What is a Sukuk?

A sukuk is an Islamic financial certificate, similar to a bond in Western finance, that complies with Islamic religious law commonly known as Sharia. Since the traditional Western interest-paying bond structure is not permissible, the issuer of a sukuk sells an investor group a certificate, and then uses the proceeds to purchase an asset, of which the investor group has partial ownership. The issuer must also make a contractual promise to buy back the bond at a future date at par value.

Understanding Sukuk

Sukuk have become extremely popular since 2000, when the first sukuk was issued by Malaysia. Bahrain followed suit in 2001. Fast forward to current times, and sukuk are used by Islamic corporations and state-run organizations alike, taking up a large share of the global bond market.

Islamic law prohibits what's known as "riba," or interest. Therefore, traditional, Western debt instruments cannot be used as investment vehicles. To circumvent this, sukuk were created in order to link the returns and cash flows of debt financing to a specific asset being purchased, effectively distributing the benefits of that asset. This allows investors to work around the prohibition outlined under Sharia and still receive the benefits of debt financing. However, because of the way that sukuk are structured, financing can only be raised for identifiable assets.

Thus, sukuk represent aggregate and undivided shares of ownership in a tangible asset as it relates to a specific project or a specific investment activity. An investor in a sukuk, therefore, does not own a debt obligation owed by the bond issuer, but instead owns a piece of the asset that's linked to the investment. This means that sukuk holders, unlike bond holders, receive a portion of the earnings generated by the associated asset.

Sukuk and conventional bonds do share similar characteristics such as:

  1. Both provide investors with payment streams. Sukuk investors receive profit generated by the underlying asset on a periodic basis while bond investors receive periodic interest payments.
  2. Bonds and sukuk are initially issued to investors.
  3. Both are considered to be safer investments than equities.

The key differences between sukuk and conventional debt instruments (bonds) are:

  1. Sukuk involves asset ownership while bonds are debt obligations.
  2. If the asset backing a sukuk appreciates then the sukuk can appreciate whereas bond profitability is strictly due to the interest rate.
  3. Assets backing sukuk are Sharia compliant whereas bonds are riba and may finance non sharia compliant businesses.
  4. Sukuk valuation is based on the value of the assets backing them while a bonds price is largely determined by its credit rating.

Key Takeaways

  • A sukuk is an Islamic financial certificate, similar to a bond in Western finance, that complies with Islamic religious law commonly known as Sharia.
  • Sukuk involves asset ownership while bonds are debt obligations.
  • Both sukuk and bonds provide investors with payment streams.

Sukuk Example

The most common form of a sukuk is a trust certificate. Surprisingly, these certificates are governed by Western law. However, the structure of this type of sukuk is fairly complicated. The organization raising funds first creates an offshore special purpose vehicle (SPV). The SPV issues trust certificates to qualified investors and puts the proceeds of the investments toward a funding agreement with the issuing organization. In return, the investors earn a portion of the profits linked to the asset.

Sukuk structured as trust certificates are only applicable if the SPV can be created in an offshore jurisdiction that allows trusts. This is sometimes not possible. If an SPV and trust certificates can't be created, a sukuk can be structured as an alternative civil-law structure. In this scenario, an asset-leasing company is created in the country of origin, effectively purchasing the asset and leasing it back to the organization in need of financing.