The Islamic finance market is developing at a remarkable pace. Since its inception three decades ago, the number of Islamic financial institutions worldwide has risen from one in 1975 to over 300 at the end of 2005 in more than 75 countries, with total assets estimated to exceed $250 billion. Even with this rapid growth, it remains in its infancy stage when compared with the global financial system.
As a result of recent developments in the Islamic financial market there has been tremendous growth in Shariah-compliant sovereign and corporate Islamic structured financial instruments known as Sukuk (Islamic bonds).
The introduction of Sukuk increased the variety of instruments that can be used to create an efficient Islamic portfolio in line with portfolio theory and financial planning.
Sukuk Definition
Sukuk are securitized assets and therefore belong to the category of assets-backed securities. Unlike conventional structures, Sukuk need to have an underlying tangible assets transaction either in ownership or in a master lease agreement.
Generally, Sukuk are a form of commercial paper that provides an investor with ownership in an underlying asset. It is an asset-backed security that has a stable income and Shariah-compatible trust certificates.
The primary condition for issuance of Sukuk is the existence of assets on the balance sheet of the issuing entity that wants to mobilize its financial resources. The identification of suitable asset is the first and most important step in the process of issuing Sukuk certificates.
The model of Sukuk security is derived from the conventional securitization process in which a special purpose vehicle (SPV) is setup to acquire assets and to issue financial claims on the assets. These financial assets claims represent a proportionate beneficial ownership to the Sukuk holders.
Types of Sukuk
Islamic markets offer different instruments to satisfy both providers and users of funds in a variety of ways. While the main types of Islamic financial instruments are conceptually simple, they may become complicated in practice as some financial institution combine aspects of two or more types of instruments.
The proper classification of assets classes will determine the type of certificates to be issued. It is vital to note that these assets can be prepared and issued for the issuance in a number of ways conditional to the need of the issuing entity.
The Accounting and Auditing Organization of Islamic Financial Institution (AAOIFI) issued standard for 14 different types of Sukuk, where some of these Sukuk are classified as tradable and others are classified as non-tradable based on the type and characteristics of the issued Sukuk. In recent issuances, the common type of sukuk were as follow:
Murabaha Sukuk
The Murabaha technique (cost-plus financing) is one of the most widely used instruments for Islamic short-term financing. It is based on the traditional notion of purchase finance.
The structure of Murabaha is relatively straightforward and is based on declared mark-up integrated into the selling price with a deferred payment. The Islamic financial institution purchase and takes title of the necessary equipment or goods from a third party, the Islamic financial institution then sells the equipment or goods to its customer at cost plus a reasonable profit.
Istisna’a Sukuk
This type of Sukuk has been used for the advance funding of real estate development, major industrial projects or large items of equipment such as: turbines, power plants, ships or aircraft (construction/manufacturing financing).
The Islamic financial institution funds the manufacturer or the contractor during the construction of the asset, acquires title to that asset and up on completion either immediately passes title to the developer on agreed deferred payment terms or, possibly, leases the asset to the developer under an Ijara Sukuk. However, it should be noted that, if the Sukuk are listed during the Istisna’a period, the Sukuk should be traded only at par as the underlying assets does not exists yet.
(Debt can’t be traded according to Islamic law)
Salam Sukuk
The main concept of Salam Sukuk refers to a sale, whereby the seller undertakes to supply a specific commodity to the buyer at a future date in return for an advanced price paid in full on the spot. The price is in cash but the supply of the purchased good is deferred. As a form of financing, the purchaser is able to acquire the assets by advance payment at a discounted price and subsequently sells the assets upon delivery. Salam Sukuk represents a type of a forward contract which is forbidden under Shariah law unless there are strict conditions attached that aims at the eliminate uncertainty. The Salam Sukuk is differ from Istisna’a Sukuk in that, the purchase price for the assets under Salam Sukuk must paid in full and the date of delivery must be fixed.
Ijara Sukuk
This is one of the most common Sukuk issuance types, especially for project finance. Ijara Sukuk is a leasing structure coupled with a right available to the lessee to purchase the asset at the end of the lease period (finance lease). The certificates are issued on stand-alone assets identified on the balance sheet.
The rental rates of return on those Sukuk can be fixed or floating depending on the agreement. The cash flow from the lease including rental payments and principle repayments are passed through to investors in the form of coupon and principle payments. The Ijara Sukuk provides an efficient medium-to-long term mode of financing.
These instruments have been used in a variety of cross-border applications for an increasing range of asset classes including ships, aircraft, telecommunications equipment and power station turbines.
Mudarabah Sukuk
This is an agreement made between a party, who provides the capital and another party (an entrepreneur), to enable the entrepreneur to carry out business projects, which will be on a profit sharing basis, according to predetermined ratios agreed on earlier (participation or trust financing). In the case of losses, the losses are born by the provider of the funds only.
Musharakah Sukuk
This is very similar to the Mudarabah contract and it’s widely used in equity financing. The structure of Musharakah requires that both parties provide financing to the projects. And in case of losses, both parties will lose in proportion to the size of their investment.
Other Types of Sukuk
Other types of Sukuk have been defined by AAOIFI, but are not widely used such as Sukuk Al Wakala, Sukuk Al Muzra’a, Sukuk Al Musaqa, Sukuk Al Muqarasa, Sukuk Ijara Mowsufa Bithimn, Sukuk Manfaa Ijara, Sukuk Manfaa Ijara Mowsufa Bithimn and Sukuk Milkiyat Al Khadamat.
Sukuk Rating
Similar to the conventional securities, Sukuk can be rated on a sovereign and corporate basis. The rating analyst or the rating agency will mainly focus on the credit rating of the instrument and any expected default or losses, the agency will give high priority to the legal, the structure and the underlying assets of the Sukuk.
It should be noted that, the rating agency will take the Sukuk assets in account only if the assets in place, otherwise, the rating will be based on the borrower portfolio.
Risk Underlying Sukuk Structure and Issuance
Sukuk are exposed to different type of risks. One of the most important risks is the market risk which is composed to interest rate risk, foreign exchange risk, equity pricing risk and commodity risk.
Other types of risks that should be considered are liquidity risk, business risk and Shariah compliance risk.
Recent Trends in Sukuk Markets The Sukuk market through the past five years has seen a rapid surge in issuance across Asia and the Middle East. The Sukuk certificates for a medium term investment reached in 2004 a market volume of around $7 billion. The amount grew to reach around $20 billion at the mid of 2006.
From future prospective, the number and the variety structured Sukuk products are expected to continue to expand in the future as most of companies and financial institutions seek to tap into the significant liquidity of Islamic investors looking for Shariah-compliant investments.
(Asem AlBuolayan is a financial analyst. He is based in Dhahran.)
