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I always referred to sukuks as Islamic bonds. And I’m not the only one.
But what is an Islamic bond to be precise? It’s a bit of an oxymoron.
A bond is a debt instrument that pays an interest rate. If there aren’t any interest payments throughout the life of the bond - like a zero-coupon bond - then the interest is paid at maturity.
But in Islam we know that a loan cannot bear interest.
A loan is a charitable act. And if you’re not feeling charitable, then you invest and share the risk and profits with the recipient of your funds.
You lend money and expect the principal back. Nothing more. You can secure your loan with collateral from the borrower but you can’t expect to receive more than you’ve lent.
Or you may even decide to let the borrower keep the money and never pay it back. Especially if they find themselves in difficulty. This is even recommended in the Qur’an:
“If it is difficult for someone to repay a debt, postpone it until a time of ease. And if you waive it as an act of charity, it will be better for you, if only you knew.” (Qur’an 2:280)
So an Islamic bond isn’t the right term. It’s often used for easier comparison relative to conventional finance.
However there are a few things that stand out if I look into sukuks in detail.
First, the sukuk is typically backed by an asset. Meaning that the company raising funds by issuing the sukuk is borrowing against an asset it owns. Like a commercial building or a factory.
To be more specific, let’s say a company wishes to raise $500 million via a sukuk. It also has $500 million worth of real estate on its balance sheet.
The Investor will ‘buy’ $500 million of real estate from the company and lease it back to the company. The Investor receives lease payments (I.e. rent) from the company throughout the life of the sukuk. These lease payments could in theory be fixed or a percentage of what the company is able to generate in profit using this asset.
Here the coupons of the sukuk are tied to a cash-generating asset. The investors receive payment for leasing the asset to the company. Unlike a traditional bond where the money paid out to investors is interest and not directly tied to any business-related activity. Of course, it goes without saying that the interest companies pay most often comes from the profits it generates from its business activities. But not always. Some companies have to raise funding or raise more debt in order to settle previous debt obligations.
The important element is that the return that the sukuk investors can expect to receive comes directly from said business activity.
So you’d expect that sukuk investors will have their returns tied to the performance of the asset. But that’s not the case in practice. The investor isn’t taking on asset performance risk. He’s taking on credit risk of the company.
What this means is that the investor’s returns are based on the company’s ability to pay. Not whether the asset performs well or not.
How so?
When reading through the different prospectuses for these types of sukuks, you will always find that the company, in one way or another, makes up for any shortfalls. If the asset used to back the sukuk doesn’t generate enough profits, the company will pay the difference.
There’s different ways this can be done. The details are beyond the scope of this essay but in essence the company is guaranteeing a rate of return. Which is why you always see a fixed percentage of return in any sukuk. That should already get you thinking. How can the return on an investment be fixed if we don’t know how the investment will perform?
The only way is if the company steps in to pay for the difference should the profits generated be lower than the pre-agreed coupon. In other words, this is just like a debt instrument. The return is guaranteed.
They can use all types of tricks to make you think that the return of the sukuk is tied to the performance of the asset, but that’s not what investors want. The investors want something that looks like a bond. They want to invest in an instrument where the returns are fixed and guaranteed. No matter what happens to the asset.
Which is why every single sukuk has a credit rating. And the credit rating is the same as the credit rating of the company issuing the sukuk to raise funds.
Why would an investment instrument, that should be tied to a business venture, be given a credit rating? Because the returns generated aren’t entirely tied to the asset. They are based on the ability of the company to pay those returns. It’s just a debt in disguise.
Now let’s go back to the asset that was ‘sold’ by the company to the investor. The asset would be ‘held’ by the investor throughout the term of the sukuk.
The quotation marks will make sense soon. There’s a reason for putting them.
In a sukuk, the most important element is that the investor gets back the money they invested at the end of the term. The money was initially used to pay for the commercial property that was originally held by the company. The company sells this property to the investor in exchange for funding. And as we said, it leases it from the investor and the investor receives lease payments throughout this period.
So what happens at maturity?
The company ‘buys’ back that same asset. This way the investor can redeem the sukuk and receive their capital back.
But what happens if the price of the asset changes? It’s very unlikely that the market price of the asset will remain unchanged after some years.
This is effectively pre-agreed when the sukuk is issued. The company will buy back the asset from the investor at a price they determine today.
That’s basically a forward agreement.
A forward is a financial instrument where a buyer and a seller agree to a transaction at a future date based on a price and quantity agreed today.
But forwards are impermissible in Islam. You cannot secure a transaction when both the item in question and the cash exchange will happen in the future. There’s a level of uncertainty here that makes it impermissible. Not only that, but in a forward you can’t agree to sell something that you don’t yet own. Or may not even exist.
What is permissible is referred to as a Salam contract. In this case the item in question is paid for upfront and will be delivered at a future date. This was deemed permissible during the time of the Prophet Muhammad (pbuh) as farmers needed upfront investment to grow their crops which they could deliver at a later date.
But if a sukuk agreed to using a salam then it would have to pay for the asset upfront and receive it at maturity of the sukuk. This defeats the purpose of raising money via the sukuk in the first place.
So how do they go about this?
They create a synthetic forward. An agreement that looks like a forward but isn’t technically a forward.
Let me explain.
They use undertakings, in other words a promise, to take a certain action if a certain condition is met. So if at maturity the asset is worth less than the agreed price, in this case $500 million, because property values have gone down, the company promises to buy back the asset for the same price of $500 million.
Likewise, if the price of the asset goes up because the property market is booming, then the investor agrees to sell the asset at the same price of $500 million to the company at maturity.
You end up achieving the same outcome as that of a forward. This way the investor is guaranteed to see their original investment amount returned in exchange for ‘selling’ back the asset to the company.
Now you may be asking yourself, why am I using quotation marks when referring to buying and selling of these assets that are important in a Sukuk Al-Ijara (which is the type of sukuks I’ve been discussing so far)?
Because the company isn’t really selling the asset.
The company still keeps it on its balance sheet. If it were a true sale then it would no longer be on its balance sheet. It wants to have the option to sell the asset on the market to a third party if the opportunity arises. It may then be able to redeem the sukuk before the maturity date.
So it kind of sells the asset and the investor kind of buys the asset. But not really. So it’s not a true sale.
There are other sukuks in the market. Ijara is usually the go-to structure as there’s less of a gray area from a shariah point of view. But it’s also difficult. The company needs to identify assets equal to the amount it wants to raise.
This is why most ijara sukuks tend to be the go-to method for sovereign issuers. It’s a lot easier for governments to identify and use assets to raise money against.
You also have musharakah, mudarabah, wakala and murabaha sukuks.
A musharakah is an agreement where different parties inject capital into a business venture. They then split profits based on pre-agreed percentages.
In this case the company raising funds may insert capital in the form of assets like a property or a factory. The investors would inject money.
The company would conduct its business and the money would have a specific use of proceeds. Any profits made would then be split between the company and the investor based on the terms of the agreement.
But the same question arises. How will you account for the fluctuation in profits generated from the business? Doesn’t the sukuk investor want a fixed return?
Easy. The company can forego its profit share. Or it can plug the gap by financing it. In other words, whatever happens to the business, the investor gets a fixed return.
In a mudarabah, the difference is that only investors inject capital. The company manages the capital but also earns a fee for managing this capital for the business venture.
Same story. If the profits aren’t high enough, the company plugs the gap. The return the investors receive has to be guaranteed no matter what.
You then have a wakala sukuk. Think of it a bit like a mudarabah sukuk but in this case the company hires a 3rd party to manage the capital. And in return they take a fee.
In a Murabaha sukuk, you’re doing something similar to an ijara sukuk but using a commodity like gold or copper instead of a cash-generating asset. The price differential of the commodity is pre-agreed based on the rate the sukuk should pay. For example, the Investor agrees to buy an amount of gold from the borrower for $10,000,000. The borrower also agrees that it will buy back this gold in a year's time with a mark-up of 7% and therefore pay the Investor $10,700,000 at maturity. The borrower could also agree to split the 7% in quarterly coupon payments of $175,000 each.
Whatever happens, the idea is the same. The sukuk is just an Islamic bond. It is made to replicate a traditional bond which is a debt instrument.
No wonder Sheikh Taqi Usmani stated in 2007 that 85% of all sukuks are non-Islamic. The main point is that sukuks should be tied to venture profits and shouldn’t guarantee a return.
In most sukuks the investors never face a risk that assets don’t generate enough profit. Or that the investors can make a higher profit than expected from the asset. Nor do they face any market price risk of the assets.
Pretty much most issuance of sukuks contradict the principles laid out by AAOIFI.
AAOIFI, an organization that sets and maintains the standard for shariah based financing, sets the gold standard for what is permissible and what isn’t from an islamic point of view. Using their principles you can determine whether an investment is halal or not.
What’s funny is that the same scholars that approve these dubious sukuk transactions also sit on the shariah board of AAOIFI. Explain that?
All these sukuks replace the asset performance risk (i.e. the profits that the asset in question generates) and the asset price risk (i.e. the market value of the asset used) with credit risk of the issuer. No matter what happens to the asset, the investors receive a fixed return that the issuer is liable to pay.
All the sukuk market has done is tailor and adjust its products so that it appeals to traditional bond investors. No one wants to adhere to real Islamic principles based on profit and risk sharing.
But it’s not all bad.
I’ve mentioned profit-participation notes (PPNs) in my previous essays which are truly profit and risk sharing.
These are simple instruments that look like bonds, but the returns they generate are tied to the profit generated by the business. Here we have something that is a lot more consistent with real Islamic finance.
I’ve mentioned one of the leaders in this space, Cordoba Capital Markets (CCM), spearheaded by Harris Irfan, who has a solid reputation in the Islamic finance industry. CCM has successfully launched a product whereby the investors and the company are sharing both the risk and the profits generated from the business venture.
This is where real ingenuity and underwriting skills come into play. Underwriting in the sense that diligent analysis of the business has to be done in order to determine the exact operational risks so that the investors know what they are undertaking.
If this was just a traditional sukuk, then more work will be done to assess the credit risk of the company raising funds rather than its operational and business risk.
When dealing with a PPN, the investors are tying their investment to the success of the business. Here they are taking on asset risk and price risk and not merely credit risk.
This requires some work which CCM has managed to do well. It requires a deep understanding of the business and to silo the risks so that the investors take on risk that is specific to one or a set of transactions rather than the whole business.
The PPN in question is used for a Brazilian nut-producing company. The funds are used only to buy raw materials (i.e. raw nuts) which the company can then process, package and sell as finished goods.
How does an investor fund this company whilst making sure that its funds are not being misallocated? And how can the investor minimize its return risk?
Given the nature of the company and the goods it sells, the prices are fairly stable and don’t see huge variations. You can expect that its profit margins are fairly predictable. This is an important point. Executing a PPN with a business who’s financials are volatile will be hard to sell to investors.
Having a good history of a company’s cash flows will also help underwrite this type of instrument better as it becomes easier to forecast future revenues.
You can also create specific vehicles that will hold the funds of the investors and be mandated for a specific use. In this case, to buy the raw materials and not to cover other unrelated costs in the business.
But whether the business is selling nuts, oil, gold or cars, a structure like the PPN forces the investors to focus on the operational skills of the business owners. Not whether they can guarantee a return and repayment of the principal.
Capital is allocated to those who can use it in the most efficient way possible. It doesn’t simply flow to businesses that can guarantee a return to their investors whilst being operational inefficient.
Furthermore, the investor should benefit from higher upside if the business does well. Corporations can take advantage from lower interest rates by paying only a tiny amount of the profits they actually generate using the funds they raise from selling a bond.
In each scenario there can be an unfair advantage.
If the market started using more structures like the PPN we would see less zombie companies. These are the companies that are hanging by a thread but are still able to tap into debt markets and keep rolling over their historical debt. Investors are happy to lend to them if they feel that the company can just about survive to pay the interest rate on the debt and/or has sufficient collateral to cover the principal.
But who would invest in such a company if the return was directly tied to their profitability?
Often in Islam we talk about how debt can be an injustice to those who need to borrow as they may find themselves buried with interest payments that keep compounding. Whilst that is true, the opposite is equally disastrous.
An economy where interest rates are low and companies with enough collateral can keep borrowing even though they are just about surviving. This is what we’ve experienced with interest rates kept low by central banks from 2008 until 2022. This misallocation of capital can cause lasting damage in the long-term in the form of flailing productivity.
It may be that sukuks have to be structured in such a way to entice investors. This may be a necessary evil. But given the lack of change since Taqi Usmani’s comments in 2007, this industry is mired by complacency.
Things have to change from the bottom up.
I manage a $100m private investment fund and I explore Islamic finance and economics through a personal lens. I help simplify financial markets from a Muslim perspective.
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