What are sukuk bonds and are they different from typical bonds?
Currently, discussions about sukuk bonds and Islamic Finance are on the increase. Here in Malawi, the Government has just approved the Introduction of Islamic Banking in the country. Sukuk is one mode of financing. Meanwhile, many established players on the international capital markets are issuing sukuks in order to excel in their businesses but how do these bonds work?
A bond is an obligation by an Issuer to return the money borrowed from an investor after an agreed period of time, and to pay a return, typically in the form of interest, during and/or at the end of the life of that obligation. Hence, the main facets of a bond issue are the credit worthiness of the borrower and the issuer of the bond, in repaying back the loan and servicing it as agreed.
Essentially, a sukuk bond is not much different, but its structure has to adhere to the rules established by Sharia (Islamic principles) Without entering into the convolutions of Islamic Finance, and focusing on sukuk bonds, if a borrower decides to borrow money directly from investors in terms of the Islamic perspective of finance, the issuer has to avoid paying interest because this is tantamount to Riba (interest), or the generation of money from money.
Understanding covered bonds or collateralised loan obligations may help us understand sukuk bonds. Whereas a typical bond indicates a debt obligation between the investor (the lender) and the issuer (the borrower), a sukuk indicates the ownership of an asset backing that obligation. Obviously, the asset backing the sukuk would be Sharia -compliant.
This concept would be readily understood by ethical investors who would not consider investments that finance activities which are not aligned to their creed, belief, or opinion. A sukuk has a secondary market in the same way as a typical bond has and investors may buy, hold, or sell the sukuk after this has been issued in the primary market. Hence, liquidity considerations are also relevant for sukuk bonds. That said, the price of the sukuk is linked to the value and credit dynamics of the assets backing the sukuk.
If the asset backing the sukuk increases in value, the value of the sukuk increases commensurately. In a typical bond structure, the interest received on a bond (Riba in terms of Islamic Finance) forms part of the overall return received on the bond. With a typical bond, the interest rate dynamics also contribute to the return on the bond if changes in interest rates cause the value of the bond in the secondary market to change.
In other words, the buyer of a sukuk bond is indirectly buying an asset that has value rather than entering into a loan obligation with the issuer of a typical debt instrument. It is therefore suggested that, the asset backing the sukuk is critical.
Consequently, the value of sukuk is linked to the increase in value and productivity of real assets and not with profit on money and inflation dynamics. Perhaps, focusing more on the economic value added created through the financing of real assets would help societies to increase productivity and real economic wealth sustainably and over the long term.
Importantly, the number of investors in the Islamic world cannot be ignored and therefore Sharia compliant vehicles capable of attracting their wealth are increasingly relevant. The sukuk is a good starting point for issuers to tap into this reality.