How do Sukuk tick all the right boxes?

In the last article while on the subject of the Shariah conditions for commencement of trading in Sukuk, I had shared with readers a comparison table for Sukuk versus the other securities. The table showed that Sukuk are the only security which ticks all six boxes and I had explained how Sukuk tick the first three boxes. I have requested IFN to provide the same table in this article too for ease of reference to readers.

Table 1: Comparison of Sukuk with other instruments
CharacteristicsSukukEquityBondsSecuritizationCovered bonds
Ownership of assetXXX, √
Performance-linked returnXX, √X
Underlying transactionXX
Equity riskXXX
Fixed returnX
Risk mitigationX
Source: Author’s own

The fourth box is of equity risk. The Sukuk comfortably tick this box too if the Sukukholders have invested in an asset-backed transaction where the only recourse is on Sukuk assets and the return is also affiliated to them — which may be fluctuating. An example is leased properties where the rent is exposed to market fluctuation.

But why only the asset-backed Sukuk should be able to tick the box? Why not the asset-based Sukuk and why is the return stable in such transactions? Let me explain. As you may be aware, there is strong demand out there in the market for fixed-income instruments since they provide capital preservation and stable earnings.

A conventional public or private sector bond provides such steady income to pension funds, hedge funds, institutional investors, high-net-worth individuals and the employees nearing retirement and to all other ‘risk-averse’ investors.

If the Islamic capital market gurus needed to tap that substantial source of funding, they faced the challenge to tailor-make the Islamic bond to offer fixed income similar to bonds to such investors but do it without breaching the Shariah boundaries. The challenge was overcome by introducing the conventional rate benchmark such as the London Interbank Offered Rate (LIBOR), first in the Islamic consortium financing on a test-case basis and then in the Sukuk.

You may refer to my article 72 for a detailed explanation on how the Shariah scholars initially agreed to allow using the conventional benchmark for Islamic financing and investment transactions. In summary, it was allowed on the basis that there must always be an underlying transaction, either a sale and purchase of an asset, or investment in an asset or project, or delivery of certain defined services and that the income distributed to investors and financiers must be ‘Islamically’ derived from such an asset or services.

I remember getting involved in one of the very first such transactions where LIBOR was applied. It was way back in 2002 for a large Islamic Ijarah syndicate financing for a power project based in Abu Dhabi where the funding currency was US dollars and the three-month LIBOR was used to ascertain the periodical lease rent for distribution among the participating banks from the UAE and abroad.

The said explanation also helped me tick the next box, which is fixed income.

Next, on risk mitigation, the Sukuk have many options. To start with, since the trustee (representing the investors) has entered into an asset purchase agreement with the obligor, irrespective of whether it is an asset-based or asset-backed transaction, the Shariah ownership of the Sukuk assets has passed to the trustee, thereby establishing the trustee’s recourse on them. Then, if it is an asset-based Sukuk transaction, the trustee has the recourse to the obligor too by way of purchase undertaking (put option in favor of the trustee). Refer to my detailed explanation in the set of Ijarah articles.

Other risk mitigation techniques for investors include seeking third-party guarantees, assignment of insurance proceeds in case of partial or total loss to the Sukuk assets and finally the collateral, either a mortgage of Sukuk assets or lien on receivables/other current assets.

As for the mitigation of risk of return or the currency fluctuation risk, there are various Shariah compliant rate and currency swaps available with Islamic banks for hedging purposes.

So you see how the Sukuk emerged in this discussion as a well-rounded and flexible instrument which ticked all the boxes a prudent investor would want to tick before making an investment decision.

I will leave the assessment of equity, bond securitization and covered bonds to the readers’ judgment but will be available at my given email address for any clarification that you may need.

Let me wrap up here until I pick up the pen for the next article.

The purpose of this educative series and the article is not to hurt any religious or commercial sentiments either consciously or even unwittingly.

Sohail Zubairi is an Islamic finance specialist and AAOIFI-certified Shariah advisor and auditor. He can be contacted at [email protected]

Next week: Discussion on Sukuk to continue.