MIR Takaful Investment

Islamic Features of a Sukuk

In this article, Hajah Salma Bee Haji Noor Mohamed Abdul Latif, Director of the Centre for Islamic Banking, Finance and Management Unit, and Dr Abul Hassan, Visiting Lecturer, Faculty of Business, Economics and Policy Studies, Universiti Brunei Darussalam, outline the various types of sukuks whose issuances are growing in the Islamic capital market. They also explain how these bonds are structured.
Dr Abul Hassan

he sukuk is rising in popularity as an investment instrument for takaful companies in the current situation when the Islamic nancial market is less developed than its conventional counterpart. Among other things, sukuks form an asset class which allows the takaful industry to create annuity-type products. As the takaful sector expands, so, too, will the market for sukuks or Islamic bonds, and in turn, the increased availability of Shariah-compliant investment vehicles fosters the development of takaful in what is a virtuous cycle. Thus, sukuks are an invaluable part of the Islamic capital market. Indeed, what is a sukuk? It is an Islamic bond which is structured by bundling leasing transactions, but behaves in practice like any highly-rated bond. In response to the emergence of interest in issuances of Islamic asset-backed nancial instruments, the Accounting and Auditing Organisation for Islamic Financial Institutions (Aaoi) released an exposure draft of its Shariah standards concerning sukuks in November 2002. According to the exposure draft, Investment sukuks are certicates of equal value representing, after closing subscription, receipt of the value of the certicates and putting it 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. Sukuks are important because rstly, they represent a new source of funds, generally at attractive rates. And secondly, they are vital to developing a deeper and more liquid Islamic capital market. There is a great deal of surplus cash sitting in Islamic nancial institutions waiting to be tapped by new nancial instruments. Sukuks can allow this pot of gold to be unlocked. If sukuks can be competitively structured according to Shariah law and a market for them is developed, the economy will benet. In this regard, we discuss the various Islamic sukuk structures and their features which differ from a conventional bond or securities.
Sukuk Structures

sukuk certicates. Shariah considerations dictate that the pool of assets should not comprise merely of debts from Islamic nancial contracts (eg Murabahah, Istisna).
Types of Sukuk

The proper classication of asset classes will determine the type of sukuk certicates to be issued. It is imperative to note that assets can be prepared for the issuance of trust certicates in a number of ways, subject to the need of the issuing entity.
1. Pure Ijarah Sukuk

This certicate is issued on stand-alone assets identied on the balance sheet. The assets can be parcels of land to be leased or leased equipment such as aircrafts and ships. The rental rates of returns on these sukuks can be both xed and oating, depending on the particular originator.
2. Hybrid/Pooled Sukuk

The underlying pool of assets can comprise of istisna, murabahah as well as ijarah. Indeed, having a portfolio of different classes of assets allows for greater mobilisation of funds. Murabahah and istisna assets can comprise a portfolio of funds. However, at least 51% of the pool must be made up of ijarah assets. Due to the fact the murabahah and istisna receivables are part of the pool, the return on these certicates can only be a pre-determined xed rate of return. The above-mentioned two types of sukuk would partially represent the strength of the issuers balance sheet.
Glossary
Ijarah, synonymous with leasing, relates to the right to use or derive prots from assets and properties owned by a third party in exchange for rent. Istisna is a transaction in which the buyer places an order for goods to be manufactured. The price and commodity specications are agreed on by both buyer and manufacturer. The price does not have to be paid in full in advance. Murabahah is a sale in which the seller discloses the actual cost of goods sold to the buyer and adds a prot. Payment may be on the spot or deferred. Salam is a sale whereby the seller undertakes to provide specic goods to the buyer at a future date in exchange for a price which is paid in full immediately.

Sukuk products are asset-backed, stable-income, tradable and Shariah-compatible trust certicates. The primary condition of the issuance of sukuk is the existence of assets on the balance sheet of the government, the monetary authority, corporate bodies, banking and nancial institutions or any entity which wants to mobilise nancial resources. The identication of suitable assets is the rst, and arguably the most integral step, in the process of issuing
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MIR Takaful Investment

3. Variable Rate Redeemable Sukuk

Under some conditions, implementing sukuk by representing the full strength of an issuers balance sheet can prove to be benecial. Several corporate entities refer to these sukuks as Musharakah Term Finance Certicates (MTFCs). They can be considered as an alternative to the sukuk because of their seniority to the issuers equity, redemption features and relatively stable rate of return as compared to dividend payouts. MTFCs have a few advantages. First, employing musharakah returns is preferred by jurists as such an arrangement would strengthen the paradigm of Islamic banking that considers partnership contracts as the embodiment of core ideals. Secondly, the oating rate of return on these certicates would not depend on benchmarking with market references such as the London Inter-bank Offer Rate (Libor), but would instead be contingent on the rms balance sheet.
4. Zero-coupon non-tradable Sukuk

Another possible sukuk structure can be created where the assets to be mobilised do not exist yet. Consequently, the objective of the fund mobilisation would be to create more assets through istisna. However, certicates of this nature would not readily be tradable because of Shariah restrictions. The primary asset pools to be generated would be of a nature warranted by istisna and instalment purchase/sale contracts that would create debt obligations. The certicate on these debt arrangements can be termed as xed-rate zero-coupon sukuk.
5. Embedded Sukuk

These could be sukuks whether zero-coupon, pure ijara or hybrid, with the embedded option to convert into other asset forms, subject to specied conditions.
Islamic Features of the Sukuk

Sukuks serve to replicate the functions of tradable securities in mobilising resources from markets and injecting liquidity into the enterprise or government and in providing a stable source of income for investors. The sukuk bears the nancial risk, and it is distinguished from conventional bonds and asset securitisation in several ways: Conventional investors in corporate and government bonds hope to capitalise on favourable developments in interest rates. Capital gains are accumulated when xed-rate bond prices rise as variable market indices fall. The legitimacy of sukuk structures in the Shariah lie in the fact that they do not take advantage of interest rate movements. Sukuk are directly linked with real sector activities, such as the funding of trade or production of tangible assets. Hence, these will not create short-term speculative movement of funds and potential nancial crises. Sukuk investors have an inherent right to information about the use of their investments, nature of the underlying assets, and other particulars that would be considered redundant in conventional investments. This will help to introduce discipline in the market.
More to Sukuks than Prots

years. First of all, Bahrain, in a pioneering move, issued domestic sovereign xed-rate ijarah and salam sukuks in 2001. It was followed by the issuance of oating-rate Ijarah sukuks as well as pooled sukuks by corporations and sovereigns in several countries. These sukuks are based on salam, ijarah, istisna, istisna-cum-ijarah and on the basis of pooled portfolios. However, some corporate and sovereign sukuk prospectuses have come under increased scrutiny for their Shariah suitability. The predominant feature of several of the prospectuses is the oating-rate return distributed to the certicate holders. The market reference used is Libor over which a competitive premium is added. However, it should be observed that in the case of the ijarah sukuk arrangements, Libor serves as a market reference for the returns and the intrinsic distributions arise from the rentals pertaining to the leasing arrangements with the originator and special purpose vehicle. The sukuk issuance by the Jeddah-headquartered Islamic Development Bank serves as an excellent and promising example for future arrangements. The prospectus contains clear and precise Shariah considerations outlined by numerous leading scholars and involves an innovative portfolio combination of ijarah, murabaha and istisna projects. Also, returns are not ambiguously related to market benchmarks, but a xed rate of return is agreed on. One dimension of the paradigm of Islamic nance that should not be lost upon compromises for increased protability is altruism. In this regard, sukuks have not only mobilised previously untapped public sector funds, but have also provided long-sought funding for development projects. The Qatar Government issued sukuk securities to fund a large medical complex (Hamad Medical City) in Doha, and the Malaysia sukuk certicates raised funds for several government owned hospitals as well as ofces. Most signicantly, the IDB sukuks raised funds for projects in 21 developing nations in a wide range of schemes that include power transmissions, hospitals, steel manufacturing, mineral water networks, livestock breeding, sea port development, pharmacology research, agricultural irrigation, telecommunications projects, rural development and colleges.

The sukuk market has emerged during the previous ve

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