WT Essay. Christoph Schweinberger. Sukuk Islamic Bonds. Subject: MPF_AFIN Finance (Basics) Advisor: Ing. Luděk Benada
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1 WT 011 Essay Christoph Schweinberger Sukuk Islamic Bonds Subject: MPF_AFIN Finance (Basics) Advisor: Ing. Luděk Benada
2 I Contents Contents... I List of Illustrations... II Abstract... III A. The Islamic world Sharia Sharia applying countries... 1 a. Mixed Systems... 1 b. Classical sharia systems... 1 c. Secular systems Riba... B. Sukuk Definition Sukuk vs. conventional bonds Types of Sukuk... 4 a. Mudarabah... 4 b. Musharakah... 5 c. Ijarah... 5 d. Salam... 6 e. Istisna a Sukuk trade... 7 Bibliography Book sources... 9 Bibliography Internet sources... 10
3 II List of Illustrations Figure 1: Countries with Sharia rule...
4 III Abstract The Sharia (Islamic law) prohibits the paying and receiving of interest. Therefore Muslims are not able to issue or purchase conventional bonds. Rather the investment systems of choice are the so called Sukuk. Sukuk certifies the ownership of an asset rather than of a cash flow, like in ordinary bonds. This way the holder of Sukuk gets the revenues the asset generates. Using this system Muslims have a Sharia-conform investment method.
5 1 A. The Islamic world This chapter will deal as an introduction to the topic and explain the basic backgrounds about the Islamic world and the financial system there. 1. Sharia Sharia is the religious law of Islam and all Muslims are urged to live after its rules. It provides a set of rules and guidelines to live after. Many Muslims consider the Sharia consisting of two parts. The first one is the Quran, which is an actual religious text. For Muslims the Quran is what the Bible is for Christians. The second part of the Sharia is the so called Sunna. This word summons up the actions and teachings from the prophet Muhammad. When people refer to the sharia, they are, in fact, referring to their sharia in the name of the eternal will of the Almighty God. 1 Just like in any other religion there are different approaches and interpretations of these guidelines. Jan Otto makes clear that over the centuries the Sharia has been deeply influenced by local countries, cultures and people.. Sharia applying countries Not every Muslim country applies Sharia. And those who apply it don t do it to the same extend. According to Otto, there are three rough types of legal systems in Muslim countries. a. Mixed Systems In Mixed Systems, that make the majority, the rules of Islam play an important role and influence the national law to quite some degree. Nevertheless, law is still separated from Sharia and differs from it. b. Classical sharia systems Just a small number of countries have the classical sharia systems. In these systems Sharia is basically national law with only minor differences. 1 Otto, J., Sharia(s), 008, S. 7 Cf. Otto, J., Adaptations of Sharia, 008, S.7-8
6 c. Secular systems In secular systems politics and law are completely separated from religion. Therefore in these systems Sharia is more a guideline for private life than for national law. 1 Source: Wikipedia, Countries with Sharia rule, 011, Figure 1: Countries with Sharia rule 3. Riba The literal meaning of riba is increase or addition or surplus. In Islamic law Riba is banned by several verses in the Quran, especially by 3:130 and :75. It is one of the seven heinous sins. 3:130 O you who have believed, do not consume usury, doubled and multiplied, but fear Allah that you may be successful. :75 Allah has permitted trade and has forbidden interest. 3 Unfortunately it is not entirely clarified what Riba actually is. The first Caliph, Umar, is reported to have said that The last [of Qur'an] that was revealed was the passage [ ] on riba; and, behold, the Apostle of God passed away without [ ] having explained its meaning to us 4. Nevertheless most Muslims have paying or receiving interest in a common understanding of Riba Cf. Otto, J., Islamic systems, 008, S.8-9 Visser, H., Riba translation, 009, S.31 Wikipedia, Riba verses, 011, Meherally, A., Riba meaning, 007,
7 3 B. Sukuk Since a basic understanding of the religious backgrounds in the Islam is established this chapter will deal with Islamic bonds known as Sukuk. 1. Definition Most conventional bonds receive interest. Since receiving interest is prohibited in Islamic law, it is not possible to hold conventional bonds for Muslims. Sukuk offers an Islamic conform way of bond-like investment. Definition by Balala: Suk (or its plural sukuk) is a transferable instrument with bond-like qualities. It represents proportionate beneficial ownership in an underlying asset for a defined period with the risk and returns associated with the cash flows generated by the particular asset/s belonging to the investors (sukuk holders). 1 So basically Sukuk are tradable, asset-backed, medium-term notes. Although they are often referred as Islamic bonds they are in fact not. They are more bond-like. The main difference is, of course, that Sukuk don t provide a predetermined interest rate. Nevertheless, investors still have the chance for a steady income flow. Sukuk are asset-backed and represent sometimes (not always) ownership of real assets Balala, M., Sukuk definition, 011, S.9-30 Visser, H., Sukuk definition, 009, S.63 Cf. Visser, H., Sukuk background, 009, S.63
8 4. Sukuk vs. conventional bonds Sukuk Conventional bonds Claim Ownership of asset claim Cash flow claim Type of Return Sukuk holders get a share from the revenues the asset generated and/or a share from the purchase of the asset Predefined interest and principal payment Expire Either market value, a prearranged figure agreed by both parties or a fair value 1 Predefined value Next to the plain methodical differences there are also ideological differences. Bond trading is very common and the aim is to make money by exploiting interest rate developments. There is little to no interest in the real value or the asset that may stand behind that bond. Also what is financed through the bonds usually doesn t matter. This way of thinking is inacceptable in the Islam. 3. Types of Sukuk a. Mudarabah Mudarabah Sukuk represent projects and activities managed on the Mudarabah principle. This principle can roughly be compared to the silent partnership. The issuer of the Mudarabah is also the Mudarib and therefore responsible for managing business. The investors (Rabb al-mal) are undivided owners of the assets but are usually not involved in business decisions. They get profit according to the percentage of ownership, but they also have to bear the losses if there are any. The Mudarib gets also a share of the profit but since he doesn t participate in the capital he doesn t have to bear losses. Mudarba Sukuk are used for enhancing public participation in big investment projects Cf. al Nasser, L., Sukuk expire, 009, Cf. Balala, M., Sukuk ideological differances, 011, S.31-3 Cf. Ayub, M., Mudarabah Sukuk, 007, S , compare also: /Mudaraba%0Sukuk.htm
9 5 Mudarabah Sukuk in practice: Arcapita Bank, a Bahrain-based investment firm has mandated Bayerische Hypo-und Vereinsbank AG ( HVB ), Standard Bank Plc ( SB ) and WestLB AG, London Branch ( WestLB ) (together the Mandated Lead Arrangers ), to arrange a Five Year Multicurrency (US$, and ) Murabaha-backed Sukuk. Sukuk will have a five-year bullet maturity and proposed pricing three month LIBOR +175bps. 1 b. Musharakah Musharakah Sukuk is often used in projects where huge amounts of money are required. Just like with Mudarabah Shukuk, the certificate represents a proportionate ownership of the assets. The main difference is that the intermediary party will be a partner of the group of subscribers. So the issuer also participates in the capital and therefor in the losses, if there are any. Due to this the Musharakah Sukuk are considered safer than the Mudarabah. Musharaka Sukuk in Practice: Sitara Chemical Industries Ltd, a public limited company, made a public issue of profit-and-loss sharing based term finance certificates (TFC s) worth Rs 360 million which were subscribed in June 00. The TFC s had a fixed life tenor of five years and profit and loss sharing was linked to the operating profit or loss of the Chemical Division of the company. 3 c. Ijarah Ijaraj Sukuk are used for development of infrastructure with a long term scope like e.g. airports, roads, schools or hospitals. Since this kind of projects is usually huge the number of investors is as well. 1 3 Nisar, S., Mudarabah Sukuk in practice, 010, Cf. Ayub, M., Musharakah Sukuk, 007, S Nisar, S., Musharaka Sukuk in practice, 010,
10 6 Ijaraj Sukuk use leasing as financing instrument. A real asset is purchased by the funds created by issuing the Sukuk. This asset then belongs to the Sukuk holders and is leased back to the Sukuk issuer. The leasing payment represents the return payment to the Sukuk holders. Important is, that the Sukuk holders bear all costs of maintenance and of damage to the asset. 1 Ijara Sukuk in Practice: In December 000, Kumpulan Guthrie Berhad (Guthrie) was granted a RM1.5 billion (US$400 million) Al-Ijara Al-Muntahiyah Bit-Tamik by a consortium of banks. The original facility was raised to re-finance Guthrie s acquisition of a palm oil plantation in the Republic of Indonesia. The consortium was then invited to participate as the underwriter/primary subscriber of the Sukuk Transaction. d. Salam Salam Sukuk works with the concept of advances payment for goods that are delivered later on. The price for the certificate is equal to the price of the goods. Essentially to a Salam Sukuk is that the full price is paid in advance and that there is a fixed delivery date. 3 Salam Sukuk in Practice: Aluminum has been designated as the underlying asset of the Bahrain Government al Salam contract, where by it promises to sell aluminum to the buyer at a specified future date in return of a full price payment in advance. The Bahrain Islamic Bank (BIB) has been nominated to represent the other banks wishing to participate in the Al Salam contract. BIB has been delegated to sign the contracts and all other necessary documents on behalf of the other banks in the syndicate. At the same time, the buyer appoints the Government of Bahrain as an agent to market the appropriate quantity at the time of delivery through its channels of distribution. The Government of Bahrain provides an additional undertaking to the representative (BIB) to market the aluminum at a price, which will provide a re- 1 3 Cf. Ayub, M., Ijaraj Sukuk, 007, S , compare also /Ijara%0Sukuk.htm Nisar, S., Ijara Sukuk in practice, 010, Cf. Ayub, M., Salam Sukuk, 007, S
11 7 turn to al Salam security holders equivalent to those available through other conventional short-term money market instruments. 1 e. Istisna a Istisna a Sukuk is quite similar to Salam Sukuk. The contract agrees on advanced payment for future delivery or on future payment for future delivery. It is usually used to provide the financial capacities for manufacturing the goods. The main differences to the Salam Sukuk are: 1) Subjects of a Salam Sukuk don t necessarily need manufacturing while those of Istisna a Sukuk need. ) For Istisna a Sukuk it is not necessary to pay the full price in advance. 3) Istisn a contracts can be cancelled before the issuer starts manufacturing. Salam contracts cannot be cancelled once effected. 4) In Istisna a Sukuk the time of delivery is no essential part. 3 Istisna Sukuk in Practice: Tabreed s five-year global corporate Sukuk (on behalf of the National Central Cooling Company, UAE) provided a fixed coupon of 5.50%. It is a combination of Ijara Istisna and Ijara Mawsufah fi al dhimmah (or forward leasing contracts). The issue was launched to raise funds to retire some existing debt, which totals around US$136 million, as well as to finance expansion Sukuk trade Not every type of Sukuk can be traded freely. There are several regulations according to which it is possible to buy or sell Sukuk on the secondary market Nisar, S., Salam Sukuk in practice, 010, Cf. Ayub, M., Istisna a Sukuk, 007, S Cf. ibn_abdullah, Differances Salam and Istisna a, 010, Nisar, S., Istisna a Sukuk in practice, 010,
12 8 Mudarabah Sukuk Musharakah Sukuk Ijarah Sukuk based on freehold existing assets Ijarah Sukuk of existing assets subject to head lease Ijarah Sukuk based on future tangible assets Tradable at market price Tradable at market price Tradable at market price Tradable at market price or at a rate agreed upon Tradable at market price only after the asset is leased Sukuk based on existing specified services Tradable prior to sub-leasing of such services Sukuk based on described future services Salam Sukuk Istisna a Sukuk Tradable at market price only after the source of the service is clear Only tradable at face value Tradable if funds converted into assets and before sale Source: Ayub, M., Sukuk tradeability, 007, S.408
13 9 Bibliography Book sources Ayub, Muhammad [Mudarabah Sukuk, Musharakah Sukuk, Ijaraj Sukuk, Salam Sukuk, Istisna a Sukuk, Sukuk tradeability, 007]: Understanding Islamic finance, Hoboken, NJ: John Wiley & Sons, 007 Balala, Maha-Hanaan [Sukuk definition, Sukuk ideological differences, 011]: Islamic finance and law: Theory and practice in a globalized world, London: Tauris, 011 Otto, Jan Michiel [Sharia(s), Adaptations of Sharia, Islamic Systems, 008]: Sharia and national law in Muslim countries: Tensions and opportunities for Dutch and EU foreign policy, Leiden: Leiden University Press, 008 Visser, Hans [Riba translation, Sukuk definition, Sukuk background, 009]: Islamic finance: Principles and practice, Cheltenham: Elgar, 009
14 10 Bibliography Internet sources al Nasser, Lahem [Sukuk expire, 009]: The Difference between Sukuk and Bonds, 009, ( ) ibn_abdullah [Differances Salam and Istisna a, 010]: Istisna' vs. Salam, 010, ( ) Meherally, Akbarally [Riba meaning, 007]: UNDERSTANDING "RIBA" (Usury) - Revised - September 007, 007, ( ) Nisar, Shariq [Mudarabah Sukuk in practice, Musharaka Sukuk in practice, Ijara Sukuk in practice, Salam Sukuk in practice, Istisna a Sukuk in practice, 010]: How Sukuk works: Introduction, structuring and application of Sukuk bonds, 010, ( ) Wikipedia [Countries with Sharia rule, 011]: File:Countries with Sharia rule.png, 011, ( ) Wikipedia [Riba verses, 011]: Riba: Background, 011, /wiki/riba ( )
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