SUKUK

Introduction:

Conventional bonds work in a way that a bond holder deposits a certain amount with
the bond issuer in exchange of the bond, and that bond gets him a fixed amount periodically
and at the end of bond term, the principal amount which the bond holder has paid to the issuer,
is returned fully. The periodic payments which are released to the bond holder before the
maturity date are interest payments which are made to the bond holder against the principal
amount which they have deposited. The principal amount is considered a debt to the bond
issuer. These interest payments on the principal amount make these bonds non-Shariah
compliant from an Islamic perspective. Therefore, the need for sukuk arose in order to keep the
debt instruments in the market while aligning them with the Sharia Laws. There are different
types of sukuk which operate in a different way, as explained in this chapter.

Ijara Sukuk:

Ijara sukuk are the most common type of sharia compliant sukuk, majorly because of
the fact that they can be traded in the secondary market. The Ijara sukuk involves three entities:
the firm issuing the debt instrument, the sukuk holders, and a SPV. An individual entity is
assigned the title of SPV or Special Purposed Vehicle. This entity works as an agent in the
whole process. Firms which require financing for the assets they need to perform their normal
business activities hire a SPV. SPV works as an agent for the firm and goes into the market to
arrange the funds required by the firm. The individuals or organizations which provide the
funds required by the SPV are issued Sukuk by the SPV. Once all the funds are arranged and
Sukuk issued, SPV acquires the asset which is required by the firm. The asset is then leased
out to the firm which required it.

The process of issuing sukuk generally involves two promises. The first promise is that
the firm would lease the asset, which the SPV buying and is raising funds for. This promise is
made to avoid any losses which the SPV might face if the firm refuses to lease the asset once
it is acquired by the SPV. A second promise is made regarding the acquisition of the asset. This
promise holds the firm needing the asset liable to buy the asset at a predetermined price after a
fixed leasing period. In Ijara Sukuk, the first promise is not essentially required from the firm,
but it is preferred to prevent any losses to the SPV. Additionally, future Ijara can also be done
as it is a service contract and not a sale contract.
 The periodic payments made by the firm as rent for the asset are distributed among the
sukuk holders and once the leasing period ends and the firm pays the predetermined price of
the asset, the sukuk holders are given their principle amounts back. This way the sharia
compliant asset backed sukuk are issued, which works in a similar way as the conventional
bonds.

Firm leases the

Promise 1
To ease the asset.
Gets a fee for
being the agent. SPV Firm Promise 2
To buy the asset.
Hires an SPV

Money is raised.

Risk to be borne by the

Murabaha Sukuk:

Murabaha Sukuk operates essentially the same manner as Ijara Sukuk but the only
difference in their operating procedures is that instead of the periodic rental payments in Ijara,
the firm pays Murabaha profit in instalments, which is then distributed in the Sukuk holders.

Ijara sukuk are preferred in the market because unlike the Ijara sukuk, Murabaha sukuk
cannot be sold in the market. The reason being that in Ijara sukuk, the contract after the asset
is acquired by the SPV is an Ijara contract, which means that the ownership of the asset stays
with the Sukuk holders who paid for the asset. This ownership means that the risk in case of
the asset being destroyed stays with the sukuk holders and the firm does not have to make any
further payments if the asset is destroyed. Therefore, in case the asset is destroyed, the firm
cannot be held liable for the Ijara payments. While in Murabaha Sukuk, the ownership is
transferred to the firm after the contract. Since the ownership of the asset in a Murabaha sukuk
lies with the firm, the sukuk holders cannot sell the sukuk in a secondary market as they do not
own the asset.
Musharkah Sukuk:

In Musharkah Sukuk, the SPV arranges funds on behalf of the firm from the sukuk
holders to pool in money for a business. Two promises are made in a Musharkah Sukuk. A
benchmark is set for the profit. The first promise is that if the profit is greater than the
benchmark agreed upon, the firm will give the benchmark amount to the Sukuk holders while
the amount above the benchmark will be considered as the firm’s bonus. However, if the profit
is less than the benchmark, then the firm will give the difference to the sukuk holders as a gift.
This is done to ensure that the amount equal to the benchmark is given to the sukuk holders,
similar to the coupon payments in a conventional bond.

The second promise which is essential to giving Musharkah Sukuk a structure of a bond
is a buyback promise. The firm will make a promise that after a specific period of time and
periodic payments to the sukuk holders, the firm will buy back the equity which is given to the
sukuk holders in exchange for their money at the price which was agreed upon initially. This
would equate to the principal amount being returned to the sukuk holders and the firm getting
full ownership of the business.

Now there are two issues which come with Musharkah Sukuk, which explain why this
type of Musharkah sukuk are non-sharia compliant and hence does not exist in the market.

1. The first promise ensures that in case of less than a benchmark profit, the difference is to
be gifted to the sukuk holders. This goes against the principles of Shirkat. The essence of
Shirkat is loss sharing and in case of the profits being less than a certain benchmark, the
Musharkah sukuk violate that essence and hence are considered non-shariah compliant.
2. The second issue is that you cannot buy equity at a predetermined price. If the joint
ownership is in an asset, only then can the complete ownership be bought at a price which
is determined at the time of purchase of the asset. The same cannot be said about equity in
a venture. This is due to the reason that equity can only be bought at market price and there
is no predetermined price for any equity.