Shariah condition for commencement of trading in Sukuk

Upon completion of the explanation of the Sukuk definition in the last article, I will now commence to explain how a Sukuk transaction is unfurled as well as how many kinds of Sukuk can be issued to serve the market purpose, particularly for the obligors and investors.

But before I do that, I would like to take you on a deeper dive into the unique position of Sukuk in the capital market. The champions of Sukuk proudly claim that this is the only instrument which ticks all the boxes and before the Sukuk hit the market two decades ago, there was no single instrument which could fit the bill. So, let us do the litmus test for Sukuk to know if it really is the darling of the capital market.

I have developed the following Table 1 for easy illustration and will separately explain each point for the sake of added clarity.

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

I will pick each item in the table and compare it with the characteristics. Starting from Sukuk, I see that it does have the trait for the ownership of asset for investors within the framework of the Sukuk transaction. What does that mean?

If you refer to article 148, I had mentioned in the context of the first-ever sovereign rated Sukuk, ie the Malaysian Sukuk for US$600 million, that it was the first time that I had learned the term ‘asset-based Sukuk’. Now is the time to touch upon as to what is ‘asset-based’ and ‘asset-backed’ Sukuk. Frankly, the Shariah scholars are not amused by such a distinction created by the legal fraternity since they believe that from a Shariah ownership perspective, both types of Sukuk are of the same genre.

In simple terms, an asset-based Sukuk transaction is the transaction where the Sukukholders have dual recourse, ie on the asset used for the Sukuk as well as against the obligor whereas an asset-backed Sukuk transaction is true securitization with the Sukukholders’ recourse only to the Sukuk asset and not against the obligor.

Most of the practitioners may not agree with me since they believe asset-based Sukuk are a replication of conventional bonds but having discussed the matter threadbare with the Shariah scholars while working on various Sukuk transactions, I am convinced that such titles merely assist to differentiate between securitization and non-securitization transactions. I will return to this debate while explaining the Ijarah or leasing Sukuk with the aim to prove that asset-based Sukuk do not mimic conventional bonds.

Next, Sukuk do tick the box for the performance-linked return to investors. This is true if the Sukuk facility is based on Mudarabah, Musharakah or investment Wakalah or based on a hybrid structure in which any of these equity modes is used. Readers can refer to my detailed deliberation on the aspect of how investors are rewarded from the varying performance in investment-based contracts.

The next box relates to the underlying transaction. Yes, there is an underlying transaction in Sukuk whereby an asset has been traded or the investment made into a project. This is in contrast to a conventional bond which is devoid of any underlying transaction and is simply used as a borrowing channel against a prefixed interest payment. I shall discuss equity risk, fixed return and risk mitigation in 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.