah standards for Sukuks
and its expected that issuance of these standards
would help reducing differences in fatwas issued for
Sukuks.

Sukuk-Criticism
Some Sukuks are criticized for their close
resembelence with conventional bonds.
These similarities are created to adhere to the tax
and other regulatory laws of the country.
For example, in Pakistan SPVs cannot hold actual
assets. For this reason assets cannot be carved
out from the balance sheet of the issuer which
creates complexities in identification of the assets
and only a hypothecation charge ensures bank's
benefical ownership in the Musharakah assets.

Sukuk-Criticism
Similarly, concept of the Diminishing Musharakah
financing is not there in the stamp duty laws of
Pakistan, which compels banks to sell share in
assets without any legal registration.
It should be noted that concept of Diminishing
Musharakah is recognized in British stamp duty
laws since April 2003.
Nevertheless, not all of this criticism is incorrect,
and therefore
it should be ensured that
unesseccary usage of artificial structures should be
avoided as much as possible.

Sukuk-Criticism
The problems could be resolved by Shariah rating
systems
This will help investors in making informed
decisions regarding the authenticity of the Shariah
structure of the Sukuk.

Sukuk-Benefits
Sukuk can be used very effectively as a halal
alternate to conventional bonds for providing
funding for matching maturities and without
relying too much on commerical banking sector.
Another aspect of Sukuks which make them more
effective than bonds is there ability to mobilize
and motivate investors to work for the overall
benefit of the issuer.

Sukuk-Benefits
Sukuks for Government Projects
Sukuks based on Ijarah can be used very
effectively to finance Government projects.
If general public is involved in the construction of
these project through issuance of Sukuks, it can
give them sense of ownership.
Effective usage of such Sukuk would increase the
ratio of success and ratio of sustainability of the
projects by many folds.

Sukuk-Benefits
Sukuks by Private Sector
Corporate Sector can also benefit from unique
characteristic of Sukuks.
Musharakah Sukuks can be used to associate
general customer with the company.
Sense of ownership and share in the profit of the
company can be used as a marketing tool for the
products of the company.

Sukuk-Benefits
Sukuks by Private Sector

The more company earns the more return investor

would get concept can revolutionalize sales.

Even Sukuks Al Ijarah would help the companies to

position themselves as an caring member of the
society by involving community in the business of the
company.

Sukuk-Conclusion
Sukuks can be used very effectively to obtain
Shariah Compliant funding which surely bring
Allah's blessing and barakah for the business.
Issuers can also benefit from the huge increase in
liquidity in the Islamic world, and can tap on these
new sources of funds. Raising funding from the
Islamic bond market in the current environment
has been 10 to 20 basis points lower than
mainstream bonds.