What Are Sukuk And How Do They Work?

By Sakshi Srivastava - 16 Feb 2022 Last Updated: 05 Jul 2022
What Are Sukuk And How Do They Work?

There are various laws all over the world, but Sharia law (Islamic law) has always been quite versatile due to its exciting concepts. Sukuks are one such concept that falls under Islamic law, as they are a type of money lending or bond that is entered into in accordance with Islamic law.

Sukuk Ideology

The term Sukuk derives from the Arabic language and roughly translates to "legal certificates." It is a distinct type of bond entered into by Muslims because the common types of bonds entered into are not permissible under Islamic law. Sukuks were introduced when there was a need for securities that were flexible in response to economic conditions, as well as when there was a need for it to comply with Muslim Sharia law, as Islamic law prohibits "Riba" or interest.

It is defined as "an Islamic financial certificate, similar to a bond in Western finance, that complies with Sharia, the Islamic religious law commonly known."

This type of financial bond is in accordance with Sharia law, making it permissible for people of this religious belief to enter into. This type of bond is more concerned with recouping profits rather than paying interest, and it typically involves tangible assets.

When it complies with Sharia law's rules and regulations, it has key elements such as:

  • Any profit gained by a person by entering into these types of bonds if their means of income are from trading or any commercial risk.
  • Any type of interest is prohibited.
  • The assets that comprise the bond should be permissible.

For a long time, Sukuk was only found in areas where this religious group was the majority, but it has recently become as common as any other type of common bond. There is no concept of a debt obligation in this type of money lending because, once issued, the issuer sells these certificates to the investors and uses the money from the certificate to purchase any asset that complies with Sharia law, in which the investors will also have a portion of ownership.

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.

Working of Sukuk

Sukuks issue a certificate of representation of equal-value shares that shows ownership and investment in assets, businesses, and so on that comply with Islamic law and are authenticated by a Sharia scholar. Sukuk is typically entered into with the intention of profiting from the investment, and these investors receive a portion of the profit that has already been agreed upon through an agreement.

When an investor becomes a Sukuk holder, they receive a certificate that serves as proof of their ownership of the assets in which they are investing, and when the Sukuk matures, the principal amount is returned.

Procedures for Issuing the Certificate

The following are a few common steps for issuing the certificate:

  • The company that needs the capital is the originator, and they set up an SPV (Special Purpose Vehicle) to protect the assets from creditors.
  • SPVs issue Sukuk certificates, which can then be sold to investors.
  • The assets required from selling the certificates to the investors are purchased by the originator.
  • The originator purchases SPVs.
  • The money from the sale of the assets is paid to the originator by the SPV.
  • The SPV arranges for the asset to be leased to the originator, who makes lease payments to the SPV.
  • When the lease expires, the originator buys the asset back from the SPV for a very low price and distributes the proceeds to the certificate holders.

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 significant 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 important. Islamic capital markets will become much more important in the coming years as Islamic countries' incomes rise significantly. For more information regarding the working of sukuks contact to Dhanguard we will gladly assist you in every aspect.

By Sakshi Srivastava

16-Feb, 2022

Sukuks Related FAQ

Frequently Asked Questions

  • What is Sukuk?

    Sukuk is basically an Islamic version of Conventional Bonds.

  • Is Sukuk debt or Equity?

    Sukuk signify a form of equity as they symbolize certificates discussing ownership to holders of an asset or pool of assets or entitlement to its cash flows. 

  • What is a bond yield?

    Yield is a numerical figure that shows the return that you get on a bond. The simplest form of yield is calculated by this formula: Yield = Coupon Amount/Price.

Get Instant Advice