KIRAN KUMAR K V
A recent Sukuk bond issued (by Saudi Arabian Government) on Irish stock exchange for raising $9 billion in April, 2017, was a hot topic of discussion in the global investment market corridors, for it being a sovereign bond issued in accordance with Islamic finance or Shariah rules. And it was oversubscribed by nearly four times ($33 billion). It has set on record, that investment products designed and launched according to Islamic finance law, are attracting investors, outside the Islam following investment community, as well. This was not the first time though. UK Government in 2014 had issued a sovereign bond for a five-year maturity for raising £200 million, but got oversubscribed to the tune of £2.3 billion. This article is an attempt to put forth those aspects of Sukuks, that are being considered investworthy by majority of investing community wanting an exposure into sovereign wealth products and also discuss the potential direction these are taking in the coming future using latest developments.
Understanding Shariah Law Compliant Investment Products
Under Shariah law, the evident difference is in the way returns are generated for investors. Unlike, a non-Islamic investment products, these investment products, are not supposed to earn returns by way of interest, a rule called Liver (prohibition of receipt or payment of interest). Going by the logic behind the same, under Islamic rule, money is just an alternate way of measuring the value of something and money itself is not an object of any value. Therefore, money shouldn’t be used to generate more money. Essentially, compounding of money should happen, except for the reason of lending.
Then, how should the money be used by investee entity? It should generate more money by acquiring other assets and letting those non-money assets to generate more profits out of operating those assets. Thus, the Islamic banks treat their depositors as joint investors into the assets that the bank constantly keeps acquiring and trading, and any profits generated are then shared with depositors. Alternatively, the banks are also sharing the risk of owning, operating and trading those assets. Strictly, the investments are made on ownership basis, to avoid any risks of future defaults – called Maisir (prohibition of speculative transactions). This is one reason, Shariah law based investment products, attract investors, as it offers a possibility of participating in ownership of assets, projects and businesses, without actually having invested in the equity.
On the same lines, Shariah-based investment products, also offer a merit of conservative handling of the underlying investment. Gharar – a provision under Shariah law, that prohibits the investment manager to expose the depositor’s/investor’s funds into those assets that potentially present a high degree of uncertainty. It also requires that all risks are disclosed to and identified by investors.
The law requires that these investments are made in those assets and businesses that are existing in real world and not in virtual assets, like intangibles and financial papers. This ensures the investments in such products end up being invested in tangible assets like, properties, commodities and businesses.
In addition, the Shariah law also encourages ethical and moral investing principle, by making it mandatory for such investment managers to strictly not invest in business assets that are connected with gambling, alcohol and/or tobacco – called haram (prohibits religiously prohibited behaviors)
Understanding Sukuk Bonds
Sukuk is essentially a Shariah-complaint bond that offers a fixed rate of profit. Sukuks can be issued in 14 different forms. Most common ones are – Mudrabah Sukuk (partnership/finance trusteeship), Musharaka Sukuk (Joint Venture), Al-Ijara Sukuk (Leasing), Murabaha Sukuk (Purchase Order), Salam Sukuk (Deferred Commodity Delivery), Istisna Sukuk (manufacturing or project finance) or a combination of above. For instance, the 2014 UK Government sovereign bond quoted above was issued in the form of Al-Ijara structure. Al-Ijara Sukuk is of the type of leaseback arrangement, where the asset’s ownership is transferred to the bondholder and the same asset is leased back to the issuer by the bondholder. Thus, the bondholder, gets ‘rent’ and not ‘interest’.
Sukuks are one of the most popular instruments under Islamic financial markets. It is estimated that more than 10% of the global Islamic finance industry is accounted by Sukuks. As discussed above, complying with Shariah law, Sukuks offer the below features in general :
– Sukuks represent ownership, that is undivided
– Sukuks enable the holders to participate in the risk-returns of underlying assets
– Sukuks are asset-based, especially in tangible assets
– Sukuks do not offer any guaranteed returns
– Sukuks can be issued for a purpose none other than permitted under Shariah Law
Is everything alright with Sukuks?
No doubt, Sukuks are gaining popularity, across the globe, with nearly $328 billion worth of Sukuk bonds outstanding worldwide. The total issuance has touched almost $73 billion in 2016.
Despite these, they are not out of criticisms. One of the criticism came from, one researcher in the area – Sheikh Usmani, stated that almost 85% of Sukuks sold may not comply with Shariah Laws in their entirety. In fact, when this criticism was made in 2007, many investors exited in the secondary market and the total market value came down from approximately $50 billion to $ 15 billion. This also gives an idea of the preferential behavior of investors into these securities being compliance with Islamic law, than any other feature. Another economist Mahmoud El-Gamal, complained on the modalities of issuers of few Sukuks who go on to declare a fixed rate of return paid, without using the interest. He also, criticized the practice of, use of the word ‘rent’ instead of ‘interest’ does not necessarily take away the essence of the conventional bond per se.
Sukuks also pose a potential misuse of legalities surrounding it by the issuers. In a recent (2017) instance of Dana Gas Company of Abu Dhabi, which declined honoring its commitments of profit distribution for Sukuk holders citing the reason of lack of financial liquidity. The company is right as per Koranic Law, as the holders of said bond are essentially the owners and the payment of coupons (aka share of profit) is at the discretion of the managers. Creditors have filed a suit on the company in London, citing the bond does not comply with Shariah Law, and hence, “illegal” in UAE, where the company operates from. The British Court held that, the company is bound to make payment of coupon duly, as the Bond was issued as per English Law, and thus, cannot be viewed from Sharia Law perspective. The unlawful nature of the bond in UAE (for having not complying with Islamic Law) is the risk the company has to manage.
While the case of Dana Gas, might have given a relief for investors into Sukuks, it also brings up in the open the potential added risk of investing into these products – Discretionary Default Risk. More so, because, there is no authority that declares whether a particular bond is Shariah compliant.
Despite criticisms and issues, Sukuks continue to attract investors in the global sovereign issuance market. Both issuer and investor sides have begun fixing the loose ends in the Indentures. Some issuers have found to have inserted a clause that waives the right of holders to challenge the issuer’s compliance with Shariah. The consensus view is that, the demand for investment grade Sukuks may continue, whereas non-investment grade issues may face the fear of extinction, especially in the emerging markets. Or, like many other investment products, newer innovations in the product design might emerge as time elapses. Yet, the Shariah or Islamic or Koranic Law is something that may not change its settings into a shared standard with co-existence nature with prevailing judicial laws. This would encourage continued patronage for Sukuk like products within and outside Islamic investing community, former by compulsion, and the latter for optional diversification.