A sukuk is an investment certificate of equal value representing an undivided share of ownership in assets, usufructs, services or a Sharia-compliant activity, whose income comes from those assets rather than from interest. Often called an Islamic bond in the press, a sukuk differs from a bond because its holder owns a share of something real and receives a share of its income, and does not simply hold a claim for repayment of a loan.
Who issues sukuk and what they finance
Governments issue sukuk to finance budgets and infrastructure, state-owned companies issue them to fund airports, power plants and ports, and banks issue them to build their capital. Corporates use them for property portfolios, aircraft and plants. Each issue is tied to identified assets or to a business activity, which is what the investor reads in the prospectus when deciding whether the structure matches his requirements.
Investors include banks, takaful operators, pension funds, asset managers and wealthy individuals, along with funds that serve smaller savers. Many of them value sukuk for diversification as well as for compliance, since the certificates offer exposure to different issuers and sectors from those they hold in equities.
A sukuk as a title of ownership rather than a debt acknowledgement
A bondholder lends money and receives interest regardless of how the funds are used. A sukuk holder becomes a co-owner of an asset or business and receives a share of the rents or profits that it generates.
What the AAOIFI standard on investment sukuk requires
The standard requires each certificate to represent a real share of an identified asset, transferred to investors together with the rights and obligations attached to it. The prospectus must describe the contract used, the use of proceeds and the Sharia board opinion approving the issue.
Trading a sukuk: when is the sale permitted?
A certificate backed by tangible assets can be sold at any agreed price. If it mainly represents receivables or cash, its transfer must follow the rules on sale of debt, which largely restricts it to trading at par.
Why the nature of the assets sets the resale price
If the pool contains, for example, 70% leased buildings and 30% receivables, most boards allow sale at market price. Below a certain level of real assets, the rules differ between jurisdictions and Sharia opinions.
How sukuk income and redemption are paid
Income on a sukuk certificate follows the underlying contract. In a lease-based issue the holders receive rent, in a profit-sharing issue they receive a share of the profit actually earned, and in a sale-based issue they receive instalments of a price. Redemption happens at maturity, when the originator buys the assets back or the vehicle winds up and distributes the proceeds, depending on the structure.
Holders should read how the periodic distribution is calculated. Some structures pay a rent that is fixed in advance, which gives a predictable profile; others pay a variable return, which depends on performance. The prospectus explains the dates, the way the rate is set and what happens if the assets earn less than expected, including the use of reserves.
The steps of a sukuk issue
The originator, a state or a company, identifies assets, sets up a special purpose vehicle, drafts the contracts, obtains a Sharia opinion and a rating, then places the certificates with investors. Arranging banks, lawyers and trustee agents support every stage.
The special purpose vehicle and its trustee role
The vehicle, often a company in a specialised jurisdiction, buys or leases the assets with the issue proceeds. It acts as trustee on behalf of holders, collecting the income and passing it on to them in proportion to their certificates.
Asset-backed or asset-based: recourse in a default
In most issues, investors have no enforceable property right over the assets and must claim against the originator, like a creditor. The rare truly asset-backed sukuk allow them to seize and sell the underlying asset.
Ratings and legal documentation
The major rating agencies assess most international sukuk, relying mainly on the originator's creditworthiness. Documentation often follows English law for the financing contracts, while the transfer of assets falls under local law.
Risks borne by sukuk holders
A sukuk holder carries credit risk on the originator whenever the structure gives only a contractual right to be paid by it. Beyond that, the holder faces market risk, because the price of the certificate moves with rates and sentiment, liquidity risk, since secondary trading can be thin, and compliance risk, which arises if a board later questions a feature of the structure.
There are also asset risks. A building may lose its tenant, a plant may produce less than forecast and a project may be delayed. Whether the holder bears these depends on the contract: in a true partnership the loss reaches the investor, whereas in many asset-based issues the originator promises to buy the assets back, which turns the exposure into one on its solvency.
The 2008 statement and what followed
In 2008, AAOIFI's Sharia board issued recommendations after scholars criticised many issues. They targeted sukuk whose structure copied the profile of a bond too closely, without any real transfer of risk.
No guarantee of capital at face value
The manager of a Musharaka, Mudaraba or Wakala sukuk may not undertake to buy back the assets at face value; repurchase takes place at market value or at a price agreed at the time of sale. Ijara sukuk remain subject to their own rules.
No manager loans to top up an expected return
The statement prohibits the manager from lending to holders when actual profit falls short of the announced return. It may, however, build a reserve from past surpluses or pay advances recoverable from later distributions.
Who issues sukuk, and how individuals can invest
Malaysia and the Gulf states dominate the market, but countries such as the United Kingdom in 2014 or Turkey also issue. As denominations often exceed 200,000 dollars, individuals usually invest through funds or through retail sovereign sukuk offered in some countries.
What to read in a sukuk prospectus
The prospectus is the document that tells the investor what a sukuk really is. It names the originator and the issuing vehicle, describes the assets, sets out the contracts, states the dates and amounts of distributions and lists the risk factors. It also records the opinion of the Sharia board and the ruling on which that opinion relies, which is useful for comparing the compliance work behind different issues.
- Whether holders have a real right over the assets or only a claim on the originator.
- Who buys back the assets at maturity and at what price.
- How the periodic distribution is set and what happens if income falls short.
- Which law governs the contracts, the transfer of assets and any dispute.
- Which Sharia committee approved the issue and on what basis.
A careful investor compares these points between two issues of similar rating and maturity. Differences in the answers explain differences in price better than the label of the structure does.
The main types of sukuk
The name of a sukuk refers to the Islamic contract that structures the issue. The table summarises, for each type, what the investor holds and where the income comes from. It describes the theoretical structure: the rights that are actually enforceable and the recourse in the event of default are found in the prospectus of each issue.
| Type | Structure | Remuneration | Point to watch |
|---|---|---|---|
| Ijara | Lease of tangible assets to the issuer | Rent | Redemption rules specific to Ijara sukuk |
| Murabaha | Purchase and resale of an asset with an agreed margin | Margin on the resale | Mostly used for the short term; a receivable, so limited tradability |
| Musharaka | Share in a business or a partnership | Profits shared in the agreed proportions | Losses follow each party's share of capital |
| Mudaraba | One capital provider, one manager who contributes expertise | Profits shared according to a ratio fixed in advance | Redemption at market value, not at par |
| Wakala | An agent invests on behalf of the holders | Income from the activity; the agent receives a fee | Redemption at market value, not at par |
| Salam | Advance payment for goods delivered later | Defined by the issue documentation | Generally used in agriculture |
| Istisna | Financing of a construction or a manufacturing project | Defined by the issue documentation; payment according to progress | Depends on completion of the project |
Some issues combine several of these contracts; these are known as hybrid sukuk.
An Islamic name guarantees neither the capital nor recourse
In most issues, investors have recourse against the originator as a creditor would, and not against the underlying asset. The return is not guaranteed: it follows the income of the asset or the activity, and a risk of loss exists. Before investing, read the prospectus to find out whether the certificate gives a real right over the asset, who buys back the assets and at what price, and which Sharia committee approved the issue.
Providers offering these services
- Islamic Development Bank (sukuk issue) : The Islamic Development Bank reports a public sukuk issue of US$1.25 billion, an example of an issuer placing certificates.