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The Potential and Risk of Sukuk 2011

1.0 Introduction

In the modern economy, debt market and bonds are an integral part of the financial sector and

effectively supplement the funds provided by the banking sector. From the conventional

perspective, bonds can be defined as a long-term contract under which a borrower agrees to

make payment of interest and principal, on specific dates, to the holders of the bonds. (Brigham,

E. C. and Ehrhardt, M. C., Financial Management, 11th ed., 2005)

According to Longman, bonds are actually certificates or documents of debt issued by a

government or an organization for an amount of money they borrow from the bondholders,

promising them that it will pay back the money it has borrowed, usually with interest. (Longman,

Business English Dictionary, 2000)

1.1Introduction of Sukuk

Sukuk, plural of ‘Sakk’ means “legal instrument, deed or check”. Sukuk is the Arabic name

for a financial certificate but may also be considered as Shariah-compliant ‘Bonds’. Although

Sukuk is generally referred to as Islamic bonds, it is better descrived as an asset-based

investment, as the investor owns an undivided interest in an underlying tangible asset which

is proportionate to his investment.

The claim embodied in Sukuk is not simply a claim to cash flow but an ownership claim.

Monies raised by the issuance of the Sukuk notes are used to invest in an underlying asset,

a trust is declared over that particular asset and thereby the certificate holder will own a

beneficial interest in that asset in proportion to his investment. Therefore, the investor is

entitled to the benefits that entail, including a proportion of the return generated by that

asset (Mohamed Z., Azmi & Associate, 2010)

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1.2History of Sukuk

In classical period Islam sakk (sukuk) & ndash; which is cognate with the European root

"cheque" (which itself derives from Persian)- meant any document representing a contract or

conveyance of rights, obligations or monies done in conformity with the Shariah. Empirical

evidence shows that sukuk were a product extensively used during medieval Islam for the

transferring of financial obligations originating from trade and other commercial activities.

The essence of sukuk, in the modern Islamic perspective, lies in the concept of asset

monetization - the so called securitization - that is achieved through the process of issuance

of sukuk (taskeek). Its great potential is in transforming an asset & future cash flow into

present cash flow. Sukuk may be issued on existing as well as specific assets that may

become available at a future date. (aibim.com)

1.3History Sukuk in Malaysia

The roots of Sukuk in Malaysia are embedded in the Islamic banking and financial system. It

began in 1973 with the establishment of Tabung Haji (Pilgrims Fund), the country’s first

Islamic financial institution.

A decade later, Bank Islam Malaysia became the first full-fledged Islamic commercial bank

in Malaysia. In 1993, the government took another bold step and introduced the Interest

Free Banking Unit (IBU), which is an Islamic window within existing commercial banks. IBU

allows the parallel existence of conventional and Islamic banking systems in a bank.

The Islamic money market was established in 1994 as the final major requirement for a

complete Islamic banking system. It currently serves as a place to trade Islamic financial

instruments. In addition, the establishment of a National Shariah Council, a single source of

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reference to advice on the legality and compliance of Islamic financial instrument

transactions with the Shariah, streamlined the development process.

The first Sukuk issuance in Malaysia was for Shell MDS in 1990. A syndicate of financiers

arranged a Bai Bithaman Ajil transaction of RM75 million (US$22 million) for a tenure of five

years, and another RM50 million (US$14.73 million) for eight years.

The next notable development was the RM300 million (US$88.42 million) Sukuk issuance by

Petronas Dagangan in 1994. The first Sukuk in Malaysia to be rated, it was assigned a long-

term AA1 rating by Rating Agency Malaysia (now known as RAM Rating Services) in

February 1994. It was also the first Islamic instrument to be listed on the Kuala Lumpur

Stock Exchange (now Bursa Malaysia).

The Islamic financial market is one of the fastest-growing capital pools, and is quickly being

drawn into the mainstream of the financial system. The Malaysian Sukuk market has

successfully outgrown its infancy phase.

The viability of Islamic finance is no longer an issue as the success of the domestic Sukuk

market within a short period is testimony of the widespread acceptance of Islamic financing

principles in the country. In Malaysia, Sukuk constituted 34.24%, or RM212.11 billion

(US$62.5 billion) of RM619.53 billion (US$182.58 billion) total outstanding debt securities as

at the 30th June 2008.

Sustaining such growth requires a good legal and price discovery mechanism to enable

market participants to be updated on valuation levels and their rights. In this regard,

Malaysia has a good legal framework in place, which has shown its impartiality. However,

the issue of valuation remains a grey area.

In marking-to-market using market price, the last transacted price of the instrument is taken.

Market price is reliable only in an efficient market where information infrastructures are

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established and liquidity is sufficient. In the bond and Sukuk markets, less than 1% of bonds

is traded on a daily basis.

Furthermore, bonds and Sukuk that were traded may encounter the next trade only after

several weeks or months. Hence, the last traded price may no longer reflect the bond’s true

value as certain pricing factors, such as interest rate and credit environment, have lapsed.

Due to the low level of liquidity in the bond and Sukuk markets compared to the equity

market, the ability of players to obtain market prices is extremely difficult.

Moreover, the “non-independence” of traditional sources of bond and Sukuk prices in

Malaysia, as well as the lack of a comprehensive set of rules and regulations regarding the

origination and usage of generated bond and Sukuk prices, create a situation of information

asymmetry between market players.

Despite the market growing to a substantial size, the ability of market players to obtain

independent pricing as well as to compare and evaluate the portfolio performance of fund

managers comes close to impossible. To eliminate this impediment to the bond and Sukuk

markets, the Securities Commission of Malaysia (SC) decided to create a new capital

market infrastructure: the bond pricing agency.

2.0 Types and Principles of Sukuk and Bonds

2.1Types of Sukuk and Bonds

2.1.1 Types of Sukuk

Sukuk can be of many types depending on the type of Islamic modes of financing

and trades used in its structuring. The following are the common types of Sukuk:

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2.1.1.1 Sukuk Ijarah

This is one of the most common Sukuk issuance types, especially for project

finance. Sukuk Ijarah is a leasing structure coupled with a right available to

the lessee to purchase the asset at the end of the lease period. The

certificates are issued on stand-alone as sets identified on the balance sheet.

The rentals rated of return on these Sukuk can be fixed or floating depending

on the agreement. The cash flow from the lease including rental payments

and principle repayments are passed through to inventors in the form the

lease including rental payments and principle repayments are passed through

to investors in the form of coupon and principle payments. The Sukuk Ijarah

provides an efficient medium-to-long term mode of financing.

2.1.1.2 Sukuk Mudharabah

This is an agreement made between a party, who provides the capital and

another party (an entrepreneur), to enable the entrepreneur to carry out

business projects, which will be on a profit sharing basis, according to

predetermined ratios agreed on earlier. In the case of losses, the losses are

born by the provider of the finds only. Sukuk Mudharabag are used to

enhance public participation in big investment projects.

2.1.1.3 Sukuk Musharakah

These are investment Sukuk that represent ownership of Musharakah equity.

The structure of musharakah requires that both parties provide financing to the

projects. In case of losses, both parties will lose in proportion to the size of their

investment. Sukuk Musharakah are used to mobilize funds to establish new

projects, or to develop an existing one, or to finance a business activity on the

basis of partnership contrats.

2.1.1.4 Sukuk Istisna’

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This type of Sukuk has been used for the advance of funding for real estate

development, major industrial projects or latge items of equipment such as

turbines, power plants, ships or aircraft (construction / manufacturing financing)

(Mohamed Z., Azmi & Associate, 2010).

2.1.2 Types of Bonds

Bonds can be of many types depending on the type of conventional bonds modes of

financing and trades used in its structuring. The following are the common types of

Bonds:

2.1.2.1 Zero-coupon Bond

Zero coupon bonds are bonds that do not pay interest during the life of the

bonds. Instead, investors buy zero coupon bonds at a deep discount from

their face value, which is the amount a bond will be worth when it "matures"

or comes due. When a zero coupon bond matures, the investor will receive

one lump sum equal to the initial investment plus the imputed interest, which

is discussed below.

The maturity dates on zero coupon bonds are usually long-term—many don’t

mature for ten, fifteen, or more years. These long-term maturity dates allow

an investor to plan for a long-range goal, such as paying for a child’s college

education. With the deep discount, an investor can put up a small amount of

money that can grow over many years.

(http://www.sec.gov/answers/zero.htm)

2.1.2.2 Government Bond

A debt security issued by a government to support government spending,

most often issued in the country's domestic currency. Government debt is

money owed by any level of government and is backed by the full faith of the

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http://www.sec.gov/answers/zero.htm


government. Federal government bonds in the United States include: the

savings bond, Treasury bond, Treasury inflation-protected securities (TIPS),

and others. Before investing in government bonds, investors need to assess

several risks associated with the country such as: country risk, political risk,

inflation risk, and interest rate risk.

Lending to a national government in the country's own sovereign currency,

government bonds, are free of credit risk, because the government can raise

taxes or simply print more money to redeem the bond at maturity. But this

does not mean risk-free. (http://www.investopedia.com)

2.1.2.3 Corporate Bond

A debt security issued by a corporation and sold to investors. The backing for

the bond is usually the payment ability of the company, which is typically

money to be earned from future operations. In some cases, the company's

physical assets may be used as collateral for bonds.

Corporate bonds are considered higher risk than government bonds. As a

result, interest rates are almost always higher, even for top-flight credit quality

companies. (http://www.investopedia.com)

2.1.2.4 Municipal Bond

Municipal bonds (also known as “munis”) are attractive to many investors

because the interest income is exempt from federal income tax and in many

cases, state and local taxes as well. In addition, munis often represent

investments in state and local government projects that have an impact on

our daily lives, including schools, highways, hospitals, housing, sewer

systems and other important public projects.

(http://www.investinginbonds.com/learnmore)

2.2Principles of Sukuk and Bonds7

http://www.investopedia.com/

http://www.investopedia.com/


2.2.1 Principles of Sukuk

2.2.1.1 Requirement of underlying asset

Under ùqud muàwadhat or contracts of exchange (such as bai` bithaman

ajil, murabahah, istisna` and ijarah), an asset, whether tangible or intangible,

must be made available for sukuk to be issued subject to the following:

The underlying asset and its use must comply with the requirements of

Shariah.

An encumbered asset, such as an asset charged to a financial institution, or

an asset that is jointly-owned with another party, can only be used as

underlying asset provided the issuer has obtained consent from the chargee

or joint-owner.

Where receivables are used as the underlying asset, they must be mustaqir

(established and certain) and transacted on cash basis (on spot).

2.2.1.2 Asset pricing

Sukuk underùqud muàwadhat involves the sale and purchase of underlying

assets. When the investors purchase the underlying assets, the purchase

price must comply with the following SAC pricing guidelines:

The purchase price should not exceed 1.51 times of the market value of the

asset.

In cases where the market value of a particular asset could not be

ascertained, a fair value or any other value must be applied.

2.2.1.3 Ibra’ (Rebate)

Provision for ibra’ may be stipulated in the primary legal document provided

that such provision shall not be part of the pricing section.

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Through the application of ibra’, variable rate mechanism may be applied to

sukuk BBA, murabahah and istisna` which may be benchmarked to the

prevailing market rates.

2.2.1.4 Ta`widh (Compensation)

Ta`widh is permissible under both ùqud muàwadhat and ùqud ishtirak only

in the event of delay in payment. However, under ùqud ishtirak, ta`widh is

limited to the failure of the issuer/obligor to distribute the realised profit on

time. Ta`widh does not apply to expected profit.

The rate of ta`widh should be as prescribed by the SAC from time to time and

is available on the Islamic Capital Market section of the SC website.

2.2.2 Principles of Bonds

2.2.2.1 All projects in the bond bill must be accomplished and must be completed

within the scope and within the budget as identified in the bond bill.

2.2.2.2 The additional 5% in funding that is intended to cover project management

costs and inflationary increases should be reserved in a separate line item in

each individual capital improvement project’s budget. The 5% will be held in

reserve, and should not be included in the dollar amounts available for

design, construction, contingencies, or equipment.

2.2.2.3 Only the General Assembly has the authority to alter the project list, including

any deletions.

2.2.2.4 All bond projects are equally important and no project should be inordinately

impacted by inflation simply because of its place in the overall sequence.

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2.2.2.5 Each campus and affiliate should have an official project description and cost

estimate for each bond project. As needed, each campus should consult with

the Office of State Construction in the North Carolina Department of

Administration to define the project scope and estimated cost. Information

used to develop the official scope and cost estimate should be consistent with

the UNC Capital Study.

2.2.2.6 Each campus and affiliate, in conjunction with the Office of the President,

should prepare a spending plan to fully implement the bond bill package. At

the appropriate time and after consultation with the Board of Governors,

modifications can be considered to transfer savings achieved from projects

expedited in the early years of the plan to projects planned for the out-years

to mitigate inflationary impacts or other necessary changes.

2.2.2.7 In cases where a bond project will use not-state funds to supplement funds

appropriated in the bond bill, funds authorized in the bond bill should be spent

first, unless this is found to be inconsistent with other state policies or

procedures.

2.2.2.8 Funds included in the bond bill, as a Reserve for Repairs and Renovations

and Cost Overruns, will be placed in a reserve in the Board of Governors’

capital improvement budget code. The Board of Governors will determine use

of these reserve funds, subject to approval of the Director of the Budget.

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3.0 The differentiate between Sukuk and Bonds

Beside Sukuk is followed by Islamic finance terms and Bond is followed by conventional finance

term, there have many other different in order to show sukuk is not only term

Sukuk Bonds

Sukuk represent ownership stake in an

underlying asset.

Sukuk are financial fixed income certificates

that are permissible within the provisions of

Islamic Sharia law as they are raised on

trading in, or construction of, specific and

identifiable assets [rather than being

interest based like bonds].

The income from Sukuk is related to the

original legal contract that governs the

relationship between the Sukuk provider

and the customer [owner of the Sukuk].

A bond represents the issuer’s pure debt.

Bonds are securities in the form of a debt

that will be paid back before a certain date,

termed the date of maturity, in addition to

interest [on this debt]. In short, a bond is a

debt security in which borrowed money is

repaid along with interest at a fixed rate.

Bonds also include a fixed rate of interest

regardless of loss or gain

*Sources: http://www.asharq-e.com/news.

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4.0 Potential of Sukuk

The global Islamic financial sector has witnessed an encouraging growth over the last decade

and is currently estimated to be at around US$1trillion. It is predicted to be the world’s fastest-

growing financial sector for the coming years with an estimated global potential of US$4trillion.

Sukuks have turned out to be an important driver to raise finance under the Islamic mode of

financing. In today’s business practice, the term Sukuk means a claim similar to that

represented by a trust certificate. In essence, the Sukuk is a financial instrument that sits above

a Shari’ah-compliant underlying structure which generates an income for the holder of the

instrument. Islamic finance has many qualities that could lend themselves to securitization as a

means of raising funds. Shari’ah compliant tools must have asset-driven returns for example,

which is a notable feature of securitization. (http://www.sukuk.me/news/articles/73/Global-

sukuk-markets.html)

4.1The Development of Islamic Finance Industry

The growing role of Islamic finance in mobilizing and channeling funds to productive

investment activities across borders contributes to more efficient allocation of funds across

borders and facilitates international trade and investment. Greater diversification of risk also

contributes towards promoting international financial stability. The more recent development

in Islamic finance is the growing significance of the Sukuk market to become an increasingly

important component of the Islamic financial system. Five major trends are having a

significant bearing on the future development of the global Sukuk market.

Firstly, the bond market is now becoming key to meeting the funding requirements for both

the public and private sectors in emerging market economies. This is particularly the case

for the Middle East and Asia, which are among the fastest-growing regions in the global

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http://www.sukuk.me/news/articles/73/Global-sukuk-markets.html

http://www.sukuk.me/news/articles/73/Global-sukuk-markets.html

http://islamonline.com/islamic-finance/islamic-finance.html

http://sukuk.me/

http://islamonline.com/islamic-finance/islamic-finance.html


economy. This includes financial needs of the private sector following the privatization and

implementation of infrastructure projects. The development of the Sukuk market will provide

opportunities for the corporate sector, the government agencies, multinational corporations

(MNCs) and multinational development institutions to raise funds through the issuance of

Sukuk to meet their financing requirements. The Sukuk market also serves as an important

platform, complementing the conventional bond market in enhancing the effectiveness and

efficiency for the mobilization and allocation of funds within the domestic financial system,

as well as in the international financial system.

Secondly, while there has been growing interest in the issuance of Sukuk by corporations,

sovereigns and MNCs, the demand for Sukuk significantly exceeds the supply. Today, the

global Sukuk market, denominated in international currencies, is estimated to exceed

US$50 billion. Although the size of the market is modest by global standards, the Sukuk

market is experiencing remarkable growth, increasing at an average rate of growth of 40% a

year.

The significant demand for Sukuk has also been spurred by the high levels of surplus

savings and reserves in Asia and in the Middle East. This has been reinforced by increased

liquidity in the international financial system in search of higher returns and greater

diversification of risk. Since the issuance of the first sovereign global Islamic Sukuk by the

government of Malaysia in 2002, there has been a series of other issues by the

governments of the United Arab Emirates, Qatar, Bahrain and Pakistan. An increased

number of multilateral agencies have also issued Sukuk to finance development projects. In

addition, both government agencies and the corporate sector have considered the Sukuk

market as an attractive financing instrument.

Thirdly, there are a great number of global players such as investment banks, Islamic banks

and securities firms that are involved in the issuance of Sukuk in the international financial

markets. A large number of western banks are also providing Islamic financial services

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taking advantage of the opportunities and to provide customized products and services to

their customers.

Fourthly, the established international financial centers have also shown interest in

promoting the development of the Sukuk market including enacting the appropriate

legislative provisions. These developments would augur well for the development of the

Sukuk market.

Finally, the regulatory and supervisory paradigm continues to evolve. Indeed, the recent

decade has witnessed significant global shifts in the approach to regulation and supervision

across many countries. In addition, the harmonization of standards and practices is also

important. The establishment of the international standard setting organizations, such as the

Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organization for

Islamic Financial Institutions (AAOIFI), to formulate appropriate prudential and accounting

standards that not only facilitate the process of harmonization but also contribute to the

strengthening of the Islamic financial system. IFSB has already formulated the prudential

treatment for Sukuk investment by the Islamic financial institutions as stipulated in the

capital adequacy standards.

The Islamic finance industry is growth rapidly with the current positioning which, in Middle

East and North Africa have 204 million Muslims from GCC countries like, UAE, Iran and

Egypt where this is 13% of total Muslim population in the world. GCC countries (excluding

Oman) have 17 commercial banks offering Islamic banking and the AUM is USD100 billion.

In South East Asia have 16 million Muslims in Malaysia and 195 million Muslims in

Indonesia and 13% of total Muslim population in the world. Malaysia has AUM USD31 billion

and the Islamic money market in Malaysia ranging from USD8 – 12 billion monthly. There

had issued 60% of the world’s Sukuks in 2006.

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Have also 439 million Muslims in India, Pakistan and Bangladesh and 16 million Muslims in

United Kindom, United State, Germany and France where it accounted for 41% of the total

Muslim population in the world. (Overview of Islamic Finance, Grail Research, 2007.)

This can be seen comparison of the sukuk market in Malaysia ad the biggest issuer in the

world and sukuk market in the United Kindom to see how far the development of the global

sukuk market.

4.1.1 The Potential of Sukuk Market in Malaysia

Significant progress has been achieved in the development of the Malaysian Sukuk

market. In 2007, Malaysia accounted for about two-thirds of the global Sukuk

outstanding, amounting to about US$47 billion. Malaysia not only represents the

largest Sukuk market in terms of outstanding size, but also in terms of number of

issuance.

In developing the Sukuk market, Malaysia provides a total solution for Sukuk

activities by offering a complete Sukuk issuance and trading platform, supported by

four elements: a wide range of Islamic instruments, strong legal and regulatory

infrastructure, sound Shariah governance framework and talent supply. These

elements are also further strengthened by Malaysia’s comprehensive Islamic

financial system with all the key components of the financial system comprising the

Islamic banking, Takaful, Islamic money and capital markets that are now at an

advanced stage of development. These different parts of the Islamic financial

system not only facilitate the issuance and the distribution of the papers but also

create a strong demand for Sukuk by providing a broad investor base.

There is also a variety of Islamic instruments in the Sukuk market in Malaysia that

include currency swaps and Islamic forward contracts available to facilitate hedging

and other risk management activities. The Malaysian Sukuk market is also

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supported by appropriate rules and regulations, and by the pool of experienced

global and domestic players as well as the legal and accounting professionals

including legal and tax consultancies, as well as documentation in the issuance and

trading exercise.

Malaysia aim to be as an international Islamic Financial Center (MIFC) , thus

develop Malaysia into a center for the origination, distribution and trading of Sukuk

to provide further impetus to the development of an increasingly vibrant and

progressive bond market in Malaysia as well as in the Asian region. This would

reinforce the international dimension of the Sukuk market in Malaysia by providing

linkages with international issuers and investors. To deepen and widen the bond

and Sukuk markets, Malaysia has further liberalized the foreign exchange

administration rules to allow multilateral financial institutions, MNCs and other

national corporations to issue both ringgit and non-ringgit denominated instruments

in capital market. Malaysia also has in place the financial infrastructure and

facilitative rules that contribute towards efficient price discovery and shorter time to

market, thus providing an efficient platform for Sukuk issuance and trading

activities. The established legal, regulatory and Shariah framework in the Islamic

financial infrastructure in Malaysia is reinforced by the supporting financial

infrastructure, including the settlement and bond information system.

To facilitate an efficient Sukuk issuance process in Malaysia, an MIFC one-stop

center is being established as a single contact point for efficient delivery process to

facilitate the issuance of Sukuk. To further facilitate this process, there is no

restriction on the ability to use international rating services, on the ability to hedge

positions and on the ability to swap issuance proceeds into foreign currency.

As part of ongoing efforts to position Malaysia as an attractive gateway for the

issuance of Sukuk, a number of legal and regulatory requirements are further

customized to reduce the cost of Sukuk issuance. Profits and dividends received by

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non-resident investors from holding of ringgit and non-ringgit Islamic instruments

issued in Malaysia are exempted from withholding tax. Special Purpose Vehicles

(SPVs) for Islamic financing purposes via the Islamic capital market are not subject

to the administrative procedures under the Income Tax Act 1967. In addition,

companies that establish these SPVs are given a tax deduction on the issuance

cost of the Islamic securities incurred by the SPV. The issuance cost for all Islamic

securities approved by the Securities Commission is also eligible for tax deduction.

Finally, there is a stamp duty exemption for 10 years on instruments relating to

Islamic securities under the MIFC. These initiatives have positioned Malaysia as a

competitive and attractive Sukuk market in the global arena.

Malaysia has also put in place an efficient platform for trading of bonds including the

Real-time Electronic Transfer of Funds and Securities System (RENTAS), Fully

Automated System for Issuance/Tendering (FAST), and Bond Information and

Dissemination System (BIDS) to provide post-trade transparency and market

liquidity on par with developed markets. Malaysia also has a payment system link

with the Hong Kong Monetary Authority on US dollar settlements, while Malaysian

government securities can be cleared with Euroclear.

Finally, a conducive environment for innovation has been put in place. In 2006, the

Malaysian market continued to generate innovative products with the launch of

Sukuk using Mudarabah, Musharakah and Ijarah. Landmark issuances, such as the

exchangeable Sukuk Musharakah by Khazanah Nasional, marked the world’s first

issue of its kind, incorporating full convertibility features common to conventional

equity-linked transactions.

4.1.2 The Potential of Sukuk Market in United Kingdoms

A recent report from Ernst & Young (E&Y)2 shows that between 2007 and 2009

sukuk are still largely originated from Malaysia and the GCC. Issuance from other

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jurisdictions such as Indonesia is increasing, but at this point in time still negligible.

Figure 1 below shows how the issuance compares geographically. (E&Y Islamic

Funds and Investments Report, 2009)

The exact potential size of the market is difficult to determine, mainly as a result of

the fact that the instrument is still relatively new and the number of European listed

issues is still fairly low. However, given the characteristics defined in the previous

section, 69% of the investment professionals that have responded to the survey have

indicated that they would consider investing in a European Sukuk issue.

Like any other bond, the issue would have to fit within the overall portfolio and meet

the investment requirements associated with, among others, issuer, credit quality

and size. The total demand depends on the investor and is often associated with a

percentage of the issue size or a percentage of their total holding. The fact that the

market is still relatively young has an impact on the perceived risk levels and

available liquidity which are in turn reasons to approach investing in a Sukuk with

caution.

The potential demand is currently still difficult to assess due to the fact that the

market is still relatively young and the total outstanding amount of Sukuk is small

compared to the overall bond market. However, where a few years ago the majority

of respondents would not have heard of Sukuk, we found that in excess of 85% of

the respondents have heard about the instrument and in excess of 50% has invested

in them. (European Sukuk Issue, 2010)

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5.0 Risk of Sukuk

5.1Risk-Rewards Sharing

The development of Islamic Financial products that provides impetus to the economic

machinery of a country are no doubt a pleasant initiative. Whether the new Ijara’h based and

Murabaha – based trading contracts have led the Islamic financial institutions to introduce

Islamic financial dealings in banking, or the fine tuning of these and other transactions to

ensure Sharia’h compliance, these are welcome signs. Sukuk as equity scrips simply, open

huge possibilities to explore and adapt, with the Sharia’h permissibility (of course, inclusive

of fair play and justice to the parties involved). Though currently operating mostly at

institutional and sovereign level, with the volumes of transactions breaking the previously set

records, quite often, these can also be utilized for small scale investment needs, if the

operational costs can be met easily. Sukuk have the flexibility to mould the financial

requirements and investment opportunities according to the Sharia’h requirements, as well

as meeting the requirements of investments (demand and supply side). More importantly,

these instruments have provided an alternate choice to the market in the form of non-debt

based ( like Ijarah sukuk) and equity –based and other quasi-equity investments that can

also be availed productively However, in the conventional finance perspective , many of the

sukuk structures are still considered as an “Islamic Debt structure”, especially in regulatory

treatment. (Jabeen Z. & Javed M. T., 2007)

5.2Relative Risk Of Sukuk Over Bonds

The governments bonds are always considered to be safe, liquid and in terms of return they

provide a lower yield. The sukuks are growing fast along with the government and

conventional bonds. The sukuks invest money as per Shariah principles in halal businesses

as such they are safer when compared to the conventional bonds. When empirically

analysed for sukuks’ riskinessthe results reveal that they are m oderately risky than

government bonds and less risky than conventional bonds. As risk and return are positively

correlated the sukuks provide a lower return. These results support the popularity of the

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sukuks though yield is less due to their less risky nature. All these results imply that the

sukuks are more apt investment for risk averters, whether they follow Islam or any other

religion. Investors who choose bond market for investment will be normally risk averse else

they will go to stock market which is more risky and with better YRs. (Ramasamy R.,

Munisamy S., M. Helmi M. H., 2011)

5.3Risk Assessment of Sukuk

The market for Sukuk certificates continues to grow and an important facet of this growth is

the increased number of sovereign issuances typified by those issued by Malaysia, Bahrain

and Qatar and, interestingly, Saxony-Anhalt in Germany. These certificates are appealing to

global investors without having too much bearing on the underlying ‘Islamicity’ of the

certificates. Accordingly, Islamic secondary markets receive a boost because such

sovereign issuances and the subsequent attraction of global investments encourage

increased corporate confidence in their private issuances. Nevertheless, Ijarah Sukuks

continue to prevail as the most popular manifestation of Sukuk certificates. This is largely in

part to their unambiguous Shari’ah conformity and familiar leasing formulae. However,

leasing contracts on underlying real estate properties cannot single-handedly support the

growing diversity of Sukuk investors. With increased global investors there will be a myriad

of investment needs and thus other avenues of Sukuk issuances should be implemented to

satisfy these demands. Istisnaa, Mudarabah and Musharakah certificates are established as

part of the AAOIFI standard and can be garnered to offer a plethora of Sukuk structures.

The recent Sukuk issuance by the Islamic Development Bank serves as an excellent case

study in this regard with their Shari’ah compliant diversity of investments.

With the rapid emergence of Sukuk markets, risk management considerations have also

come to the vanguard of the industry. Novel financial instruments bring with them original

financial risks. An analogous situation represented itself in conventional financial markets in

the early 80s with the emergence of interest rate derivatives to hedge against the financial

risks of bonds. With the globalization of financial markets and increased convergence of

Islamic finance and conventional markets, indirect interest rate effects as well as other

20


financial risks will necessitate the development of Islamic financial risk management

techniques. Derivatives are inherently against Shari’ah considerations because of the

uncertainty associated with them that amounts to Gharar. However, we have discussed the

possibility of extending the functions of embedded options to fit the needs of Sukuk

certificates and Shari’ah considerations. This facility provides a debt structure framework

that helps replicate the functions of traditional instruments and in turn benefit from the

convexity gains of these instruments. Neftci and Santos (2003) identify two major hurdles in

emerging markets for acquiring convexity gains. Firstly, there are no markets for liquid

interest rate derivatives. Secondly, interest rate fluctuations lead to significant increases in

credit risk and lower the bond’s price. Accordingly, investors in emerging markets suffer from

the negative effects of volatilities but cannot benefit from the positive effects. Such benefits

have been garnered in conventional emerging markets such as Brazil where interest rate

volatilities in the 90s warranted a protective cushion against these fluctuations in the form of

puttable and callable bonds. These debt structures can be transferred to the Sukuk

issuances in accordance to outstanding Shari’ah concerns. (Tariq A. A., 2004)

5.4Sukuk vs. Eurobonds: Value-at-Risk Different

The market for Sukuk2 has grown tremendously in recent years, from less than $8 billion in

2003 to $50 billion by mid-2007. 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/supranational issues in the international bond markets.

Sukuk are in many aspects similar to conventional Eurobonds. Sukuk 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 albeit less than conventional bonds; they are

assessed and rated by international rating agencies; and are mostly cleared under

Euroclear (listed in Luxemburg). The convergence between Islamic and conventional

21


finance, particularly in the case of Sukuk, is gaining momentum as foreseen by several

scholars (Mirakhor 2007).

This said, there are certain differences between conventional bonds and Sukuk. A bond

represents the issuer’s pure debt, while Sukuk represent ownership stake in an underlying

asset. For example, an Ijarah (lease) contract that is often used to structure sovereign

Sukuk creates a lessee/lessor 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 (Thuronyi, 2007). (Cakir S. & Raei F., IMF

Working Paper, 2007.)

22


6.0 Conclusion

Sukuks can be used very effectively

23


Reference

1. E&Y Islamic Funds and Investments Report 2009

2. Cakir S. & Raei F., IMF Working Paper, 2007

3. European Sukuk Issue, 2010

4. http://www.bloomberg.com/news/2011-10-07/malaysian-islamic-banking-assets-rise-15-percent-

to-123-billion.html

5. http://cms.sb24.com/modules/news/EnglishNews/news10.html?uri=/en/index.html

6. http://cms.sb24.com/modules/news/EnglishNews/news10.html?uri=/en/index.html

7. http://www.mifmonthly.com

8. http://www.sc.com.my

9. Ramasamy R., Munisamy S., M. Helmi M. H., Global Journal of Management and Business

Research, 2011

10. Tariq A. A., Managing Financial Risks Of Sukuk Structures, 2004

11. Jabeen Z. & Javed M. T., Sukuk-Structures An Analysis Of Risk-Reward Sharing And Wealth

Circulation, 2007

24

http://www.sc.com.my/

http://www.mifmonthly.com/

http://cms.sb24.com/modules/news/EnglishNews/news10.html?uri=/en/index.html

http://cms.sb24.com/modules/news/EnglishNews/news10.html?uri=/en/index.html

http://www.bloomberg.com/news/2011-10-07/malaysian-islamic-banking-assets-rise-15-percent-to-123-billion.html

http://www.bloomberg.com/news/2011-10-07/malaysian-islamic-banking-assets-rise-15-percent-to-123-billion.html


Appendix

12. 2010 LIST OF SUKUK APPROVED BY SC

Qtr No. Issuer Shariah Principle Size of Issues

(RM mil)

Q1 2010 1. Haluan Gigih Sdn Bhd Musharakah 240.00

2. Lafarge Malayan Cement Berhad Murabahah 350.00

Q2 2010 1. Cagamas Berhad Ijarah, Wakalah, Bai

Bithaman Ajil

5,000.00

2. CJ Capital Sdn Bhd Musharakah 114.00

3. Kencana Petroleum Berhad Mudharabah 250.00

4. LBS Bina Group Berhad Mudharabah, Murabahah 135.00

5. Maju Expressway Sdn Bhd Musharakah 550.00

6. New Pantai Expressway Sdn Bhd Bai Bithaman Ajil 74.00

7. Padiberas Nasional Berhad Musharakah 750.00

Q3 2010 1. AmIslamic Bank Berhad Musharakah 3,000.00

2. Bank Pembangunan Malaysia

Berhad

Tawarruq 2,000.00*

3. Celcom Transmission (M) Sdn Bhd Ijarah 4,200.00

4. Malaysia Airports Capital Berhad Ijarah 3,100.00

* Combined issue size limit of RM2.0 billion with Conventional Commercial Papers

Programme

Q4 2010 1. Aman Sukuk Berhad Musharakah 10,000.00

2. Alluvium Berhad Ijarah 615.00

3. Gamuda Berhad Musyarakah, Murabahah 800.00

4. KNM Group Berhad Musharakah 1,500.00

5. Konsortium Lebuhraya Utara-Timur

(KL) Sdn Bhd

Musharakah 820.00

6. Point Zone (M) Sdn Bhd Murabahah 500.00

7. Senai-Desaru Expressway Berhad Ijarah 5,580.00

8. TTM Sukuk Berhad Commodity Murabahah 750.00

25


Table 1: Top 20 Corporate Issuers as on June 2010 (RM billion)

Issuer CBs Sukuks Con. MTN

Islamic MTN Total

Cagamas — — 9.30 8.85 18.15

Khazanah — 13.20 — — 13.20

Binariang GSM — 3.17 — 8.28 11.45

Project Lebuhraya — 6.57 — 3.68 10.25

Prasarana 5.11 2.00 — 2.00 9.11

Maybank 6.10 2.50 — — 8.60

Rantau Abang Capital Bhd — — — 8.00 8.00

Malakoff Corp — 1.70 — 5.60 7.30

KL International Airport 1.60 4.76 — — 6.36

AM Bank 1.60 — 4.33 — 5.93

Value Cap 5.10 — — — 5.10

1 Malaysia Development Bhd. — — — 5.00 5.00

Jimah Energy Ventures — — — 4.77 4.77

Tanjung Bin — — — 4.59 4.59

Bank Pembangunan Malaysia 1.00 — 2.60 0.90 4.50

Putrajaya Holdings — 1.70 — 3.65 5.35

YTL Power International 2.20 — 1.70 — 3.90

Tenaga Nasional 1.50 2.15 — — 3.65

Danga Capital — — — 3.60 3.60

RHB Bank 0.60 — 3.00 — 3.60

Total 24.81 37.75 20.93 58.91 142.40

Total Outstanding 63.48 70.47 45.48 89.40 294.65

Top 20 as % of Outstanding 39.10% 53.60% 46.00% 65.90% 48.30%

Source: Bank Negara Malaysia Fully Automated System for Issuing/Tendering (FAST).

Types of Sukuk

Description of

Sukuk structure Credit Risk

Rate of return (Interest rate

risk) FX risk Price risk Other risks

Zero coupon

Sukuk Istisna’, Murabahah debt certificates –

Unique basis of credit risks exist, see, Khan and

Very high due to fixed rate, remains for

If all other conditions are similar, FX risk

Price risk relates to the prices of the

Liquidity risk is serious as far as thenon-tradable

26


non-tradable Ahmed (2001)

the entire maturity of

the issue

will be the same for all cases of Sukuk. However, those Sukuk which are liquid or which are relatively short term in nature will be less exposed. The composition of assets in the pool will also contribute to the FX risk in different ways. Hence this can be very useful tool to overcome the FX risk by diversifying the pool in different

currencies.

underlying commodities and assets in relation to the market prices. Ijara Sukuk are most exposed to this as the values of the underlying assets may depreciate faster as compared to market prices. Maintenance of the assets will play an important part in this process. Liquidity of the Sukuk will also play an important part in the risk. Salam is also exposed to serious price risks. However, through parallel contracts these risks can be

overcome

Sukukare concerned. Business risk of the issuer is an important risk underlying Sukuk as compared to traditional fixed incomes.

Shari’ah compliance risk is another one unique in case of Sukuk. Infrastructure rigidities, i.e., non-existence of efficient institutional support increases the risk of Sukuk as compared to traditional fixed incomes, see Sundararajan, &

Luca (2002)

Fixed Rate

Ijara Sukuk

Securitized Ijara, certificate holder owns part of asset or usufructs and earns fixed rent -

tradable

Default on rent payment, fixed rate makes credit risk more

serious

Very high due to fixed rate, remains for the entire maturity

of the issue

Floating Rate

Ijara Sukuk

Securitized Ijara, certificate holder owns part of asset or usufructs and earns floating rent indexed to market benchmark such as LIBOR –

tradable

Default on rent payment, floating rate makes default risk lesser serious – see

previous case

Exists only within the time of the floating period normally

6 months

Fixed rate Hybrid/ Pooled

Sukuk

Securitized pool of assets; debts must not be more than 49%, floating rate possibility exists

– tradable

Credit risk of debt part of pool, default on rents, fixed rate makes credit

risk serious

Very high due to fixed rate, remains for the entire maturity

of the issue

Musharakah Term Finance

Sukuk (MTFS)

Medium term redeemable musharakah certificate based on diminishing musharakah – tradable as well

as redeemable

Musharakah has high default risk (see Khan and Ahmed 2001), however, MTFS could be based on the strength of the entire balance

sheet

Similar to the case of the floating rate. This is however, unique in the sense that the rate is not indexed with a benchmark like LIBOR, hence least exposed to

this risk

27


Salam Sukuk

Securitized salam, fixed-rate and non-

tradable

Salam has unique credit risk (see Khan and Ahmed

2001) Very high due

to fixed rate

28

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