Why Sukuk Are Catching On

Publicly-beneficial financings with predictable revenues and profit potential

iStock_000043398104SmallThis June, the UK became the first non-Muslim sovereign to issue sukuk and, later this month, South Africa will become the second.   Luxembourg and Hong Kong are reportedly soon to follow.   

Sukuk are the Islamic equivalent of conventional bonds, but they reflect important cultural differences from the fixed income securities known in the West.  For one thing, sukuk are only issuable by companies or projects deemed morally worthwhile (halal) by a board of Islamic scholars.  They are not available, for example, to transactions involving alcohol, tobacco, pork or gambling.  

The word sukuk1 comes from the Persian word for “cheque” which means any business contract undertaken in conformity with Shari’ah (Islamic law).   Sukuk certificates were used extensively during medieval Islam for transferring financial obligations originating from trade.  

Why Islam forbids the charging or paying of interest 

Under Shari’ah, money is regarded as a measure of value and not as an asset in itself.  For that reason, Shari’ah does not permit anyone to receive income from money alone and forbids the generation of money from money

Under Shari’ah, money is regarded as a measure of value and not as an asset in itself.  For that reason, Shari’ah does not permit anyone to receive income from money alone and forbids the generation of money from money (interest or riba)2.   

Shari’ah thus prohibits Islamic banks from charging or paying interest, trading in debts or other receivables (for anything other than par), engaging in conventional lending or issuing credit cards.  Contrarily, Islamic banking is based on the sharing of profits and losses on real assets and the prohibition of riba.  

Pure interest-bearing bonds are thus verboten in Islam.  The owners of sukuk must therefore derive their income or gain from an ownership interest in tangible assets, such as the property or commercial operations financed by the sukuk. The sukukholders then lease the underlying asset to the sukuk issuer and are able to collect their regular cash flows as rent, which is permitted under Shari’ah.  Today, that rent is often benchmarked to an interest rate index like LIBOR.  When the sukuk matures, its issuer repurchases the underlying asset from the sukuk-holders at its then-current market value. 

Risks and rewards of sukuk

Investors in sukuk thus take the risks and reap the rewards of the underlying asset.  That asset must generate the cash flows of the sukuk and the eventual profit or loss on the investment. If its underlying asset appreciates in value over the lifetime of a sukuk, the sukuk-holder actually benefits from the upside, which accounts for the additional appeal of sukuk as a financing option for Islamic investors.

Payments to sukuk-holders must come from the net profits of the assets or enterprise underlying the security.

To qualify as sukuk, a financial instrument must satisfy three Shari’ah principles.  The sukuk certificate itself must represent an ownership interest in assets or commercial or industrial enterprises that are capable of generating revenues.  Payments to sukuk-holders must come from the net profits of the assets or enterprise underlying the security.  When the sukuk matures, the amount payable to its holders must be the then-current market value of the underlying assets or enterprise and not the principal originally invested.  Sukuk are not issuable if their returns are guaranteed by their issuers or if their issuers are obligated to repurchase the underlying assets at predetermined prices.  These are the principal characteristics distinguishing sukuk from conventional bonds.

Increasingly popular investment  

Within those Shari’ah parameters, sukuk can be structured to accommodate all kinds of assets, projects, businesses or investments, provided of course that the financings are deemed halal by a Shari’ah board.   

Since Malaysia issued the first modern sukuk in 2000, over $800 billion of sukuk have been issued in the Middle East, Southeast Asia and, more recently, Africa3.  Most of those issues have been denominated in US dollars and are governed by English law.  Sukuk issues are now listed on the London Stock Exchange, the Bursa Malaysia, the NASDAQ Dubai and the Luxembourg Stock Exchange4, with Malaysia and the states of the Gulf Cooperation Council5 being the most active sources of issuance since the vast majority of sukuk comprise assets and commercial activity centered in those geographic areas.   

Sukuk are now the instrument of choice for financing long-term infrastructure projects in Islamic countries6.  At the same time, the pool of potential investors for sukuk has been growing steadily throughout the Muslim7 and even non-Muslim worlds and, if sukuk needed the imprimatur of a major Western player to boost its profile in global finance, Goldman Sachs just provided it by announcing its intention to underwrite a new $500 million, 5-year sukuk together with Abu Dhabi Islamic Bank, the National Bank of Abu Dhabi, Dubai’s Emirates NBD Capital and Saudi Arabia’s National Commercial Bank

1 Sukuk is a plural noun, so one does not refer to multiple issues as sukuks.

2 In a Muslim mortgage, for example, the bank buys the house and then sells it to the occupant slowly over time. Islamic banks also issue certificates of deposit that pay a share of the banks’ investment profits rather than a fixed rate of interest.

3 African issuers include Gambia, Sudan and Senegal, all of which have predominantly Muslim populations.

4 Though sukuk are listed on exchanges, there seems to be some question as to whether they can be traded in the secondary market in accordance with Shari’ah. Presumably, to avoid forbidden riba, secondary market prices for sukuk must reflect the values of their underlying assets or operations rather than being based on relative interest rates or credit ratings like conventional bonds.

5 The GCC states consist of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates.

6 There are 49 predominantly Islamic countries in the world today.

7 The world’s 1.6 billion Muslims account for more than 23% of its current population.

8 HSBC was the first Western bank to issue sukuk in 2011.