chapter 7 sukuk and securitisation

ISLAMIC INVESTMENT

Mahyuddin Khalidem

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Sukuk and Securitisation

1

Topic Outline

Securitisation

Bonds

Sukuk

Asset Backed Securitisation

Asset Based Securitisation

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Introduction

In normal conventional market, security is a document,

representing receivable amounts owed by the issuer in favour of

the holder.

Normally the amounts secured by a security are interests bearing

loans.

Different kinds of securities:

Bonds issued by a company

Bonds issued by a government

Debentures

Certificates

Notes

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Securitization

Definition:

“Issuing certificates of ownership, against an asset, investment pool

or business enterprise.”

If the securities represent the proportionate ownership of the

holder in illiquid or tradable assets, the trade of such securities

is permissible.

The sale of such security will be tantamount to the sale of

holder’s proportionate share in the assets.

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Securities from Shariah Perspective

Securities representing a loan or debt (such as bonds) cannot be sold or purchased.

If they are sold at a price higher or lower than their face value, it is considered as “Riba”

If they are purchased at their face value (Bai al-Dayn), this involves “Gharar” and hence prohibited.

However, securities may be assigned to a third party at par value.

The difference between sale and assignment (al-hawalah) is that transfer in al-hawalah is with recourse while transfer in sales in without recourse.

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Originators Investors Capital Market

• Transforms relatively

illiquid assets into liquid

and tradable capital

market instruments

• Cheaper financing costs

due to higher rating via

credit enhancement

• Allows diversification of

financing sources

• Facilitates removal of

assets from the

originator’s balance

sheet

• Provides a variety of

product choices at

attractive spreads that

attract a diversified

investor profile

• Allows investment

products to be tailored

to meet specific

investor needs - variety and flexibility of

credit

- maturity and payment

structures

• The existence of

secondary

securitisation

markets for

benchmark purposes

• Facilitates and

encourages efficient

allocation of capital

• Reduces risks within

the banking system

Benefits of Securitisation

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Bonds

Bonds which is one of debt Instruments – are promissory notes that are traded in the market

Bonds are categorised by

Issuer Tenor Coupon type

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Types of Bonds

Types of bonds (by coupon type):

Coupon bonds

Pay periodic interest based on coupons

Zero coupon bonds

Pay no interest on maturity but only the face value. The purchaser will buy at discount.

Interest

Can be fixed or floating. Floating interests are determined in reference to say KLIBOR + x%. If KLIBOR is 10% and x is 2 then for a bond of RM1000 the interest

is RM120

Types of bonds (by tenor):

Callable bond

Callable by issuer at a predetermined price before maturity. Investor is normally paid higher than straight bonds

Convertible bond

Allows holder to redeem at face value or convert it to a predetermined number of stocks

Types of bonds (by issuer):

Government Corporate

Long Term Govt Bond Corporate Bonds

Short Term Treasury Bills Commercial papers

Sukuk

Sukuk

Sukuk (plural) and sakk(singular) means legal instrument, deed, and

check.

Referred to any certificate representing

a contract or conveyance of financial rights,

obligations, or money transactions that is Shariah compliant.

Islamic Jurisprudence

Council

“Any combination of assets (or the usufruct of such assets) can be

represented in the form of written financial

instruments which can be sold at a market

price provided that the composition of the

group of assets represented by the sukuk consist of a

majority of tangible assets”

AAOIFI

“Investment Sukuk are certificates of equal value representing undivided shares in

ownership of tangible assets, usufruct and services or (in the

ownership of) the assets of particular projects or

special investment activity”

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What are Sukuk?

Sakk is believed to be the source root of the European

Check

The origin of sukuk can be traced to the Middle Ages

whereby sukuk were largely used by Muslims as papers

representing financial obligations originating from trade and other commercial

activities.

Sukuk refers to an Islamic investment certificate, which allows investors to have rights

of ownership of the asset, including the cash flow and risks associated with such

ownership.

Sukuk offers risk diversification for Investors for their

portfolios.

Sukuk are asset-backed, tradable, and Shariah

compatible trust certificates

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Securitization and Sukuk

In the modern Islamic perspective, sukuk lies in the concept of asset monetization – or also called securitisation -

that is achieved through the process of

issuance of sukuk.

Its great potential is in transforming an asset’s future cash flow into

present cash flow. Sukuk may be issued on existing as well as specific assets that

may become available at a future date.

Tawriq

• Means to render something into cash.

• It is about transforming a deferred debt for the period between the establishment of the debt and the maturity period into papers, which can be traded in the secondary market.

Tasnid

• Means the transformation of illiquid debts into negotiable papers (sanadat).

Taskik

• Means the process of dividing assets into papers (sukuk) or certificates.

• Securitization of assets into papers, securities, or certificates with the features of liquidity, tradability, and cash equivalence.

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Securitization and Sukuk

The funds raised through the issuance of sukuk should be applied

to investment in specified assets rather than for general

unspecified purposes.

This implies that identifiable assets should provide the basis for

Islamic bonds.

Since the sukuk are based on the real underlying assets, income

from the sukuk must be related to the purpose for which the

funding is used.

The sukuk certificate represents a proportionate ownership

right over the assets in which the funds are being invested.

The ownership rights are transferred, for a fixed period ending

with the maturity date of the sukuk, from the original owner

(the originator) to the sukuk holders (IFSB, Jan. 2009).

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Reasons for Issuing Sukuk

Growing demand from investors to place their funds in accordance with Shariah compliant principles.

Governments or corporates are able to raise funds for their working capital or project

financing for infrastructure and development projects under a Shariah compliant framework instead of debentures or loans

with high interest rates.

The funds collected also serves the purpose of liquidity

management for financial institutions and individuals

undertaking Shariah compliant business because it complies with

their internal monetary and regulatory policies.

To facilitate the development of the local, regional, and global

sukuk market, and to tap into a wider investor base.

Sukuk are a means for the equitable distribution of wealth as it allows all investors to share

returns from the true profits generated from the asset.

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Sukuk vs. Bonds

Sukuk Definition Bonds

• Sukuk are financial

certificates representing

beneficial ownership of real

assets.

• It gives the investor

proportional beneficial

ownership in the asset on

which the sukuk are based.

Underlying Asset • Bonds are proof of debt and

not a share of ownership in

the asset.

• It is a debt obligation from

the issuer to the bond

holder.

• The asset on which sukuk

are based must be tangible

and in compliance with the

Shariah and Islamic

principles.

Issuer Representation • Bonds are issued to finance

almost any purpose that

complies with local

regulatory legislation.

• In sukuk, the issuer is not a

borrower, but can either

be:

• A buyer in a sale contract; A

lessee in a lease contract; A

partner in a partnership

contract.

Issue Unit • Bonds are debts, whereby

Issuers are the borrowers

from the investors (bond

holders).

• Each sukuk represents a

share of the underlying

asset.

• Each bond represents a

share of debt

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Sukuk vs. Bonds

Sukuk Bonds

The face value of sukuk is

based on the market value of

the underlying asset.

Issue Price The face value of a bond price

is based on the issuer’s

creditworthiness (including it’s

rating).

Returns are termed as

dividends and will depend on

the underlying Shariah contract

used.

Sukuk holders receive a share

of profits from the underlying

asset (and accept a share of

any loss incurred).

The amount of profit cannot be

ascertained, it could be fixed

or vary as it is based on the

sharing of profit and loss.

Returns Sharing Returns are termed as

coupons.

Bond holders returns can be

ascertained and they receive

regularly scheduled (and often

fixed rate) interest payments

for the life of the bond

regardless of Issuer’s loss or

gain.

The capital is not guaranteed

for sukuk holders.

Upon maturity, Sukuk is valued

based on the market value, a

pre-arranged figure (agreed

upon by the two parties) or a

fair value.

Capital Guarantee The bond principal amount is

guaranteed upon and payable

upon maturity date.

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Sukuk vs. Bonds

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Bond Item Sukuk

Short, Medium and Long Term Tenor Short and Med-Term (≤5 yrs)

Debt Financing Category No debt but ownership of specific asset

and its cash flows

Not necessary, unless collateralized Underlying Necessary underlying asset, usually

tangible asset

Fixed in time, and amount Claim Ownership claim on specific asset and its

cash- flows

Depends on rating, yield environment and

demand (book-building)

Pricing Use of indicative yields-benchmarked on

reference rates

Fixed income (known/predetermined cash

flows)

Total Returns No guarantee in returns

Unrestricted Funding Purpose Restricted for use in Shariah compliant

assets, in a predetermined manner.

Sukuk Payment Structures

Generally, the payments on the sukuk are structured in two forms:

Amortising Securities or Amortising Sukuk.

The payments representing the amortising of the invested capital together with the profits (fixed or

floating) derived from the investments.

Non-amortizing securities or non-amortizing sukuk.

The payments of the derived profits (fixed or floating) are made periodically

during the tenure of the sukuk,

While the payment that represents the invested sum is scheduled at the end of period i.e. at the final maturity date of

the sukuk.

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Sukuk Payment Structures

However, there have been innovations whereby the redemptions

to the sukuk are in the form of exchangeable such as equities

or commodities.

In the case of exchangeable with equity, the periodic payments

to the sukuk could be from the dividend income stream paid to

the equity.

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Tradability of Sukuk

The sukuk can be classified as

Tradable

Non-tradable

Based on the underlying tangible

assets or

Proportionate ownership of a

business or investment portfolio.

Tradable sukuk are very essential for Islamic financial

institutions to enable them to manage their short-term

liquidity requirements.

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Tradable Sukuk

•Sukuk, to be tradable, must be owned by sukuk holders, with all rights and obligations of ownership in real assets, whether tangible, usufructs or services, capable of being owned and sold legally as well as in accordance with the rules of Shariah,

•The Manager issuing sukuk must certify the transfer of ownership of such assets in its (sukuk) books, and must not keep them as his own assets.

AAOIFI Shariah Standard (17) on Investment Sukuk

•Sukuk, to be tradable, must not represent receivables or debts, except in the case of a trading or financial entity selling all its assets or a portfolio with a standing financial obligation, in which some debts, incidental to physical assets or usufruct, were included unintentionally, in accordance with the guidelines mentioned in.

•As per AAOIFI Sukuk based on ijarah, istisna’, mudharabah, or musharakah principles are tradable. Non-tradable sukuk represent receivables of cash or goods. For example, sukuk of salam or murabahah are non-tradable sukuk.

AAOIFI Shariah Standard (21) on Financial Papers

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Tradable Sukuk

In Malaysia, as per the resolution of the SAC of the SC, bay al-dayn is permissible and it must be made in cash.

It recognizes:

Bay al-dayn or debt trading as one of the acceptable principles for sukuk issuances

Shariah-compliant cash receivables arising from contracts such as murabahah, bai bithamin ajil

(BBA), ijarah or istisna’ are converted into tradable debt instruments.

This enables tradability of debt and equity based sukuk in the secondary market in accordance with Shariah principles.

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Sukuk Structure

Return for investment in sukuk in most cases are linked to cash flows and performance of underlying assets

In general, trading of indebtedness is prohibited, unless it is traded at par

Middle East and some other jurisdictions - Only allow debt trading at par

Malaysia – Trading of indebtedness is permissible at any value provided the underlying contract is

Shariah e.g. Bay Bithaman Ajil / Bay Dayn

From Shariah perspective, Islamic financing should only be raised for trading in specified and identified Shariah compliant assets

Issuance of Sukuk must be supported by an underlying asset

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Factors for considering a Sukuk structure

Economic objectives of

the Issuer.

Availability of assets.

Level of debt that the

company has.

Credit rating of the Issuer

Legal framework

Tax implication

of a structure

Definition of Assets

Under the shariah the assets must meet the necessary conditions:

Must exist physically (land, building, machinery)

Must be pure;

Must have use (however restricted to halal use and not for example for operations of casino or alcohol sales outlet);

Must be owned by the seller;

Must be free from encumbrances;

Must be known by specifications, descriptions, location, etc.

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Sukuk Must Comply to the Underlying Shariah Principles

Funds raised must be used for Shariah compliant (halal) activities.

Fund raised may be used to finance needed tangible assets. Specificity of assets is important, since Sukuk unlike conventional bonds cannot be used for general financial needs of the issuer.

Income received by sukukholders (investors) must be derived from the cash flows generated by the underlying.

Sukukholders have a right to the ownership of the underlying asset and its cash-flows.

Clear and transparent specification of rights and obligations of all parties to the transaction, in particular the originator (customer) and sukukholders.

No fixity in returns.

Shariah Contracts Underlying Sukuk

The application of these contracts of transaction results in the sukuk backed or secured by such assets, thus having an in-built security to the investments.

A sukuk can be structured based on any or a combination of two or more, of the Islamic contracts of transactions such as

The contracts of participation (uqud ishtirak) of mudarabah and musharakah

The contracts of exchanges (uqud mu’awadat) such as bai bithamin ajil, murabahah, salam,

istisna’a, and ijarah.

Sukuk can be structured in different ways depending on the underlying contract.

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Type of Sukuk, Characteristics, and Underlying Contracts

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Type of Sukuk Characteristics Underlying Contract

Pure Ijarah Sukuk Issued on stand-alone assets identified on the

balance sheet.

The rental rates of returns on these Sukuk can be

both fixed and floating.

Ijara

Hybrid/Pooled Sukuk The underlying pool of assets can comprise of

Istisna’, Murabahah receivables as well as Ijarah

The return on these certificates can only be a

pre-determined fixed rate of return.

Istisna’, Murabahah receivables

and Ijarah.

Variable Rate Redeemable Sukuk

or Musharakah Term Finance

Certificates (MTFCs)

Redeemable in nature.

Has relatively stable rate as compared to

dividend payouts.

The floating rate of return on these certificates

would not depend on benchmarking with market

references such as LIBOR but would instead be

contingent on the firm’s balance sheet

actualities.

Musharakah

Zero-coupon non-tradable Sukuk The primary asset pools to be generated would

be of the nature warranted by Istisna and

installment purchase/sale contracts that would

create debt obligations.

Non-tradable

Istisna’

Embedded Sukuk These could be Sukuk whether zero-coupon,

pure-Ijara or hybrid.

Has embedded option to convert into other asset

forms depending on specified conditions.

pure-Ijara or hybrid

Asset Backed Securitisations

Asset Backed Securitisations creates new opportunities to

popularise mudharaba or qirad, and/or musharakah contracts,

Ability to ring-fenced risks with more secured contracts such as

ijarah, murabaha, salam or other compounded contracts of

exchanges, whereby;

Risks mitigated through secured cash-flow streams and with lesser

operational and credit risks,

More shariah compliant due to Special Purpose Vehicle involved

in direct investments or business activities – avoidance of Bay al-

Dayn issues.

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Special Purpose Vehicle in Sukuk Structure

Characteristics of SPV

Bankruptcy remoteness Thinly capitalizedFormed for specific purpose; no

other activates undertaken

Do not add to the cost of transaction; capital and tax

efficient

Special Purpose Vehicle (SPV) is normally established based on the common law distinction between legal and equitable

right/ownership

SPV is considered to assume legal ownership (right as recognized by court of law) of the underlying asset used in sukuk

or securitization for the benefit of the beneficiary (whose interest or right is

recognized by the court of equity)

A split is thereby caused to the concept of ownership as a result of which the

beneficiary is not empowered to take or assumed all rights as an established owner of the asset as is required by Shariah law

If he is truly to be considered as a true owner as per the Shariah provisions that will give him several rights that include

right of free disposal and possession without restriction.


SPV(Mudharib)

Mudharaba

or Musharakah

Certificates

Pool of Investors

(Rabb al Mal or Musharkah

Partners)

Subscrip

tion fo

r Certificates ($

)

Direct Investments

through ijarah,

murabahah or other

real estate businesses or

trading activities

Cash-flow stream ($)

Profit Distribution

Ex

pen

ses for m

eeting

op

erational

requ

iremen

ts

1

2

3

4

5

6

7

3

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1. Sale of asset to the SPV – True Sale

2. SPV issues asset-backed securities to investors

3. Proceeds from the sale of ABS go to the Originator

4. (Interest) & principal repayments to Investors

SPV Investors

1.

2.

3.

Originator

3a.

4.

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Asset-Backed Securitizations

Islamic Asset-Backed Sukuk adds a new

dimension to ICM products

True sale – legally belong to SPV

Non-recourse sukuk / ABS - credit risk performance is determined

solely by underlying asset

SPV – bankruptcy remote (independent)

Correspondence of income streams with actual income and

value of the assets

Ratings are primarily dependent on a risk analysis of the assets or

performance of assets

Unilateral purchase undertaking (if any) – at market value

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Asset-Based Securitizations

Majority of sukuk issued has been on simple “ijarah” structure –

unsecured financing or known as asset-based securitization.

Originator seeking financing “sells” the assets to SPV for a value

equal to financing required and lease it back

SPV – subsidiary of originator

Lease payments provide fixed income stream which may be

benchmarked to an index / LIBOR +;

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Conducted on non true-sale basis so repayment and

risk/performance is not asset backed but originator based

Purchase undertaking of asset at maturity with pre-determined

value

Ratings are primarily dependent on the riskiness of the

borrower/ sponsor/ originator/ lessee

Assets only used to facilitate Shariah-compliance.

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Based on Ijarah:

Non-true sale – condition to repurchase at maturity

Payment of rental / profit can be derived from ijarah or other sources

SPV

Sukuk

Originator

Sukuk

Sukuk Sukuk

Sale of asset

Sukuk proceeds

Lease & repurchase payments for assets

Sukuk proceeds

Asset repurchase

Periodic payments:

Lease flows and principal (via amortisation/repurchase)

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There are also structures of sukuk al ijarah under an Asset-

Backed Scenario.

True sale, though

The ownership of the SPV is transferred to the originator or the

lessor at end of lease. Original underlying sale has been true sale.

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SPV

Certificates of

Investments

Investors

1.

Offer for Sale

of securities

2.

Asset Provider

3. Sale & Purchase

of Asset (payment of

asset acquisition

Cost US$) Asset

4. Transfer of Ownership of

Asset to SPV

1st Transaction: SPV and Asset Provider

1st Relationship: SPV and Investors

Step 1

$

Creation of Sukuk al Ijarah

37


SPV Project Owner1. Execution of al

ijarah contract

ASSET

2. Rental of Asset on fixed term and fixed

rental basis

Ijarah Rental

Obligation

Certificates(evidence of obligations)

3. Issuance of ijarah rental Obligations Promissory Notes to SPV

implying cash flow stream on asset.

Step 2

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SPV Project Owner

1.Regular Ijarah Rental

Payments

Asset

5. Asset transferred to Project Owner

Investment

Certificates

Holders2. Scheduled Distributions of Coupon Payments to Holders

Of Investment Certificates issued by SPV

3. Final Repayment

Representing Total

Settlement equal to

Initial Purchase Price

Of Asset by SPV

4. Payment of Final Amount being final settlement of

Obligations under Ijarah Contract

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Assets purchased by the SPV are funded by the issuance of

floating rate Trust Certificates, representing beneficial

ownership in the assets and having beneficial rights on the lease;

Upon maturity of the lease, SPV sells asset to the Project Owner

at the original price.

Proceeds from this sale will be utilised to meet the final

payment to investors.

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Asset-Based Sukuk vs Asset Backed Sukuk

Asset based Sukuk Asset backed Sukuk

Feature Using Shariah compliant assets/business ventures to facilitate issuance of Sukuk

Asset backing Shariah compliant assets/business ventures which form PRIMARY source of income /return to investor. Issued in various Shariah principles

Key Accounting Concept/ treatment

ON balance sheet (for originator/obligor)

OFF balance sheet (for originator)

True sale criterion: legal & off balance sheet accounting

Funding Cost Market driven mainly depending on originator/issuer credit rating/standing

Mainly based on the strength of the asset cash flow

Rating Corporate rating of issuer/obligor Strength of cash flow

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Summary

In this chapter you have learned about:

Securitisation

Bonds and Sukuk

Asset Backed Securitisation

Asset Based Securitisation

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Thank you43

chapter 7 sukuk and securitisation

Education