Publication date: March 03, 2023
Sukuk is a financial bond that complies with Islamic religious law commonly known as Sharia. The traditional Western interest-paying bond structure is prohibited in the Islamic law because the riba, or interest debt, goes against precepts of Islam. Therefore, the Islamic countries and investors need a structure to link the returns and cash flows of debt financing to a specific asset being purchased, effectively distributing the benefits of that asset. In order to do that, in Malaysia, the sukuk was created twenty three years ago and, since then, it has become extremely popular in Islamic finance.
Sukuk represents aggregate and undivided shares of ownership in a tangible asset as it relates to a specific project or a specific investment activity. An investor in sukuk, therefore, does not own a debt obligation owed by the bond issuer, but instead owns a piece of the asset that’s linked to the investment. This means that sukuk holders, unlike bond holders, receive a portion of the earnings generated by the associated asset. Hence, financing can only be raised for identifiable asset, this means an asset whose commercial value can be measured.
In the global capital market, the sukuk has been normally issued as trust certificates by English law. Nevertheless, in civil law countries sometimes this cannot be integrated into their systems and because of that they issued sukuk structured as participating notes under legislation similar to that used for asset-backed securities. In a typical trust certificate transaction, the entity trying to raise funds (the obligor) will establish an orphan offshore special-purpose vehicle (SPV) in a suitable jurisdiction. The SPV issues trust certificates to investors and uses the proceeds to enter into a funding arrangement with the obligor, and the rights of the SPV as financier are held under an English law trust in favour of the certificate holders. The most common structures for funding arrangements in the Islamic market include: a sale and leaseback (ijara) structure, a form of trade finance (murabaha) and a joint-venture equity investment (musharaka).
In an asset-based sukuk structure, the overriding reliance of investors is on the credit strength of the obligor. These asset-leasing companies are specifically incorporated so as to be able to issue certificates under an ijara structure to investors, thereby allowing the asset-leasing companies to purchase assets and lease them back to the obligor. Effectively, the asset-leasing company finances the acquisition of such assets using funds raised by the issuance of certificates, and the lease-rental payments from the obligor mirror the profit distributions due under the certificates. The cash flows from the lease rentals, therefore, are used to service such profit distributions to certificate holders.
An example of legal services on a business operation based on sukuk investment can be in the purchase of some kind of fossil resources on Middle East such as gas and oil pipelines or in the constructions of renewable energy plans based on ESG initiatives. Here, a law firm can assist the buyer company with the issuance of sukuk certificates and the establishment of global medium- and long-term note programme. It is important to receive critical advice from capital markets, finance, corporate and tax perspective since is a “new” type of investment in western countries with great consequences and that moves a large amount of capital.
Both one and the other bonds provide investors with payment stream. Both are issued to investors and may be used to raise capital for a firm. Western bonds and sukuk are considered to be safer investment than equities.
The key differences are that sukuk involves asset ownership while bonds are debt obligations. Second, if the asset backing a sukuk appreciates the sukuk can appreciate whereas bond yield is strictly due to its interest rate. Assets that back sukuk are legal whereas bonds are often riba and may finance no sharia compliant businesses or fuel speculation. Sukuk valuation is based on the value of assets backing them while a bond’s price is largely determined by its credit rating, whereas sukuk investors receive profit generated by the underlying asset on a periodic basis while bond investors receive periodic interest payments.
Following the previous argumentation, for a corporate or a sovereign the sukuk market brings a potential marketing benefit for issuers active in Islamic markets, the base of Islamic investors is still largely untapped and there is a significant unmet demand for products such as sukuk. There is potential for crossover into other niche financial markets, such as the broader ethical investment market and green transition market in Islamic countries. The global Sukuk bond market has proved popular with a wide range of participants. From a social and ethical point of view, Sukuk financing is a desirable solution for large-scale projects, avoiding interest-bearing debt. Several sovereign and quasi-sovereign countries have been able to finance large projects that have a direct and positive impact on the communities and economies of Sharia-compliant countries. As a result, Sukuk bonds are recognised and accepted as a more “ethical” way of raising finance, with a positive impact on society, which is also consistent with the growing adoption of ESG investment.
Since the key element in attracting investors is the creditworthiness of the debtor, it may be difficult for companies or sovereigns with inadequate credit ratings to access this market. A sukuk whose underlying financing arrangement is based on ijara will necessarily require the debtor to have adequate income-producing assets at its disposal on which to base the transaction. In addition, unless the correct mechanics are included in the documentation, substitution of similar assets within and outside the structure would be impossible. This could limit the debtor’s ability to sell or trade the asset over the life of the transaction.
Unlike the conventional bond market, the standardisation of documents for sukuk issuance has been slow to develop, which may have negative cost implications. From transaction to transaction, to the extent that the structure used for sukuk deviates from typical structures already well-recognised in the market, the involvement of Shariah scholars is necessarily required. This can add an additional cost and an element of unpredictability to the process of structuring the transaction. As Shariah experts have divergent views on the compliance of structures, there is no unified and established body of opinion on these issues.
The tax treatment of sukuk may differ from that of conventional bonds in certain jurisdictions.
Global ESG bond issuance has been increasing during the last decade reaching the benchmark of $1 trillion in 2021 and has the tendency to increase much more. The green sukuk also hit record with the $6.1 billion mark, despite its representing only 1% of ESG bond issuance and 4% of total sukuk issuance. But, what are green sukuk? Green Sukuk are Sharia compliant investments in renewable energy and other environmental assets. Proceeds are used to finance construction, to refinance construction debt, or to finance the payment of a government-granted green subsidy. They may involve securitizing future income cash flows from ring-fenced projects or assets with specific criteria attached. There are several types of green sukuk, including sovereign (issued by a government) and corporate (issued by a private sector organisation).
Education is the key to unlocking the potential of green sukuks. It is important for potential investors to be aware of the great opportunities offered by investment in environmental projects. Large infrastructure projects can take many years to plan, build and operate. Investments in materials, logistics and technologies that support climate change objectives are long-term and should be treated as such. However, green sukuks generate strong returns and represent low-risk investments. Sectors such as renewables are poised for massive growth over the next three decades as the world embarks on an ambitious decarbonisation drive. Renewables will account for almost 95% of the increase in global electricity capacity by 2026, and the clean energy market is forecast to reach almost $2 trillion by 2030.
While there are many opportunities for Green Sukuk in the solar energy, plans of Gulf countries also have significant potential for renewable energy for sustainable development, plus have significant requirements for investment to protect themselves from the impacts of climate change.
Sukuk investment is the main financial form in which investment is being structured in the Islamic world. Any investor wishing to invest in one of these countries should be aware of it. It is also an option to consider in non-Islamic countries with a large Islamic population, such as Western European countries. The UK has already seen this trend and has been doing this type of bond for a number of years and has been leading the Western sukuk market for years.
In the world of sukuk investment, it is worth highlighting the opportunities offered by the ecological transition, especially the energy transition in Middle Eastern countries. These countries, which have large amounts of capital from hydrocarbons, also wish to join the decarbonisation process as a plan for the future and as a contingency plan for the depletion of their natural reserves of fossil fuels. As a Shariah-approved ethical investment, there is no religious impediment as long as sukuk bonds, which are based on direct investment returns and not on interest, which is illegal under Islamic law, continue to be used.
It would be advisable for countries with large Islamic populations to begin to create legal frameworks for this type of investment in their systems and thus allow a large amount of capital that was previously wasted or that fled to its countries of origin to remain in the country and be used to make investments within its borders. It would also help to attract foreign capital investment from these countries.