A Primer on Sukuk

6/11/2013 4:09:23 PM

Sukuk are one of the most commonly used instruments in Islamic finance. They are also the vehicle behind some of the most dramatic growth seen in the capital markets in recent years. Government and corporate issues from both Muslim and non-Muslim countries have driven the rapid growth of Sukuk. By the end of 2011, the date for which data were most recently available, outstanding Sukuk were valued at $182 billion and were growing at a rate of 30% per year. So, what exactly are these popular investments?

Sukuk is the plural of the Arabic word Sakk, which means “certificate.” They are defined as certificates of equal value representing undivided shares in ownership of tangible assets (physical things), usufruct (the right to use something), or services.  When a company issues shares of Sukuk, they are always equal in value. They may sell a large or small number of shares, but the actual value of a single share remains the same. Undivided shares means the asset can be sold without being divided. For example, if several shareholders decide to purchase Sukuk representing the underlying asset of a bridge, the bridge doesn’t have to be physically separated into several parts. (Good news for drivers who prefer their bridges to be in one piece when they use them.)

A word about conventional bonds
Sukuk are sometimes referred to as “Islamic bonds.” But Sukuk differ from bonds in the sense that bonds represent an interest-based loan repayable to the holder. A bond is an IOU-type agreement where the issuer agrees to pay interest and repay the principal to the bondholder on a specified date. Repayment often takes many forms, depending on the structure, yet the broad idea is to reward the lender for the provision of capital. With conventional bonds, the lender takes no direct ownership risk and is rewarded regardless of the debtor’s ability to repay.

When governments or corporations issue a bond, they’re essentially selling IOU’s to investors. The investor receives interest payments as a reward for a bond purchase; the rate of interest usually depends on the credit worthiness of the issuer. Each bond has a specific maturity date, which is when the issuer owes the investor the principal amount loaned. So the investor gets his or her principal back after receiving interest payments for letting the issuer use their money.

 How Sukuk are different
Sukuk don’t work the way bonds do. They don’t represent debt or an IOU. They represent an ownership stake in an existing asset or project and a return from the income generated by it. When governments or corporations issue Sukuk, as they have done at increasing rates lately, investors who purchase them are rewarded with a share of profit derived from the asset. (Think, for example, of rent from a commercial office building. Those periodic payments function like a fixed-income product.) The investor’s ownership of Sukuk gives him or her the right to receive a share of profit from the Sukuk’s underlying asset. So, the sale of Sukuk is equivalent to the sale of the Sukuk holders’ share of ownership.

A practical example
If Google wants a new facility, one way of financing the project is through the issuance of bonds. Google will sell bonds (i.e., debt) to investors to raise the capital to build the facility. Depending on the credit worthiness of Google, an interest rate is determined and agreed to be paid to debt holders. These bonds are sometimes held by the original debt holders. Sometimes they’re sold off to others. So, in this case, if you participate in the transaction, the only thing you are really buying is debt, and you are trading what you do not own. 

With Sukuk, you can purchase the facility (asset) through a “middle man” called a Special Purpose Vehicle (SPV), so now you have direct ownership of the asset. The SPV then takes the facility and leases it to Google for a fixed amount of income each month. So, the derived income is through rent (i.e., lease payments), rather than interest-based lending.

Why Sukuk?
Sukuk are a much-needed part of the global economy. The issuance process is straightforward, despite exotic terms like “Special Purpose Vehicle,” and all parties contract with one another, making clear all rights and responsibilities. And they’re asset-backed, a must-have for greater peace of mind in today’s debt-fueled and leveraged economies. By its nature, the product doesn’t allow for the types of abuses and lack of transparency commonly associated with debt and debt-based derivatives. And because they’re asset-backed, many Sukuk investors feel they are an inherently more stable product than bonds. A stabilizing force in today’s capital markets? What a concept.

Opinions expressed are those of the author or fund manager, are subject to change, are not guaranteed and should not be considered recommendations to buy or sell any security and should not be considered investment advice.

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