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Saturday, 14 September 2013

Bonds and Sukuk: A Comparative Overview

The subject matter of this article encompasses an area of Islamic finance that has seen rapid growth over the last two decades. The objective of this article is to give the reader an overview of two commonly used debt capital market instruments: the conventional bond and, its Islamic finance equivalent, the sukuk. Bonds are the most widely used debt security on the capital markets and they can be issued in numerous forms. At a basic level a bond is a certificate of debt under which the issuer obligates itself to pay the principal and interest to the bondholders on specified dates. There are certain characteristics that one can associate with bonds; firstly a bond represents a debt obligation, secondly businesses can raise capital by issuing them since they can be marketed to a wide range of investors through a syndicate of financial institutions on the capital markets through a listing on the London Stock Exchange or to a small group of investors thorough a process known as Private Placement. Conventional bonds bear interest and this interest bearing characteristic of a conventional bond is its main distinguishing feature from its Islamic counterpart, the sukuk. The emergence of the sukuk has its origins under the Sharia as derived from its primary source, The Holy Quran which strictly prohibits the use of interest (riba). The are various types of bonds, for example there are fixed rate bonds, variable rate bonds, step-up or step-down bonds, collars, zero coupon bonds and equity linked bonds that include convertible bonds, bonds with warrants and exchangeable bonds. For the purposes of this article we are not going to focus in detail on the various kinds of conventional bonds although we shall go into such details for sukuks. It should, however be noted that conventional bonds and the sukuk serve a very useful purpose depending on the differing commercial objectives of businesses. For example, it is clear that a company which wants to expand its operations to a new geographical territory through vertical or horizontal business integration needs capital. Let us assume that the management of the company in our example decides to make an acquisition of a competitor. Possible solutions to acquire the capital required for this acquisition would include sources of debt and equity finance. Let us further assume that the company decides to raise the capital through debt finance. In this situation it could raise the required capital by issuing bonds to investors and if it is a relatively large acquisition then a syndicated loan could also be on the cards. Therefore, bonds can serve different purposes in different contexts and are the most widely used debt security on the international capital markets as well since they can be listed on a stock exchange.  

        A distinguishing feature of sukuk from conventional bonds is the fact that bonds proceed over interest bearing securities whereas the sukuk are investment certificates that consist of ownership claims in a pool of assets. Bonds are a proof of debt, whereas sukuks are a proof of ownership. The main difference is that bonds include a fixed rate of interest regardless of loss or gain, while the income from sukuk is related to the original legal contract that governs the relationship between the sukuk issuer and the holders of the sukuk certificates. One of the most prevalent advantages in issuing sukuk is the creation of a wider investor base because of its acceptability by the global investing community. Muslim investors, or Islamic institutions, are not the only ones who are allowed to invest in Islamic sukuk; even conventional institutions can invest in sukuks and any issuer can issue a sukuk as long as the issuer does not use the proceeds from the sale of the sukuk for non-Sharia compliant projects and/or activities. The different structures of investment sukuk are very similar to asset backed securitisation and selling assets, or productive activities, to an SPV it makes the financial structure more secure. In addition, the sukuk holders are proportionate owners of the assets. For a long period of time, Islamic institutions were troubled by the hassle of having to deal with financial intermediaries whose interest based products were not Islamically acceptable. Securitisation allows Islamic banks to overcome these shortcomings by engaging themselves directly with the assets to be financed, and with investors in the pools of these assets. Furthermore, it paves the way for Islamic banks to negotiate the Islamic acceptability of the terms under which the users hold these assets. Finally, by issuing investment sukuk much needed liquidity is brought about for Islamic banks and mobilised funds are generated from the proceeds of sukuk. These mobilised funds could be used in the constructing or developing of projects and tangible assets. This is Islamically permissible and does not contradict with Sharia laws and principles as investors are actually trading their ownership interest in tangible assets rather than trading in monetary debts. Liquidity has always been the most critical issue for Islamic banks; the creation of investment sukuk is an instrumental initiative in solving this problem.

In conclusion we shall analyse the impact of the sukuk market on one of the leading financial centres in the world, the City of London. The groundwork for this was laid down by Sir Howard Davies when he was Chairman on the Financial Services Authority (“FSA”). In a conference on Islamic Banking and Finance in Bahrain in September 2003, he said that he had ‘no objection in principle to the idea of an Islamic bank in the UK and that the UK had a clear economic interest in trying to ensure that the conditions for a flourishing Islamic market are in place in London’. He added that a soundly financed and prudently managed Islamic institution would be ‘good for Muslim consumers, good for innovation and diversity in our markets and good for London as an international financial centre’. Since then the FSA has been very active by making regulations in order to extend the scope of Islamic banking. This proactive approach can be seen in the Financial Services and Markets Act 2000 (Regulated Activities) (Amendment) Order 2010 that has been instrumental in laying the framework for sukuk to become financial instruments. They have built on the structure on the Finance Acts 2003 & 2007 that waived stamp duty for mortgages that were sharia compliant. The Finance Act 2007 clarified the tax framework further in the case of sukuk. Furthermore; the UK government has pursued the creation of an Islamic subeconomy, which it prefers to call ‘alternative financial investments’. This governmental effort has been facilitated by the establishment of Her Majesty’s Treasury Islamic Experts Group and the HM Revenue and Customs Islamic Finance Group. The UK now houses five domestic Islamic financial institutions which claim to offer Sharia-compliant financial products and services and the City of London has established itself as the third largest market for Islamic finance after the Gulf Co-operation Council states and Malaysia.

It is hoped that this analysis of the sukuk as an international Islamic institution has allowed the reader to form a comprehensive view as to what extent the pendulum of Islamic financial instruments has swung in the last decade. The potential for future growth in this area is immense and the development of secondary markets for trading of sukuks would further facilitate this unprecedented growth. A paradigm example of this trend can be seen in the recent listing by Banque Saudi Fransi of its U.S. $2 billion sukuk programme being the first sukuk programme established by a Saudi bank to be listed on the London Stock Exchange. This provides us with a foretaste of things to come as more banks in the Middle East could follow a similar path. As Professor Jean-Francois Seznec comments that “At a time when global economics forces are causing great hardship for people around the world, and the harsh demands of the market seem to supersede concern for the well-being of fellow humans, Islamic banking may serve as a means of re-imbuing modern banking with ethical norms. Within the broader financial system, Islamic finance can play a role in re-establishing a sense of ethics that has been lost and try to make its concept and products acceptable to ethically minded Muslims, Christians, Jews and others who are engaged in financial transactions”.