What is Sukuk Bond?

By Sakshi Srivastava - 10 Mar 2022 Last Updated: 20 May 2022
What is Sukuk Bond?

Sharia-compliant fixed-income capital markets instruments, also known as sukuk in Arabic and sometimes incorrectly referred to as 'Islamic bonds,' have steadily increased their share of global markets over the last decade.

Sukuk are financial products whose terms and structure are Sharia-compliant, with the goal of producing returns comparable to those of traditional fixed-income instruments such as bonds. In contrast to a conventional bond (secured or unsecured), which represents the issuers debt obligation, a sukuk technically represents an interests in an underlaying funding arrangement structured according to Sharia, entitling the holder to a proportionate share of the returns generated by such arrangement and, at a specified future date, the return of the capital. By writing this Blog Dhanguard will enhance you with more knowledge in Sukuk Bond

In general, sharia compliance entails the following:

  • Profits from these funding arrangements must be derived solely from commercial risk-taking and trading
  • All forms of conventional interest income are prohibited
  • The assets subject to the funding arrangement must be permissible in their own right (halal)

The overall risk profile and economic return for the investor are similar to that of a conventional bond in which the bondholder is a debtor of the issuer.

Kinds of Sukuk

Sukuk issued in global capital markets have primarily been structured as trust certificates governed by English law. Some civil-law jurisdictions that do not recognize the concept of trust have issued sukuk structured as participating notes in accordance with legislation similar to that used for asset-backed securities.

Trust Certificates

In a typical trust certificate transaction, the entity seeking funds (the obligor) will establish an orphan offshore special-purpose vehicle (SPV) in an appropriate jurisdiction. The SPV sells trust certificates to investors and uses the proceeds to enter into a funding arrangement with the obligor, and the SPVs rights as financier are held in an English law trust in favor of the certificate holders.

Alternative Civil-law Structures

The above trust certificate structure requires that the concept of trust be recognized in the relevant jurisdiction where the obligor is located. This is very rarely case in many jurisdictions, particularly those of the civil-law tradition. As a result, alternative structures for carrying out sukuk transactions in accordance with local laws have begun to emerge.

Turkey, which has passed specific legislation to allow the use of sukuk, is an interesting example of trend. This legislation permitted the formation of asset-leasing companies, which are a type of SPV regulated by Turkey’s Capital Markets Board.

These asset-leasing companies are specifically formed to be able to issue certificates to investors through an ijara structure, allowing the asset-leasing companies to purchase assets and lease them back to the obligor.

Credit risk for Investors

Despite the fact that the sukuk is issued by an orphan SPV, the investors is not typically exposed solely to the credit risk of that SPV. On the contrary, today’s typical sukuk transactions are primarily designed to expose the investors to the obligor’s credit risk.

Potential investors must consider whether the sukuk only provides recourse to the obligoror also to a separate segregated estate represented by the assets subject to the funding arrangement underlying the sukuk. In today’s sukuk market, the answer to this fundamental question is not always obvious.

Understanding the true nature of the link between the funding arrangements and the assets to which it relates is critical to understanding the sukuks economic risk and allocation.

Asset-based vs. Asset-backed financing

In an asset-based sukuk structure, investors place their primary trust in the obligor's creditworthiness rather than the underlying assets. This allows the obligor to simplify its reporting and asset segregation because the obligor knows that the investors are relying solely on the obligor's credit strength.

In an ijara transaction, for example, where the obligor sells an underlying asset to the SPV, which is then leased to the obligor, if the sukuk is structured as a typical asset-based structure, it becomes irrelevant for an investor to fully analyze the sale value of the asset in question or the potential value of the lease if leased to third parties, because the investors will rely solely on the credit strength of the obligor as sole

The profit return and return of capital in an asset-backed sukuk are ultimately determined by the assets themselves. In contrast to an asset-based structure, investors are likely to want to assess the value of the assets (and the related underlying transaction) themselves.

The Benefits and Drawbacks of Sukuk

Some key benefits of entering the sukuk market for a corporate or a sovereign include:

  • Should issuers active in Islamic markets seek investments in those markets, there is a potential marketing benefit.
  • The investor base represented by Islamic compliant investors remains largely untapped, and there has historically been significant unmet demand for products such as sukuk.
  • There is the possibility of crossover into other niche financial markets, such as the broader ethical investment market, which could provide a reputational advantage.

The following are some disadvantages of the Sukuk market:

  • The credit standing of the obligor is the most important factor in attracting investors, corporates or sovereigns with a poor credit rating may find it difficult to enter this market.
  • A sukuk whose underlying funding arrangement is based on ijara will inevitably require the obligor to have suitable (halal) income-producing assets on which to base the transaction. Furthermore, unless the correct mechanics are included in the documentation, the substitution of similar assets into and out of the structure would be impossible. This may limit the obligor's ability to sell or deal with the asset during the term of the transaction.
  • In contrast to the conventional bond market, the standardization of documents for sukuk issuance has been slow, which can have negative cost implications.
  • From transaction to transaction, the involvement of sharia scholars is required to the extent that the structure used for the sukuk differs from the typical structures already well recognized in the market. This can add some extra cost and unpredictability to the transaction structuring process.
  • There is no absolute unified and settled body of opinion on these issues because sharia scholars have differing views on how compliant the structures are.
  • In some jurisdictions, the tax treatment of sukuk may differ from that of conventional bonds.

Conclusion

Though this type of financial investment is not widely used, there has been a shift in focus toward the Islamic Capital market in recent years, which has resulted in investors playing a larger role in the Sukuk process.Even though Sukuk promises profit, that is not the only criterion that is required in today's economy; customer satisfaction is also an important factor. Islamic capital markets will become much more important in the coming years as Islamic countries' incomes rise dramatically. Connect with experts of Dhanguard if you need more details regarding Sukuk Bond.

By Sakshi Srivastava

10-Mar, 2022

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