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 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”.
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