Sukuk Definition

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Sukuk (wallstreetmojo.com)

BondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more pay borrowers a fixed or floating interest rate for a set period. But Sharia forbids Muslims from paying or charging interest (riba in Islamic law) as such investments are not halal in Islam. Returns on sukuk might be in the form of profit, rent, or both. In addition, the issuer must buy back the certificate at par value at a later period.

How Does Sukuk Work?

Sukuk is not a bond (interest-bearing security), which is not halal under Sharia law. Instead, this financial certificate provides partial ownership in identifiable assets, projects, businesses, or investing activities. As a result, the holder earns returns or cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more as profits, rent, or both from the undivided asset ownership. The sharia-compliant certificate is issued through a special purpose vehicle (SPV)Special Purpose Vehicle (SPV)A Special Purpose Vehicle (SPV) is a separate legal entity created by a company for a single, well-defined, and specific lawful purpose. It also serves as the main parent company’s bankruptcy-remote and has its own assets and liabilities.read more that the issuer sets up to raise funds.

Key Takeaways

  • Sukuk is an Islamic financial certificate or note issued by a special purpose vehicle. It adheres to Sharia, an Islamic religious code, and substitutes for a standard interest-bearing bond.The issuer sells the certificate to the investor and uses the proceeds to purchase a physical asset, giving the investor direct partial ownership.Investors can share the earnings generated by the asset they hold rather than any form of interest. The returns might take the form of profit, rent, or both.The sukuk types accessible in the market are Sukuk al Murabaha (Debt), Sukuk al Ijarah (Property), Sukuk al Istisna’a (Project), Sukuk al musharaka (Business), and Sukuk al Istithmar (Investment).

The term sukuk derives from the Arabic word ‘sakk,’ meaning certificate. The issuer issues the certificate to the investor and promises the ownership rights in the current or future asset for a specific period. Once the investment is made, the investor is entitled to a portion of profits and losses (not debtDebtDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more obligation or interest) associated with the asset per the terms of the agreement.

Each sukuk has a face value based on the underlying asset’sUnderlying Asset’sUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more value, which the investor should pay or purchase at a discounted rate. The future cash flow derived from the underlying asset is deposited as the current cash flow.

Sukuk Process

The process of issuing sukuk is as follows:

  • The issuer, obligator, or originator (business or government) seeking financing forms an offshore SPV, an incorporated entity. It shields the underlying asset from creditorsCreditorsA creditor refers to a party involving an individual, institution, or the government that extends credit or lends goods, property, services, or money to another party known as a debtor. The credit made through a legal contract guarantees repayment within a specified period as mutually agreed upon by both parties.
  • read more if the originator suffers financial difficulties.SPV sells trust certificates to investors, giving them partial ownership of the underlying tangible assetTangible AssetTangible assets are assets with significant value and are available in physical form. It means any asset that can be touched and felt could be labeled a tangible one with a long-term valuation.read more and allowing them a share in its profits.The certificate details the specific asset, project, joint ventureJoint VentureA joint venture is a commercial arrangement between two or more parties in which the parties pool their assets with the goal of performing a specific task, and each party has joint ownership of the entity and is accountable for the costs, losses, or profits that arise out of the venture.read more, or investing activity and the quantity of the investment, its face value, interest rates, and maturity period.The issuer receives the proceeds from the sale via a finance contract, which it uses to purchase the sharia-compliant asset.SPV purchases the asset from the issuer and pays the asset sale proceeds to the issuer. In addition, the former can leaseLeaseLeasing is an arrangement in which the asset’s right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.”read more the asset back to the issuer and collect lease paymentsLease PaymentsLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration.read more from the latter.Lease payments are dispersed as lease income by SPV to investors.When the lease term ends, the issuer pays SPV face value for the asset.The proceeds of this transaction will be distributed to investors.

Structure

Asset-based and asset-backed sukuks are both possible. The former requires the issuer to purchase the underlying sharia-compliant asset, invest or lease it on behalf of the investor, and then use the proceeds. On the other hand, the latter entitles the investor to a portion of the tangible asset’s profits or losses.

The certificate can be categorized into the following types based on the form of ownership held by the investors:

  • Sukuk al Murabaha (Debt) Sukuk al Ijarah (Property/Asset)Sukuk al Istisna’a (Project)Sukuk al Musharaka (Business)Sukuk al Istithmar (Investment)

Examples

Let us consider the following sukuk examples to understand the concept better:

Example #1

Mehwish, an investor, met Alec, whose company suffered from financial turmoil. Alec called Mehwish to present a proposal and said how profitable his company has been in the past and is likely to continue in the same way in the future. He tells her about his attempt to raise capital by inviting more and more investors into the venture. Alec asked Mehwish to join him.

Being an Islam follower, Mehwish was not ready to invest in bonds. Thus, Alec offered her sukuk certificates and promised profit-sharing as agreed upon by both parties.

Example #2

Indonesia granted $2.7 million for the Maluku Conservation Center under a green sukuk fund for biodiversity objectives in 2020. In addition, the sukuk has been used to fund important infrastructure projects in the country, such as railways, harbors, airports, etc. The investors gain a percentage of the profit from public infrastructurePublic InfrastructureThe constructions, facilities, systems, concrete, and other structures owned and maintained by the central or state government are referred to as public infrastructure. Such facilities and services, including roads, water, electricity, and telecommunications, are offered to the general public with or without charges.read more because the government issues the financial certificate.

Sukuk vs Traditional Bonds

The word sukuk is often mistakenly substituted by Islamic bond, which is not an acceptable investment under Sharia law. When a sukuk is stated to be Sharia-compliant, it signifies that it follows the following rules:

  • The profit earned only through commercial risk-taking and trade is the return on investment.No financial interests of any type are permitted.The assets in question must be halal.

When comparing sukuk with conventional bonds, there are many similarities and differences:

Similarities

  • Investors will receive payoutsSold to investors with a set maturity period and can be used to raise funds for a variety of reasonsSuperior and safer investing alternatives to equitiesEquitiesEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company’s balance sheet.read moreIssuers sell them, and they can be traded over the counter or on stock exchangesStock ExchangesStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ.read more

Differences

This has been a guide to Sukuk and its meaning. Here we explain how does sukuk work along with its process, structure, examples. You may learn more about financing from the following articles –

Sukuk is a Sharia-compliant financial product provided to Muslims as an alternative to traditional bonds. The value of the underlying asset determines its face value. This financial certificate allows the investor to hold a portion of identifiable assets, projects, businesses, or investments. As a result of the undivided asset ownership, the holder receives returns or cash flows in profits, rent, or both.

Sukuk is considered equity because it is issued in the form of certificates. The sharia-compliant certificate is issued by the issuer’s special purpose vehicle (SPV) to raise funds. The issuer provides the investor with a certificate that guarantees ownership rights in a current or future asset for a fixed length of time. Following the investment, the investor is entitled to a share of the asset’s earnings and losses under the terms of the agreement.

  1. The issuer sets up an offshore SPV.2. SPV sells trust certificates to investors.3. The issuer receives the proceeds from the certificate sale and purchases the sharia-compliant asset.4. SPV purchases the asset from the issuer and pays the asset sale proceeds to the issuer.5. The issuer then distributes proceeds among investors.
  • Capital StructureMortgage BondFinancial Guarantee