sukuk

Introduction

Bonds are important part of overall financial system. Well developed bond markets ensures stable financial system as it minimize over-reliance on financing from the banking sector. The development of the bond market allows for access to funding with the appropriate maturities, thus avoiding the funding mismatches. It also allows for the diversification of risks by issuers and investors.

Sukuk- Introduction

Ø  Dealing in Bonds is not permissible according to Shari’ah because of two aspects.

Ø  Firstly, they represent a portion of Debt payable by

the issuer. Earning any kind of profit falls under the category of RIBA as defined in the Hadith

“Every loan that draws any premium is Riba”.

Introduction

Ø  Second aspect pertain to the trading of Bonds. Ø  Shariah prohibits trading of debts (Bai Dayn) as it

involves Gharar.

Introduction

Ø  Sukuk are developed as alternative of Bonds. Ø  A Sukuk represents proportionate actual or

beneficial ownership in an Asset or a Pool of identified assets.

Ø  For a defined period the Risk and Return

associated with such Assets belong to Sukuk holders which makes their return permissible for the holder.

Introduction

Trade of such Sukuks is permissible, because it will be equivalent to the sale/ purchase of holder’s proportionate share in the assets. However, trading of Murabahah and Salam Sukuks is not permissible.

Sukuk- International Overview

Sukuk are gaining popularity as alternative source of funding.

Growth has been fuelled by strong demand for Shariah compliant

assets.

Malaysia and Middle East have emerged as key Sukuk centers

Also issued in Germany, Britain, japan, Philippines , Pakistan, etc.

Ijarah concept is the most popular amongst issuers of global Islamic

securities

Global Sukuk Issuance (Billion dollars)

Global Sukuk Issuance

Sukuk versus Conventional Bonds

Sukuk 1.  Income is generated

from assets

2.  Return is expected

3.  Negotiability is restricted to specific types of Sukuk

Conventional Bonds 1.  Income is derived

from debt instrument.

2.  Return is interest and pre-determined.

3.  Negotiable financial paper

Sukuk 4.  Sukuk issuer is a

seller of assets 5.  Sukuk holder is an

owner of assets 6.  Seller-Buyer

relationship 7.  Business risk-return

relationship

Conventional Bonds 4.  Bond issuer is a

borrower 5.  Bond holder is a

lender 6.  Lender-borrower

relationship 7.  Issuer guarantees

the payment of face value and periodic interest

Sukuk 8. Major risk lays with underlying assets

9. Return is expected from the underlying assets

10. Return of investor’s capital cannot be guaranteed

Conventional Bonds 8. Major risk is with issuer – credit risk

9. Interest payment is an obligation

10. Issuer is obligated to return investor’s capital (face value)

Sukuk- Types

Ø  The issuance of Sukuk requires an exchange of a Shariah compliant underlying asset for a financial consideration through the application of various Islamic commercial contracts such as the Mudarabah, Musharakah, Ijarah, Istisna, Salam and Murabahah.

Ø  The equity-based nature of Mudarabah and

Musharakah Sukuk exposes investors to the risks connected with the performance of the project for which the financing is raised.

Sukuk- Types

In contrast, issuance of Sukuk on principles of Ijarah and Murabahah yields deterministic receivable and hence result in predictable and somewhat fixed returns for the prospective investors.

What does an originator looks for?

Capital relief Managing Assets liability Off balance sheet funding Reducing concentration risk Direct access to capital Markets Improved RoA / RoE

Sukuk Al Ijarah

Sukuk Al Ijarah

Ø  Ijarah is an Islamic alternate of conventional leasing. Ø  Issuing certificates of ownership of assets, leased to

a particular customer is known as Sukuk Al Ijarah or simply Ijarah Sukuk.

Ø  Ijarah Sukuk concept is one of the most popular

concepts among issuers of global Sukuk. Ø  A simple process is explained next.

Sukuk- Sukuk Al Ijarah

Ø  If a Company requires, for example, 500 million for the purchase of land, real asset, equipment etc it can issue Ijarah sukuk equaling that amount in small denominations, say 500,000 each.

Ø  After collection of funds from the investors the

company either purchases the asset on behalf of the Sukuk investors or transfers the ownership of the already acquired asset to sukuk holders usually by establishing a Special Purpose Vehicle (SPV), which owns the underlying assets.

SPV Structuring

Characteristics of the SPV q Bankruptcy remoteness q Thinly capitalized q Formed for specified purpose; no other activities

undertaken q Does not add to the costs to the transaction – Capital

efficient and tax efficient

Legal structure dependent on the regulatory and legal environment in respective country

SPV Structuring Alternative Payment structures

§  Pass through structure – SPV remits any funds collected completely and immediately to the investors

§  Pay through structures q  SPV has discretion to re-invest the funds and pay investors

accordingly to a predetermined schedule

“Conduits” – vehicle set up for the multiple issuance q  Typically credit card and Commercial Papers ( in US

and Europe)

Sukuk Al Ijarah

Ø  The investor or sukuk holders owns the asset held by SPV as Trustee in the form of Sukuk. The asset is then leased to the firm and the lease proceeds from the asset is distributed to the sukuk holders as return/dividend.

Ø  The returns on the sukuk certificates could be

either fixed or floating. As the expected returns (pre-determined rental payments) are fixed and can be treated as predictable like the coupon payments of a conventional bond.

Sukuk Al Ijarah

Ø Ijarah sukuk can be issued through a financial intermediary, a bank or a brokerage house or directly by the users of the leased asset. A third party can also guarantee rental payments.

Ø  Since the yield is predetermined and the underlying

assets are not liquid but tangible and secured, thus the Ijarah certificate can be freely traded in the secondary markets at par, premium or discount.

Sukuk Al Ijarah Structure

ABC Ltd.

(Corporate)

ABC Ltd. wishes to purchase a new asset and plan to raise finance through issuance of Sukuk.

Supplier

ABC

Ltd.

Supplier of the Asset is identified and negotiations is finalized by ABC Ltd.

Supplier

ABC

Ltd.

Issuer SPV (LLC 100%

owned

ABC Ltd.)

SPV is created by ABC Ltd. as a limited liability Company.

Supplier Supplier Supplier

ABC

Ltd.

Payment made to Supplier

Title is transferred to SPV





Issuer SPV (LLC 100%

owned

ABC Ltd.)

Investors

SPV issues certificates and receives proceeds which are used to purchase asset from the supplier

S P V h o l d s A s s e t a s Trustee and leases the plant to ABC Ltd. as per rules of Ijarah

ABC

Ltd.

SPV leases Plant to ABC Ltd. on Ijarah

Issuer SPV

Investor

SPV holds Plant/ Asset as Trustee

ABC Ltd. (Lessee)

Issuer SPV

Investors

Periodic Lease Rentals Semi-annual coupon distribution amounts

ABC Ltd. (Lessee) pays periodic rentals to SPV for tenors & amounts matching the coupon & tenor of the

Sukuks

ABC Ltd. (Lessee)

Issuer SPV

Investors

Exercises the purchase undertaking. Asset transferred to ABC Ltd.

Pays the exercise price at dissolution

Redeems the Trust Certificates at dissolution

ABC Ltd (Lessee) give the SPV an irrevocable purchase undertaking to purchase the Asset at maturity. Exercise Price = Initial Purchase Price of Asset + service costs.

Asset is transferred back on maturity, upon payment of the Exercise Price to the SPV / Sukuk Holders.

Sukuk-Sukuk Al Ijarah

Important Conditions

Ø  Ijarah Sukuk represents the holder's proportionate ownership in the leased asset.

Ø The holder will assume the rights and obligations

of the owner/lessor to the extent of his ownership. Ø As owner the holder will have the right to enjoy a

part of the rent according to his proportion of ownership in the asset.



Ø  In the case of total destruction of the asset, holder will suffer the loss to the extent of his ownership.

Ø SPV rules in some countries do not allow SPV to

hold actual tangible assets, therefore, the asset is shown on the books of the client itself instead of SPV.


Essential Condition

“It’s essential that the Ijarah Sukuk are designed to represent real ownership of the leased assets, and not only a

right to receive rent.”


Innovation in Pakistan

Ø  In Pakistan essentialy the same structure has been used to develop Sukuks based on Diminishing Musharakah.


Innovation in Pakistan Ø  There are two basic differences in Diminishing

Musharakah Sukuks: Ø  Underlying Assets is jointly owned by investors and

issuer according to specified percentage. Ø  Ownership is also transferred periodically to the

issuer. Ø  Ijarah is essential part of a Diminshing Musharakah

transaction under Shirkatul Milk.

Sukuk Al Murabaha

Sukuk al-Murabaha

Ø  Murabaha is basically the sale of goods at a price comprising the purchase price plus a margin of profit

Ø  The margin of profit must be negotiated and agreed upon by both parties to the transaction

Sukuk al-Murabaha structure

‘Borrower’

Issuer SPV

2. Sukuk issues and Sukuk proceeds

6.Sale price + profits

1.Master agreement

3. Commodity

Investors

Commodity supplier

3. Spot payment

4. Murabaha Commodity

4. Deferred payment

Overview of Structure • Issuer SPV issues sukuk, which represent an undivided ownership interest in an underlying asset or transaction. They also represent a right against Issuer SPV to payment of the Deferred Price.

• The Investors subscribe for sukuk and pay the proceeds to Issuer SPV (the “Principal Amount”). Issuer SPV declares a trust over the proceeds (and any commodities acquired using the proceeds and thereby acts as Trustee on behalf of the Investors. • Originator (as Purchaser) enters into a murabaha agreement with Trustee (as Seller), pursuant to which Trustee agrees to sell, and Originator agrees to purchase, certain commodities (the “Commodities”) from Trustee on spot delivery and deferred payment terms. The period for the payment of the deferred price will reflect the maturity of the sukuk. Trustee purchases the Commodities from a third party Commodity Supplier for a Cost Price representing the Principal Amount for spot payment.

• Commodity Supplier makes spot delivery of the Commodities to Trustee in consideration for the Cost Price. • Trustee (as Seller) on-sells to Originator the Commodities upon delivery from Commodity Supplier in accordance with the terms of the murabaha agreement • Originator (as Purchaser) makes payments of deferred price at regular intervals to Trustee (as Seller). The amount of each deferred price instalment is equal to the returns payable under the sukuk at that time. • Issuer SPV pays each deferred price instalment to the Investors using the proceeds it has received from Originator.

Required Documentation

Document Parties Summary / Purpose Murabaha Agreement Originator (as Purchaser)

and Trustee (as Seller) Trustee (and the Investor) sells Commodities to Originator on spot delivery and deferred payment terms. Documents the terms of the murabaha sale transaction as well as terms of payment of deferred price.

Sale and Purchase Agreement

Trustee (as Buyer) and Commodity Supplier (as Supplier)

Commodity Supplier sells Commodities to Trustee on spot delivery and spot payment terms

Related Structures/Structural Developments

Shari’a prohibits the trading of debt receivables, particularly when doing so at a discount may give rise to interest (riba). As discussed earlier, this limits the negotiability of sukuk certificates issued under the sukuk al-murabaha structure as such certificates essentially represent entitlements to shares of debt receivables from the purchaser of the underlying murabaha, and this structure has thus been less commonly used in recent times.

Despite the global downturn in sukuk issuance in 2008, issuances based on the sukuk al-murabaha structure increased by nearly 60%4 . Whilst sukuk al-murabaha issuances still only account for a small fraction of the total value of the sukuk market, the increased number of issuances suggest that the structure is still favoured for smaller deals, where the Investors are more likely to be buy-to-hold investors hence more immune to uncertainties over negotiability

Sukuk al-Istisna

sukuk al-istisna often combines an istisna arrangement with a forward lease arrangement – whilst the istisna is the method through which the investors can advance funds to an originator, the ijara provides the most compatible payment method to those investors.

Sukuk al-Istisna’ structure

SPV Contractor/builder

End buyer

Sukuk holders (investors)

2.Payments 4.Monthly Payments

1.Sukuk proceeds

3. Title to assets 4. Title to assets

5. Distribution of returns

1.  SPV issues Sukuk to investors and receive proceeds

2. Sukuk proceeds are used to pay the contractor/ builder to build and deliver the future project

3. Title to assets is transferred to the SPV

4. Property/project is leased or sold to the end buyer. The end buyer pays monthly installments to the SPV

5. The returns are distributed among the Sukuk holders

Sukuk al-Istisna’ characteristics

Ø  Issued with the aim of mobilizing the funds required for producing products owned by the certificate holders

Ø  The issuer of these certificates is the manufacturer (supplier/seller)

Ø  The subscribers are the buyers of the intended product

Ø  The certificate holders own the product and are entitled to the sale price of the certificates

Sukuk Al Musharakah

Sukuk-Sukuk Al Musharakah

Ø  Musharakah is a mode of financing against which Sukuks can be issued.

Ø  If a comapany required financing for any of its

project through Musharakah it can issue Sukuks against which investors would provide funding as per the rules of Musharakah.


Ø  Every Sukuk would represent holder 's proportionate ownership in the assets of the Musharakah.

Ø  Once the majority of the cash amount is

converted into fixed assets, these Musharakah Sukuk can be treated as negotiable instruments in the secondary market.

.



Ø  Profit earned by the Musharakah is shared according to an agreed ratio between the Issuer and Investors at an agreed ratio.

Ø  Loss is shared on pro rata basis. Ø  Profit & Loss is shared between the investors as

per investment ratio only.


Important Conditions Ø  To ensure tradability of the Sukuks following

condition should be adhered to: Ø  All the assets of the Musharakah should not be

in liquid form. Ø  At least 20% of the value of Portfolio should be

invested in non-liquid assets.


Musharakah Sukuks can be used for number of purposes including: Construction of Projects and factories Expansion Projects Working Capital Finance

SPV

Musharaka

Originator/ Corporate

1.Physical asset contribution

2a. Sukuk proceeds

3b.Periodic profits +incentive fees

3a.Periodic profits 2b. Sukuk proceeds

4. Periodic distribution of profit

Investors

0&5. Musharaka Arrangement +Undertaking to buy Musharaka shares of the SPV on a periodic basis

Sukuk al-Musharaka structure

Sukuk al-Musharaka structure 1.  The Originator/Corporate contributes some

specific assets and management skills

2.  a&b The Sukuk issuer (usually a SPV) contributes the investor’s Sukuk proceeds

3.  a&b The Originator/Corporate runs the JV, operates the assets and invests the funds. It distribute the profits

4.  Sukuk holders are entitled to the Issuer’s rights in the JV whatever they are

5.  The Corporate irrevocably undertakes to buy at a pre-agreed price the Musharaka shares of the SPV

Sukuk-Other types

Ø  Sukuks are also issued under hybird structures where number of Islamic modes of finance are used to issue a single Sukuk.

Ø  Under these structures each of Islamic mode is

applied at different intervals to cater to different requirements of the issuer.

.

Sukuk-Standardization

AAOIFI has also issue Shariah standards for Sukuks and its expected that issuance of these standards would help reducing differences in fatwas issued for Sukuks.

Sukuk-Criticism Ø Some Sukuks are criticized for their close

resembelence with conventional bonds. Ø These similarities are created to adhere to the tax

and other regulatory laws of the country. Ø For example, in Pakistan SPVs cannot hold actual

assets. For this reason assets cannot be carved out from the balance sheet of the issuer which creates complexities in identification of the assets and only a hypothecation charge ensures bank's benefical ownership in the Musharakah assets.

.

Sukuk-Criticism

Ø Similarly, concept of the Diminishing Musharakah financing is not there in the stamp duty laws of Pakistan, which compels banks to sell share in assets without any legal registration.

Ø  It should be noted that concept of Diminishing

Musharakah is recognized in British stamp duty laws since April 2003.

Ø Nevertheless, not all of this criticism is incorrect,

and therefore it should be ensured that unesseccary usage of artificial structures should be avoided as much as possible.

Sukuk-Criticism

Ø The problems could be resolved by Shariah rating systems

Ø This will help investors in making informed

decisions regarding the authenticity of the Shariah structure of the Sukuk.

Sukuk-Benefits

Ø  Sukuk can be used very effectively as a halal alternate to conventional bonds for providing funding for matching maturities and without relying too much on commerical banking sector.

Ø  Another aspect of Sukuks which make them more

effective than bonds is there ability to mobilize and motivate investors to work for the overall benefit of the issuer.

Sukuk-Benefits

Sukuks for Government Projects

Ø Sukuks based on Ijarah can be used very effectively to finance Government projects.

Ø  If general public is involved in the construction of

these project through issuance of Sukuks, it can give them sense of ownership.

Ø Effective usage of such Sukuk would increase the

ratio of success and ratio of sustainability of the projects by many folds.

.

Sukuk-Benefits Sukuks by Private Sector

Ø Corporate Sector can also benefit from unique characteristic of Sukuks.

Ø Musharakah Sukuks can be used to associate

general customer with the company. Ø Sense of ownership and share in the profit of the

company can be used as a marketing tool for the products of the company.

Sukuk-Benefits

Sukuks by Private Sector

“The more company earns the more return investor would get” concept can revolutionalize sales. Even Sukuks Al Ijarah would help the companies to position themselves as an caring member of the society by involving community in the business of the company.

Sukuk-Conclusion

Ø Sukuks can be used very effectively to obtain Shariah Compliant funding which surely bring Allah's blessing and barakah for the business.

Ø  Issuers can also benefit from the huge increase in

liquidity in the Islamic world, and can tap on these new sources of funds. Raising funding from the Islamic bond market in the current environment has been 10 to 20 basis points lower than mainstream bonds.