Bonds are securities that establish a credit relationship between the purchaser (creditor) and the issuer (debtor). The issuer receives a certain amount of money in return to the bond, and is obligated to repay the principal at the end of the lifetime of the bond (maturity). Typically, bonds also require coupon or interest payments. Since all these payments are determined as part of the contracts, bonds are also called fixed income securities.
A straight bond is one where the purchaser pays a fixed amount of money to buy the bond. At regular periods, he receives an interest payment, called the coupon payment. The final interest payment and the principal are paid at a specific date of maturity. Bonds usually pay a standard coupon amount, C, at regular intervals and this represents the interest on the bond. At the maturity of the bond, the final interest payment is made plus the principal amount is repaid.
Some bonds do not make a coupon payment. These bonds are bought for less than their face value (bought at a discount). Bonds that do not pay coupons are often called Zero Coupon Bonds (Choudhry, 2010). Bonds are issued by many different entities, including corporations, governments, and government agencies. When one buys a bond, he loans money to a company or a government entity. In return, the borrower commits to pay for the loan in two ways:
- As interest, at a fixed rate, for the life of the loan, and
- Repay the value of the loan by a certain date, known as the maturity date
There are three major types of bonds:
- Federal government bonds: Bonds issued by the Federal government are the safest. Treasury bills, notes, and bonds are available with maturities ranging from one to 30 years. They can easily be sold on the open market, and payment of principal and interest is extremely safe. But, like all bonds their value rise and fall as interest rates change; especially if the bonds have many years remaining before they mature.
- Municipal bonds are issued by state and local governments to pay for things like construction projects. The borrower pays no federal tax on earned interest, and possibly no state or local taxes, depending on whether he lives in the area where the bond was issued. However, because these bonds have tax advantages, they pay lower interest rates to the owner than other types.
- Corporate bonds are issued by corporations that want to raise money for things like buying new equipment or spending on new research. There’s no tax exemption for these bonds (Arnold, 2008).
A Sukuk is a Shariah-compliant variant of a conventional bond, investor returns are derived from legal or beneficial ownership of a business rather than interest-based debt obligations. It has economic characteristics similar to that of a conventional bond, key difference being that a Sukuk is not a debt instrument.
The most commonly adopted structures are:
- sukuk al-Ijara
- sukuk al-Masharaka
- sukuk al-Mudarabah
In today’s business practice, the term Sukuk means a claim similar to that represented by a trusted certificate. The claim stems from the fact that the certificate represents a beneficial ownership interest in the underlying asset generating cash flow. These issues are often referred to as Islamic bonds. In essence, the Sukuk is a financial instrument that sits above a Shariah-compliant underlying structure which generates an income for the holder of the instrument (Abdulkader & Adam, 2004).
In Islamic capital markets, interest rate swaps and other conventional forms of derivative instruments such as credit derivatives and detachable options are not available as Islamic law also prohibits these. Therefore, risk management requirements and considerations for competitiveness force the Sukuk structures to further evolve and offer Shariah compliant alternatives to traditional derivatives. Without Sukuk structures with such depth, the financial markets may not fully develop in many emerging economies.
Comparison between Conventional Bonds and Islamic Sukuk
The convergence between Islamic and conventional finance, particularly in the case of Sukuk, is gaining momentum as foreseen by several scholars (Mirakhor, 2006). This said there are certain differences between conventional bonds and Sukuk. A bond represents the issuer’s pure debt, while Sukuk represents ownership stake in an underlying asset. For example, an Ijarah (lease) contract that is often used to structure sovereign Sukuk creates a lessee relationship which is different than a lender/borrower relationship.
Investor protection mechanisms for Sukuk remain largely untested. Taxation could also become an issue for certain investors where the legal basis for taxation of Islamic securities is not legislated in the home country. Although international issues of Sukuk are similar to conventional bonds when it comes to such features as rating, issuance and redemption procedures, coupon payments, and default clauses, correlations of Sukuk returns with returns on conventional bonds are much smaller than the correlations of returns on conventional bonds with each other. Sukuks are in many aspects similar to conventional bonds. They are also considered to serve as security instruments that provide a predictable level of return (fixed or floating); they are traded in the secondary market although less than conventional bonds; they are assessed and rated by international rating agencies.
A conventional investment banker creates financial securities through a process of financial engineering to satisfy their clients’ various financial needs and different appetites for risks. The investment banker raises funds in the market, public and private, by selling those securities. An Islamic investment banker does the same thing; the only difference is that the process of financial engineering is limited by the Islamic Shariah; hence in Islam undesirable practices are eliminated automatically.
The creation of Islamic financial securities can be done in two distinct ways: direct structuring of securities, and the process of asset securitization. Direct structuring involves the issuance of securities initially, and the funds raised are being used to fund certain assets/projects with the client company. The profits generated from these assets/ projects are then distributed amongst security holders. The opposite to direct structuring is asset securitization, where existing assets of the client company are identified, pooled, and then securities are issued against them (McFarlane, 2007).
Many structures can generate the revenue paid to Sukuk holders. Most Sukuk issuances to date have been wholly asset-based rather than asset-backed; this has an impact on their ratings. In an asset-based Sukuk, Sukuk holders rely for payment on the company seeking to raise finance (the originator), in the same way as they would under a corporate bond issue. In an asset-backed Sukuk, Sukuk holders rely on the assets of the Sukuk for security. More importantly, in an asset-based Sukuk, the market value of the underlying assets has no bearing on the redemption amount as this is fixed at the outset when the relevant undertakings are agreed upon. More recently, the market has seen issuances with a mix of cash and assets, and in several cases, Sukuk have been issued for a new business with no tangible assets. The issuances of convertible and exchangeable Sukuk are more recent developments.
In terms of Sukuk, interest rate risk is the rate of return risk. Sukuk that are based on fixed rates are exposed to this risk in the same manner as fixed rate bonds are exposed to interest rate risk, i.e. the rise in market interest rates leads to the fall in the fixed income Sukuk values. It is also important to understand that the Sukuk certificates are exposed indirectly to interest rate fluctuations through the widespread benchmarking in their financing operations (McFarlane, 2007).
The growth, driving force, and potentials for Sukuk globally in the future
The Islamic financial services industry has witnessed a wild pace of growth during the last decade. Since its inception three decades ago, the number of Islamic financial institutions worldwide has risen to over 300 at present in more than 75 countries. The Islamic finance industry is worth about. Sukuk provide sovereign governments and corporations with access to the huge and growing Islamic liquidity pool, in addition to the conventional investor base. The structure of Sukuk is now well established in several corporate and sovereign issues in the international bond markets (Archer & Rifaat, 2002).
Malaysia and the Gulf region are the main hubs for Sukuk issuance; however, Sukuk issuance is not limited to Islamic countries. There are a growing number of issuers from the United States, Europe, and Asia. Such bonds have been issued by such sovereign borrowers as the State of Qatar, the Bahrain Monetary Agency, the Government of Pakistan, the Government of Malaysia, and the State of Saxony-Germany, in addition to international agencies such as the Islamic Development Bank and companies including Nestle, several oil companies, companies in Dubai, and the Standard Chartered Bank. US$500bn in assets, and has been growing at about 10% a year for the last decade. While estimates about the size of the industry differ, conservative sources put total assets of Islamic financial institutions at US$230bn, and they are expected to grow at over 15% during the next 5 years.
The Sukuk market has emerged in 2002 with the Malaysian government’s US$600mn Sukuk issue; the development of the Sukuk market has been facilitated by sovereign benchmark issues that have been growing strongly (up 40% in the first 6 months of 2007 compared to 2006 as a whole). In value terms, about 36% of these issues originated in Asia, primarily Malaysia, Pakistan and Brunei, and 62.1% in the period 2001-2007.
Despite the strong potential for the Sukuk market, as is the case with any evolving securitization market, some economic, legal, and regulatory challenges remain, irrespective of Shariah compliance. Ongoing efforts by key Islamic regulators, notably the Accounting and Auditing Organization for Islamic Financial Institutions, the International Islamic Financial Market, and the Islamic Financial Services Board to facilitate harmonization of standards and practices should help overcome some of these teething pains.
According to Abdel-Khaleq & Christopher (2007), the World Bank issued its first local-currency dominated Malaysian Ringgits 760mn Sukuk in 2005. Similarly, hedge funds and conventional institutional investors have increasingly been drawn to Islamic securities in search for yield pick-up and diversification. The market for Sukuk has injected a much needed scope for liquidity management in Islamic banks. Previously, such liquidity could only be secured through continuous Murabahah transactions. In a global market where conventional finance dominates, liquidity could only be acquired by transactions limited to specific Shariah acceptable commodities such as industrial goods, metals and oils. The process of issuing Sukuk certificates allows Islamic financial institutions to garner a much wider asset pool that was previously either inaccessible or inefficient.
However, some of the corporate and sovereign Sukuk prospectuses have come under increased scrutiny for their Shariah suitability. The predominant feature of several of the prospectuses is the floating rate return distributed to the certificate holders. The market reference used is the London Inter-bank Offer Rate (LIBOR) over which a competitive premium is added. However, it should be observed that in the case of the Ijarah Sukuk arrangements, LIBOR serves as a market reference for the returns and the intrinsic distributions arise from the rentals pertaining to the leasing arrangements with the originator.
The total number of Sukuks issued in the world during the last six years is close to 360 Sukuks. Industry experts predict Sukuk issuance will reach US$100bn in the next five years. According to recent statistics, Islamic Sukuk issuance worldwide has reached US$39bn in first 10 months of 2007. In the Middle East, Sukuks represent a significant new development in global capital markets as one of the fastest growing sectors in Islamic finance. As per market reports, the Islamic finance market has grown over the last decade by more than 20% yearly. Sovereign and corporate Sukuk issuance has developed phenomenally over the last two years with Japan on the verge of issuing its debut sovereign Sukuk, in addition to other non-Islamic countries which are in the process, of assessing
Global growth, driving force and potential for bond markets in the future
Today’s global fixed income market provides more opportunities than ever before, as non-U.S. bonds comprise over half of the global marketplace and represent a wide range of fixed-income sectors. For investors, the growth of the international bond market brings a wealth of new alternatives for diversification that cannot be ignored. A bond portfolio that also includes a global allocation may offer investors the benefits of diversification, wealth preservation and attractive returns.
At the begging of the year 2010, the global bond markets suffered their largest sell-off since 1994. US dollar, yen and euro yields all increased sharply, dollar yields by as much as 140 basis points. The rise in part reflected upward revisions in bond investors’ expectations about global growth prospects. An additional factor behind the rise appears to have been a change in bond investors’ assessment of the likelihood of unconventional policy measures by the US Federal Reserve (Choudhry, 2001).
In the US dollar market, the backup in yields was exacerbated by the hedging activities of holders of mortgage-backed securities (MBSs). As yields rose, the flow of mortgage refinancing started to dry up, and investors found they holding MBS portfolios with durations exceeding their targets. To return to their duration targets, many investors turned to the interest rate swap market, where their demand for the fixed payment side of the contracts contributed to a doubling of swap spreads.
Spillovers to credit and equity markets were for the most part limited. Although high-yield and emerging market spread widened as they search for yield abated, volatility in government bond and swap markets did not trigger a general sell-off in credit markets. The picture was similar in equity markets. The Tokyo equity market rallied as bond yields rose. Valuations for banks and most other financial institutions kept pace with changes in broad market indices, suggesting that equity investors were not concerned about the impact of higher yields on these institutions’ balance sheets. While investors’ increased optimism about global economic growth played an important role in recent increases in yields, unusual factors also contributed at various stages. These factors included auction results, risk management mechanisms, hedging of mortgage positions and views about “unconventional measures” of monetary policy. As a result, from a low of 3.11% on 13 June, 10-year US Treasury yields jumped above 4.40% by the end of July (Choudhry, 2010). Over the same period, 10-year Japanese government bond (JGB) yields rose by 50 basis points to 0.93%, and German bund yields by 70 basis point to 4.19%.
As the structure and depth of the international bond markets continue to evolve, new and diverse opportunities are available to institutions and individuals who choose to invest a portion of their portfolio globally. Growing issuance in inflation-indexed, corporate and securitized products have created new opportunities for investors, and financial innovation and deregulation have facilitated development of derivatives markets across the world. In some cases, international futures and swaps markets have significantly greater depth and trading volume than their U.S counterparts. Global bond opportunities can be found in high grade and high yield bonds, developed and emerging markets and investments denominated in local or foreign currencies.
Sukuk products offer a vast scope of innovation and a large potential for the growth of Islamic finance. Various structures of Sukuk based on ijarah, musharakah, mudarbah has evolved. Structures with convertibility features and those allowing the possibility of substitution of the underlying assets have also come in the market. However, these innovations have generated various Shariah, legal and economic issues and controversies. Specifically, it deals with the issues of capital guarantee, contractual structures, pricing, and asset substitution in case of ijarah Sukuk, musharakah Sukuk, and their various forms. It also covers the issues pertaining to rating of Sukuk, harmonization of Shariah rules, and problems involved in defining the governing law for Sukuk issuance.
A key development within the Islamic capital markets is the increased use of credit ratings. Infrastructure companies and sovereign entities are looking to capitalize and harness investors’ growing appetite for their assets. As noted earlier, almost all conventional rating agencies are using conventional methodologies to rate Islamic financial instruments including Sukuk despite their acknowledgement that Islamic financial institutions and instruments have their characteristics (Al-Omar & Mohammad, 1996).
However, the exclusive characteristics of Islamic instruments are not reflected in the rating and it is very probable that if these characteristics were taken into consideration the rating of Islamic instrument might have been much better. The focus of conventional rating agencies in their rating of Sukuk is on the credit of the entity providing the guarantee or the entity providing the purchase. The challenge that lies ahead is on the area of financial instruments and products innovation in the Islamic capital market in general and the Sukuk market in particular. Indeed, the Sukuk structures are now to some extent diversified. We have, for instance, sukuk based on ijarah, musharakah, mudarbah. However, more instruments are needed and existing products need to be refined as some Sukuk structures are still debated and contested (Al-Omar & Mohammad, 1996).
A basic requirement for Shariah compliance of any Sukuk structure is that it shall be backed by tangible assets. However, a concern has been voiced regarding the limited number of assets eligible for Sukuk under the ownership of Islamic financial institutions or corporations looking for fund raising. This shortfall of eligible assets could impede or slow down the regular issuance of Sukuk. However, a recent innovation has permitted the substitution of the Sukuk asset during the life of the Sukuk to address these apprehensions.
The ijarah Sukuk structure was the first Sukuk structure marketed at a global level. The structure has been used by sovereign as well corporate bodies. However, it has also been criticized by some Shariah scholars. One of the most mentioned objections against Sukuk-ijarah is the issue of guarantee (Mirakhor, and Iqbal,1988). Generally, in Sukuk issuance, a third party who is normally the originator of the Sukuk will provide a guarantee for the principal capital of the Sukuk.
Innovations in the global bonds market
There are several successful models of capital market development in emerging markets. The growth of corporate bond markets in Mexico and Malaysia, for instance, has been closely linked to the development of domestic institutional investors. Mobilizing such investors through the gradual liberalization of portfolio guidelines of insurance companies and pension funds would help transform most nations’ large pool of savings into investable funds for long-term financing. Similarly, further progress in the development of an active securitization market for consumer and small business loans would facilitate greater access to credit, by enabling risks to be shared by banks and other investors. Such securitizations, executed prudently, would help to broaden the investor base and allow for the conversion of longer-term amortizing loans into instruments more suitable for institutional investors. This development would have the added benefit of facilitating better diversification by banks of their credit and maturity risks, while providing institutional investors with the opportunity to earn higher yields by taking on some of the risks of underlying loans. Of course, securitization must include appropriate safeguards (Mirakhor, 2006).
Despite the unsettling and even dramatic recent global experience with cutting edge finance, without a renewed effort to foster financial innovation in the global economy, all countries, including emerging market economies, will underperform their potential. The principal challenge for policymakers, then, is to strike an appropriate balance between financial openness that supports growth-enhancing innovation while at the same time implementing regulations and effective supervision that limit the potential risk of financial instability. This does not mean that we should return to the exuberant pre-crisis approach to financial innovation. Neither does it suggest a one-size-fits-all approach to the issue.
A key challenge faced by many emerging markets is their heavy reliance on traditional commercial banking. While such a system may be more than adequate during the early stages of a country’s development, it may act as an unintended constraint on growth as the real economy becomes more complex and as the demand for financial services expands. There are several reasons for this: First, in the absence of robust debt and money markets, the ability of banks to grow their loan portfolio is limited by their access to deposits. Second, banks are not well placed to meet the significant needs in emerging and developing countries for long-term infrastructure financing. The size, maturity, and illiquidity of such loans make them unsuitable for traditional commercial bank financing (Arnold, 2008). The danger in such operations is that banks would take on inappropriate levels of credit and interest rate risk or else operate under a system where the government provides a financial backstop, and hence, passes on the risk to taxpayers. And, third, commercial banks often are not well-placed to diversify the credit risk in their loan portfolios their financial performance therefore typically mirrors the underlying condition of their borrowers and the local economy.
Sukuks popularly known as an Islamic or Shariah compliant ‘Bond’ whilst in fact, it is an asset-backed trust certificate. In its simplest form Sukuks a certificate evidencing ownership of an asset or its usufruct and was developed by Shariah experts for the express purpose of answering the financial world’s demand for a Shariah compliant debt instrument. The development of Sukuk in response to Shariah’s prohibition on earning returns from loan contracts which returns are based on interest. Conventional bonds and other derivative instruments that rely on profiting holders by providing returns based on interest are therefore unavailable to Muslims who wish to invest in Shariah compliant investments.
In its simplest form, a bond is a contractual debt obligation whereby the issuer is contractually obliged to pay to bond holders, on certain specified dates, interest and principal. In comparison, under Sukuk structure the Sukuk holders each hold an undivided beneficial ownership in the underlying assets. Consequently, Sukuk holders are entitled to share in the revenues generated by the Sukuk assets as well as being entitled to share in the proceeds of the realization of the Sukuk assets.
The market for Islamic financial instruments is thriving and a growing number of countries are considering tapping the Sukuk market to diversify their investor base and deepen domestic capital markets. This increase in demand, along with the standardization of Islamic securities, is expected to fuel further growth of the Sukuk market. On a different note, risks adversely affect the competitiveness of asset pricing. The novelty of Sukuks inherently entails a higher exposure to certain market and financial risks. Just like their conventional counterparts of financial instruments, Sukuks are subject to a wide array of risks inherent in their structure.
The global bond market continues to grow and evolve, creating an ever expanding set of opportunities for investors. Fixed income investments in international markets can augment the benefits of a core domestic bond allocation by providing potentially higher returns, wealth preservation, and the reduced overall portfolio risk associated with additional diversification. The growth of regional bond markets and the many potential benefits of investing globally are leading many domestic investors to look outside their own countries to leverage the best investment values around the world.
Abdulkader, Thomas & Adam Nathif, 2004, “Islamic Bonds: Your Guide to Structuring, Issuing and Investing in Sukuk.” Economy Institutional Investor.
Abdel-Khaleq, Ayman H. & Christopher F. Richarson, 2007, “New Horizons for Islamic Securities: Emerging Trends in Sukuk Offerings,” Vinson & Elkins Ltd, Briefing.
Al-Omar, Foad & Mohammad Abdel Haq, 1996, Islamic Banking, Theory, Practice and Challenges. London: Oxford University.
Archer, Simon & Rifaat A. A. Karim (eds.), 2002, Islamic Finance: Growth and Innovation London: Euromoney Books.
Arnold, Roger A., 2008. Economics. New York: Cengage Learning.
Choudhry, Moorad, 2010. Fixed Income Securities and Derivates Handbook: Analysis and valuation. London: John Wiley and Sons.
Choudhry, Moorad, 2001. The bond and money markets: strategy, trading, analysis. Securities Institute professional reference series. New York: Betterworth-Heinemann.
McFarlane, Benjamin, 2007, “London: The new Souk for Sukuk,” Financial Times, 2007.
Mirakhor, Abbas and Iqbal Zaidi, 1988, “Stabilization and Growth in An Open Islamic Economy,” IMF Working Paper No. 88/22, Washington: International Monetary Fund).
Mirakhor, Abbas, 2006, “Islamic Finance and Globalization: A Convergence?” Preliminary draft.