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Sukuk means “certificates” in Arabic but generally used to refer to Islamic financial certificates that are counterpart to conventional bonds. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) describes sukuk as “securities of equal denomination representing individual ownership interests in a portfolio of eligible existing or future assets.”

SUKUK Equity and borrowing are two main broad categories of financing modes for businesses and projects. Equity is regarded as the riskier one since equity holders take on business risks of the venture and are entitled to only the residual cashflow, i.e. cashflow that remains after paying all other obligations, including payments to lenders. In conventional finance, lenders generally lend money by buying bonds issued by businesses or governments. Bonds usually pay a fixed interest payment periodically, usually biannually or annually, until the maturity of the bonds when the face-value of the bonds is also paid to the bondholder.

Since the stream of cashflow payments to bondholders are known upfront, technically bonds are considered “risk-free”. Nonetheless, possible default risks do exist, and it is the duty of rating agencies like Moody’s or Standard and Poor’s to assess such risks and provide the information to bond holders and potential investors. In investment strategy, fixed-income securities like bonds are combined in the right proportions with equity portfolios in order to expand and achieve a favorable risk-return frontier for the overall investment portfolio.

Also, business owners who need financing, especially for working capital financing, are usually not willing to offer equity shares in their businesses since those who purchase equity become part owners of the business. Accordingly, in such circumstances, business owners may prefer to finance their cash needs by borrowing, i.e. by issuing bonds or sukuk. Therefore, technically equities are forever while bonds and sukuk are for a limited time period, i.e. having a maturity.

However, since conventional bonds pay interest on the lending, these are regarded as not shariah compliant and indeed prohibited (haram). Hence arises the need for shariah-compliant bonds. This is where sukuk, comes in.

Sukuk were developed as an alternative to the conventional bonds. Sukuk securities do not payout interests but rather a stream of income payments that are allowed in shariah, like rental payments. This is accomplished by making sukuk funds linked to some assets. Accordingly, sukuk are usually asset-backed or asset-based. For example, sukuk holders may have partial ownership in a building, and they are paid rental income collected from the tenants, until the maturity of the sukuk. At maturity, the sukuk holders may or may not be paid the original investment amount, depending on the structure of the sukuk itself.

Usually a Special Purpose Vehicle (SPV) is used for sukuk issuances for better management and protection of the rights of the sukuk holders. When a sukuk is asset-based, as is the case most of the time, it is just a financial claim like conventional bonds. In this case, the underlying assets are not owned by the SPV, but provides the sukuk holders some form of recourse in the event of payment defaults.

Since sukuk has some form of underlying assets tied to it, it is generally more stable compared to conventional bonds and hence are not so vulnerable to external shocks, as observed during the 2008 mortgage crisis in the US where the collateralized mortgage obligations (CMO) collapsed and started a global domino of financial crises. Accordingly, sukuk is becoming popular even among non-Muslim issuers and investors.

For example, Aeon Credit Services, Toyota Capital Services, which are companies of Japan origin, have issued sukuk since even before 2010. The Bank of Tokyo-Mitsubishi UFJ (BTMU), which is among the largest lenders in Japan, has also considered sukuk. On top of that, with the flexibility allowed by sukuk, Islamic financial institutions have come up with many different types of sukuk by combining it with the different Islamic contracts, like ljara, Murabaha, Musharaka, Istisna, etc., to match with the cashflow structure of the business or projects the sukuk is financing.

When it comes to waqf property development, sukuk is also an excellent instrument for injecting the much-needed liquidity for their development. Most waqf assets, as we know, are in the form of land, buildings and other fixed properties that severely lack liquid assets for their development. For any asset to be viably utilized, it must be combined adequately with liquid assets. It is the lack of liquid assets that is among the main reasons why most waqf properties are underdeveloped or utilized. However, modern innovative instruments like cash waqf and sukuk can be effectively used to fill-in the required liquidity.

To illustrate an example, consider the real-life example of the construction of the Zam-Zam tower in Makkah. King Abdul Aziz Waqf (KAAW) is the owner of the waqf land on which Zam-Zam Tower is constructed. It gave a 28-year land-lease to Binladin Group to develop Zam Zam Tower on a Build-Operate-Transfer (BOT) concept. At the end of the lease period, KAAW will fully own, take-over and manage the project. The returns from the project will then be used for social development purposes. Binladin Group subcontracted the project to Manshaat, a Kuwait-based company, to finance and build the Zam-Zam Tower. For this Manshaat was given a 24-year concession on the building. Accordingly, Manshaat issued USD390 mil worth of sukuk to finance the project, with the sukuk-holders being given the right to lease or use their specific units for 24 years.

Manshaat made an expected return of 26% p.a., which is the difference between the rate received from sukuk holders and the rate paid to the Binladin Group. Notice that with such innovative use of sukuk the waqf land lying idle beside the holy al-Haram Mosque, has been turned into a greatly beneficial project that aids all parties. The sukuk market therefore has excellent future growth prospects. The IMARC Group reported that the global sukuk market grew at a CAGR of 8% during the 2014-2019 period, while the International Islamic Financial Market reported that in 2019 alone USD 145.7 Billion worth of sukuk were issued globally; as of December 2019, the size of sukuk issuance outstanding globally was estimated at around USD 551.44 Billion.

In summary, sukuk in an innovative Islamic finance instrument that functions as a counterpart to conventional bonds, but however is linked directly to the real economy. It is versatile such that it can be easily combined with many different Islamic financial contracts. Sukuk ijarah particularly has high potentials to be accepted even by non-Muslim issuers, investors and even countries. The returns to sukuk ijarah, for example, have the ability to be a proxy or counterpart for the “risk-free rate” in conventional finance, since the cashflows in sukuk ijarah are contractual in nature, and hence fixed. All these provide sukuk the characteristics to rise and become a popular investment and financing tool among both Muslim and non-Muslim issuers and investors alike. Author is Former-Dean, Institute of Islamic Banking and Finance at the International Islamic University Malaysia.

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