Chapter 7 Sukuk Islamic Bonds SUKUK IS ITS

Chapter 7 Sukuk (Islamic Bonds) § SUKUK IS & ITS HISTORICAL ORIGIN § DISTINGUISHING FEATURES OF SUKUK FROM CONVENTIONAL BONDS § AAOIFI STANDARDS ON SUKUK Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 1

What are Sukuk? § An Arabic term for financial certificate; it is the Islamic equivalent of bond § Asset-backed instruments & tradable Sharī‘ah compatible trust certificates AAOIFI defines Sukuk as: Certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity IFSB certificates that represent the holder’s proportionate ownership in an undivided part of an underlying asset where the holder assumes all rights & obligations to such asset’ Kuwait University - College of Business Administration 2

A Brief History of Sukuk § Sak, the singular form of Sukuk was used to refer to documents or certificates representing obligations, contracts, conveyances of rights executed in conformity to the principles of Sharī'ah § The earliest usage of the Sukuk receipts relates to the method of payment of the soldiers during the Umayyad Caliphate in the 1 st century of the Islamic calendar where soldiers were given commodity coupons in place of cash § During the medieval period, sak was used as the main instrument for transferring obligations arising from commercial transactions, thus reducing movement of cash between cities Kuwait University - College of Business Administration 3

A Brief History of Sukuk § In the modern practice of Islamic finance, sak is used to provide alternative funding for financing projects through asset securitization § The Islamic Fiqh Academy of the Organization of Islamic Cooperation (OIC) ruled for legitimacy of the concept of Sukuk Kuwait University - College of Business Administration 4

Benefits of Sukuk 1. Among the best ways of financing large enterprises beyond the ability of a single party to finance 2. Provide an ideal means for investors seeking to deploy streams of capital and at the same time are able to liquidate their positions with ease should the need arise 3. Manage liquidity for banks and Islamic financial institutions 4. A means for the equitable distribution of wealth Kuwait University - College of Business Administration 5

Advantages of Sukuk § Diversification of fund sources § Secondary liquidity § Creation & enhancement of profile on the international market § Infrastructural development in Muslim countries § Pricing benchmark § Sizeable financing Kuwait University - College of Business Administration 6

Differences Between Sukuk & Conventional Bonds 1. Conventional bonds are contractual debt securities, while Sukuk represent the undivided ownership of each of the Sukuk holders in the underlying asset 2. Returns in conventional bonds comes in interest (coupon) and the principal amount whereas in Sukuk, the return is in profits 3. In conventional bonds, the contractual relationship between issuer and investor is debt/credit, while it is a partnership relationship in Sukuk 4. Sukuk holders have ownership rights in the underlying asset, while conventional bonds merely represent a debt certificate 5. Sukuk must be asset-backed, while conventional bonds may be backed by financial assets such as receivables, which are not allowed in the case of sukuk (Refer to Table 7. 1 in the text book for major differences between Sukuk and Bonds) Kuwait University - College of Business Administration 7

Differences between Sukuk and conventional bonds § Prohibition on charging or paying of interest and other Shariah constraints. § Some Sukuk (e. g. debt) are not tradable in the secondary market. § Sukuk – securitisation & issuance of sukuk (taskeek) – Transforming an asset’s future cash flow into present cash flow. Kuwait University - College of Business Administration 8

Sukuk Structure: Typical Sukuk Structure: 1. 2. 3. 4. 5. Partial ownership in a debt (Sukuk Murabaha) Asset (Sukuk Ijarah) Project (Sukuk Istisna) Business (Sukuk Musharaka) Other mixed structures Note: Typical Sukuk structure is a combination of several financial mechanisms such as Murabaha, Ijara, Istisna and so on. Kuwait University - College of Business Administration 9

Types and Structure of Islamic Bonds § Sukuk can be of many types depending on the types of Islamic finance products used in its structuring § AAOIFI identified fourteen major Sukuk-structured products § Sukuk have been classified as: 1. Tradable Sukuk 2. Non-tradable Sukuk 3. Debt based Sukuk 4. Equity based Sukuk Kuwait University - College of Business Administration 10

The Most Common Investment Sukuk § Mudarabah Sukuk (Trust Investment Bonds) ﺍﻟﻤﺮﺍﺑﺤﺔ ﺻﻜﻮﻙ § Musharakah Sukuk (Partnership Investment Bonds) ﺍﻟﻤﺸﺎﺭﻛﺔ ﺻﻜﻮﻙ § Ijarah Sukuk (Leased Asset Bonds) ﺍﻻﺟﺎﺭﺓ ﺻﻜﻮﻙ Kuwait University - College of Business Administration 11

The Fourteen Sukuk Structures of AAOIFI 1. Sukuk ijarah (leased assets certificates) 2. Sukuk ijarha mausufa bi dhima (forward lease certificates) 3. Sukuk manfaa ijarah (usufruct of a lease certificate) 4. Sukuk manfaa ijarah mausufa bidhima(usufruct of a forward lease certificate) 5. Sukuk milkiyat-al-khadamat (ownership of services certificates) 6. Sukuk al-salam (forward contract certificates) 7. Sukuk al-istisna’a (manufacturing certificates) Dr. Mohammad Alkhamis 1. Sukuk al-murabahah (cost-plus certificates) 2. Sukuk-al-musharakah (partnership certificates) 3. Sukuk al-mudarabah (trusti. Investment certificates) 4. Sukuk al-wakalah (investment agency certificates) 5. Sukuk al-muzra’a (sharecropping certificates) 6. Sukuk al-musaqa (irrigation certificates) 7. Sukuk al-mugharasa (agricultural certificates) Kuwait University - College of Business Administration 12

Structuring of Islamic Bonds § The replication of conventional bond features excluding characteristics impinging on fundamental principles of Sharī‘ah in commercial transactions e. g. prohibition of riba & gharar § The process of modelling and structuring Islamic bonds requires basic knowledge of major Islamic finance products e. g. mudarabah, musharakah, ijarah, murabahah, wakalah § Islamic finance experts developed, modeled and structured finance products through Islamic financial engineering Kuwait University - College of Business Administration 13

Mudarabah Sukuk (Trust Investment Bonds) § Investment Sukuk representing ownership of units of equal value in the Mudarabah equity § Registered in the names of the Sukuk holders on the basis of undivided ownership of shares in the Mudarabah equity § Usually structured as an agreement between the rabb al-mal who provides the capital and a Special Purpose Vehicle (SPV) § Returns shared in accordance with the percentage of share ownership of each Sukuk holder § Losses are borne by financiers but necessary measures mitigate risks (through the process of securitization) Kuwait University - College of Business Administration 14

Basic Features of Mudarabah Sukuk (MS) As articulated in the Resolution of the Islamic Fiqh Academy of the OIC in its 4 th session in 1988 1. Mudarabah Sukuk (MS) represent common ownership and entitle holders to share in specific projects against which the MS have been issued 2. Contract based on the official notice of the issue or the prospectus, which must provide all information required by Sharī‘ah for a Qirad contract 3. The MS holder is given the right to transfer the ownership by selling the sukuk in the securities market at his/her discretion 4. The manager/SPV who receives the funds collected from the subscribers to MS can also invest his/her own funds Kuwait University - College of Business Administration 15

Basic Features of Mudarabah Sukuk (MS) 5. Neither prospectus nor MS should contain a guarantee, from the issuer or the manager of the fund, for the capital or a fixed profit, or a profit based on any percentage of the capital Accordingly: i. iii. the prospectus, or the MS issued pursuant to it, may not stipulate payment of a specific amount to the MS holder profit is to be divided, as determined by applying the rules of Sharī‘ah the profit and loss account of the project must be published and disseminated to MS holders 6. It is permissible to create reserves for contingencies, such as loss of capital, by deducting from the profit a certain percentage in each accounting period 7. The prospectus may also contain a promise made by a third party, to donate a specific sum, without any counter benefit, to meet losses in a given project, provided such commitment is independent of the Mudarabah contract Kuwait University - College of Business Administration 16

Basic Features of Mudarabah Sukuk (MS) The sale of MS must follow the rules listed below: § If mudarabah capital is in money, the trading of MS will be like the exchange of money for money and it must satisfy the rules of Bai‘ al Sarf § If the mudarabah capital is in debt, it must be based on principles of debt trading in Islamic jurisprudence § If capital is a combination of cash, receivables, goods, real assets and benefits, trade must be based on the market price evolved by mutual consent Kuwait University - College of Business Administration 17

Structure of Mudarabah Sukuk Kuwait University - College of Business Administration 18

Steps Involved in the Structure of Mudarabah Sukuk § A company which needs liquidity establishes an SPV § The SPV issues Sukuk certificates to investors/sukuk subscribers § Cash generated used as capital in Mudarabah contract between SPV and an organisation appointed to manage the business § The Mudarabah business is carried out and profits are periodically distributed among the two major parties: the company and the SPV § The SPV pays the investors/sukuk holders according to the units of their individual shares in the invested capital Kuwait University - College of Business Administration 19

Musharakah Sukuk § Musharakah Sukuk are investment bonds which represent the ownership of the partnership equity § Musharakah Sukuk can be used for the mobilization of funds for new project, develop an existing project or finance a huge business activity based on joint venture contracts § The Musharakah certificate given to all Sukuk holders represent their proportion of ownership in the assets of the project being undertaken § The Musharakah certificates are treated as negotiable instruments which are tradable in the secondary market; § Can be bought and sold in the capital markets Kuwait University - College of Business Administration 20

Musharakah Sukuk § The structure of a Musharakah Sukuk is based on the joint venture partnership § Profit is shared according to an agreed predetermined ratio § Any loss is shared according to the individual contribution of the parties/sukuk holders involved § Every subscriber is entitled to participate in the management of the business if he or she wishes Kuwait University - College of Business Administration 21

A Musharakah Sukuk Structure Kuwait University - College of Business Administration 22

Ijarah Sukuk Ownership of well-defined & known assets tied up to a lease contract, rental of which is the return payable to the Sukuk holders § The contract of ijarah has been: § Structured & transformed as a competitive bond in the secondary market § Structured to allow the mobilisation of funds for development of long term infrastructure projects via the issuance of ijarah sukuk § Used as securitization of a tangible asset e. g. a hospital or airport Kuwait University - College of Business Administration 23

Different Variations Ijarah Sukuk 1. Sukuk of ownership in leased asset § It is issued with the sole aim of selling the asset to the sukuk holders through the transfer of title § The sukuk holders jointly own the asset through undivided ownership and are entitled to profits and losses accordingly § This form of ijarah sukuk can be used for the purchase of a new asset Kuwait University - College of Business Administration 24

Different Variations Ijarah Sukuk 2. Sukuk of ownership of usufructs of assets: § It is issued to conferring the right of usufruct in the sukuk holders where they become joint owners § The sukuk holders only become owners of usufruct ( )ﻣﻨﺎﻓﻊ of the assets § since the owners of asset have leased its usufruct to the sukuk holders § Sukuk holders can also sublease the usufruct of the asset to a third party 3. Sukuk of ownership of services: § Issued to subscribers to confer the ownership in such services to the sukuk holders § The sukuk holders may also sublease such services to a third party Kuwait University - College of Business Administration 25

Eg: Sukuk Ijara Name of Sukuk is derived from underlying principle that underpins Sukuk structure – in this case ijarah! Lease (Ijarah) ABC Ltd Rental Payment Pay Issue price SPV* Investor Issue Sukuk & pay profits *SPV – Special Purpose Vehicle (Issuer) Kuwait University - College of Business Administration 26 How would Murabaha or Mudaraba Sukuk look like?

Example: GE Sukuk § GE Capital, the finance arm of General Electric, has listed a recently completed US$500 million Sukuk (Islamic bond) on NASDAQ Dubai, the Middle East's international exchange. Kuwait University - College of Business Administration 27

Kuwait University - College of Business Administration 28

Ijarah Sukuk Transaction Kuwait University - College of Business Administration 29

Ijarah vs Murabaha Sukuk, example: Q: Who owns asset/debt in each structure and why is that important? Who should maintain property and how? Can certificate be traded in secondary markets? Other issues? § Difference between ijarah and, for instance Murabaha based Sukuk, is the simple issue of ownership and valuation of share in the asset. § While in Murabaha cash flow simply represents debt (dayn) resulting certificate can not be traded on secondary market. This is resolved in ijarah Sukuk where price of certificate reflect proportional price of underlying asset. § Therefore, since trading with debt at a discount or a premium is prohibited, ijarah Sukuk represents actual asset and not cash flow or debt. Kuwait University - College of Business Administration 30

AAOIFI Standards for Islamic Bonds Characteristics of Investment Sukuk § Certificates represent the rights and obligations of the owner § Common share in the ownership of the underlying asset § Sharī'ah compliance § Trading of investment sukuk and the rights they represent § Profit & losses are commonly shared by certificate holders Kuwait University - College of Business Administration 31

AAOIFI Standards for Islamic Bonds Sharī‘ah Rulings and Requirements contained in AAOIFI Standards of sukuk are classified into two categories: 1. Sharī‘ah requirements in the issuance of investment sukuk 2. Sharī‘ah rules in trading in investment sukuk Kuwait University - College of Business Administration 32

Significant AAOIFI Pronouncement on Sukuk in 2008 § Guidelines on sukuk issued earlier by AAOIFI have generated controversy among Sharī‘ah scholars, market players and investors § The AAOIFI Pronouncements on sukuk in 2008: 1. Do not stand as substitutes for the earlier guidelines 2. They are merely clarifications/directives on guidelines to avoid misapplication of requirements for issuance of investment sukuk and the Sharī‘ah rulings for their trading in the Islamic capital markets Kuwait University - College of Business Administration 33

Structuring Sukuk and Shariah risk § A recent controversy paralysed Sukuk markets when Sheikh Taqi Usmani, chair of the AAOIFI Shariah board, announced in 2007 that majority of equitybased Sukuk such as Mudaraba and Musharaka were not structured in an Islamic acceptable way. § For instance, when structuring the question of ownership must be clearly identified. It is not simply enough that Sukuk are asset ‘based’ but they must be asset ‘backed’ and therefore represent real ownership which will provide sureness for investor in case of the default. It is only in this situation that performance of the assets will be linked with profitability of investment and not arbitrary interest rate. Kuwait University - College of Business Administration 34

Contemporary Issues 1. Sukuk should be issued for new commercial and industrial ventures. If they are issued for established businesses, then the Sukuk must ensure that Sukuk holders have complete ownership in real assets. 2. The returns of enterprises should be returned to Sukuk holders regardless of what amounts they reach after costs, including the manager's fees, or the share of the mudarib in profits. If there is to be an incentive for a manager, then let it be based on the profits expected from the enterprise and not on the basis of an interest rate. 3. It is unlawful for a manager to lend money when actual profits are less than expected. 4. It is unlawful for a manager, whether a mudarib or a partner or an agent, to commit to repurchase of assets at face value. Instead, their resale must be undertaken on the basis of the net value of the assets, or at a price that is agreed upon at the time of purchase. 5. Shariah supervisory boards must abide by the Shariah Standards issued by the Shariah Council. Kuwait University - College of Business Administration 35

Rating of Islamic Bonds § Bond credit rating is the assessment of the credit worthiness of a corporation’s debt issues or government bonds. The designated grades range from ‘AAA’ which is considered as the highest grade to ‘C’ § Credit rating allows potential investors to make informed decisions before subscribing to debt securities. § There are over 50 rating agencies across the world. § The leading rating agencies: Moody's, Standard & Poor's (S&P), & Fitch‘s Rating Kuwait University - College of Business Administration 36

Rating of Islamic Bonds § Different countries have their own rating agencies, such as Malaysia, India, Bangladesh, and Sri Lanka § The two popular classifications of bonds while rating their quality are: 1. Investment grade bonds’ 2. Junk bonds’ § The Islamic International Rating Agency (IIRA) which was established by the IDB began operations in 2005 and has since been striving to ensure quality in the Islamic finance industry Kuwait University - College of Business Administration 37

Types of Islamic Bonds Ratings Islamic bonds can be rated on two bases: - Sovereign - Corporate First: Sovereign Ratings § Sovereign credit rating is the credit rating of a sovereign entity such as a national government § The risk level of the regulatory, political, economic and legal atmosphere comprises a crucial factor in sovereign credit ratings Kuwait University - College of Business Administration 38

Rating of Islamic Bonds In the country risk rating, Euromoney Country Risks consider the following factors in the ranking of countries by risk: 1. Political risk 2. Economic performance/projections 3. Structural assessment 4. Debt indicators 5. Credit Ratings 6. Access to bank finance 7. Access to capital markets Kuwait University - College of Business Administration 39

Corporate Ratings § Corporate credit rating is a credit worthiness rating in form of financial indicator to potential investors of debt securities such as sukuk § Corporate credit ratings play a significant role in the economy of a country and, more importantly, it promotes stability and sustainability in the financial industry § The level of risk surrounding a business entity determines the confidence prospective investors will have in it § Corporate entities must adopt best practices (reducing their risk level, demonstrating ability to meet financial obligations) Kuwait University - College of Business Administration 40

Rating of Islamic Bonds § The rating products in Islamic financial markets consist of all types of issuers and sukuk issues. § In the Islamic financial markets, corporate ratings involve: - Bond/sukuk ratings - Bank’s financial strength ratings - Sharī‘ah quality ratings - Corporate governance ratings - Real estate ratings etc Kuwait University - College of Business Administration 41

Rating Products and Methodology The IIRA identified the following eight major rating products: 1. 2. 3. 4. 5. 6. 7. 8. Sovereign Ratings Issuer Ratings Bond/sukuk Ratings Insurer Financial Strength Rating Banks Financial Strength Rating Sharī'ah Quality Ratings Corporate Governance Ratings Real Estate Ratings Kuwait University - College of Business Administration 42

Sovereign Ratings § A reliable third party gives an opinion on the feasibility of the repayment of the issuer or an issue of its financial obligations within the record time § The general rating of countries as sovereign entities is first carried out before the rating of particular issue or institution Methodology § Involves both qualitative and quantitative factors § Assessing the likelihood of default on debt obligations for sovereign sukuk Kuwait University - College of Business Administration 43

IIRA Ratings considers the following six analytical categories while assessing the likelihood of default on debt obligations for sovereign sukuk at maturity 1. Politics and Policy Continuity 2. The Economy–Structure and Growth Prospects 3. Budgetary and Fiscal Policy 4. Monetary Policy and Flexibility 5. The External Accounts 6. Internal and External Debt Kuwait University - College of Business Administration 44

Issuer Ratings § Rating sukuk issuer with special emphasis on ability to fulfill its financial obligation § Non-financial organs such as the corporate and Sharī‘ah governance of the entity from the bond/sukuk ratings Methodology § Non-financial organs rated with particular regards to credit worthiness and continued ability to fulfil debt obligations to stakeholders § Overall financial and institution credit worthiness of issuer determines level of investors’ confidence potential Kuwait University - College of Business Administration 45

Bond/Sukuk Ratings § Rating of sukuk in financial markets is as important to investors as to the issuer § Investors aspire to receiving dividends in a timely manner after subscribing to sukuk Methodology: § Documented terms and covenants of the issued sukuk are evaluated and the risk/return is measured § Viability of such sukuk in the secondary market will proportionally increase the number of subscribers Kuwait University - College of Business Administration 46

Insurer Financial Strength Ratings § Financial strength of the insurer of the sukuk will help in avoiding or mitigating risks § Insurer of the sukuk must have corporate ability and requisite financial strength to meet contractual obligations § IIRA aims to be a source of reliable information and ratings, encouraging growth of a financially strong insurance industry § IIRA believes it has a vital role encouraging prudent management of insurance companies and improving the industry’s strength for the benefit of all stakeholders Kuwait University - College of Business Administration 47

Insurer Financial Strength Ratings Methodology § IIRA assesses: 1. - The current financial strength and the sustainability of such financial strength of the insurance company 2. - The capability of the insurance company to meet the obligations of the policy holders and other contract holders such as the shareholders § Qualitatively, the country risks of the domicile of such company as well as its business profile are analysed Kuwait University - College of Business Administration 48

Banks Financial Strength Rating § IIRA adopts global financial practices in rating both Islamic and conventional financial institutions § The main issues in banks’ financial strength ratings is investment quality and credit worthiness § The key subject headings in IIRA’s asset quality analysis are: § § § § Banking Environment Credit or Investment Policies and Loan Administration Procedures Portfolio Composition and Characteristics Risk Management Practices Lending History and Performance Forecasting the portfolio and quality Analytical conclusions regarding economic values Kuwait University - College of Business Administration 49

Banks Financial Strength Rating Methodology § Fundamentals for assessment of banks’ financial strength: § - Market assessment § - Consideration of factors determining asset quality § - Liquidity and fund management § - Asset/Liability management § - Capital adequacy § - Adjustments to achieve economic reality § - Finance, information systems, planning disciplines § - Earnings Performance § - Ownership and management performance, reflecting all the above § - Emphasis on ability of financial institution to make profits and pay dividends Kuwait University - College of Business Administration 50

Sharī'ah Quality Ratings § Seek to assess the level of Sharī‘ah compliance of Islamic financial institutions, corporate entities or conventional financial institutions offering Islamic financial services or products such as sukuk § The Sharī‘ah quality rating aims at informing the investing public on the level of compliance of certain corporate entities with the requirements of the Sharī‘ah Kuwait University - College of Business Administration 51

Sharī'ah Quality Ratings Methodology § Assessing levels of compliance of financial institutions or corporate entities with the requirements of the Sharī‘ah: § - Authentication of products and services § Safeguards against comingling of funds in the case of an Islamic window or branch of a conventional financial institution § Code of ethics adopted by the institution § Policy of the calculation of profit or loss and the consequent sharing of same Kuwait University - College of Business Administration 52

Corporate Governance Ratings Prospective investors consider the ratings of corporate governance/corporate entities before investing § IIRA issues an independent opinion of available managerial structure and practices though variety of characteristics e. g. : §- Transparency and adequate disclosure § - History, board performance, demonstrated trustworthiness §- Management: who is the actual governor (CEO or executive team) § - Effectiveness the top management team/process §- Shareholders Kuwait University - College of Business Administration 53

Corporate Governance Ratings Methodology § Best practices in the corporate governance rating of corporate entities are used as benchmarks for assessment rather than using standards of particular country/jurisdiction § The level of fairness, transparency, responsibility and accountability are considered key in the evaluation process Kuwait University - College of Business Administration 54

Real Estate Ratings IIRA’s rating on real estate pertains to the overall rating of the developer and is not a rating of a particular project unless a specific project rating is requested § The rating is assigned after taking into account: § - Market characteristics § - The organizational structure and management quality of the developer § - Assessment of each of the projects in the portfolio the developer is executing Kuwait University - College of Business Administration 55

Real Estate Ratings Methodology § The real estate rating methodology designed by IIRA aims at providing the stakeholders with a balanced view of the strengths and weaknesses of the developer and to create a healthy environment in the industry § IIRA will analyze all on-going projects of the developer and arrive at an overall rating of the developer § The developer’s activities such as the performance of its architects, engineers, contractors, and other necessary personnel are rated accordingly Kuwait University - College of Business Administration 56

Rating Symbols and Definitions § Rating agencies convey respective opinions or decisions to the investors & other stakeholders through the use of symbols § Level of credit worthiness or the grade is determined by certain symbols § The IIRA has two major categories of rating symbols: § The International Scale Ratings: focuses on foreign-currency debt, external account liquidity, and factors affecting a country’s balance of payment § National Scale Ratings: emphasises on the capacity of a government and other institutional borrowers within a country to meet their local currency debt obligations Kuwait University - College of Business Administration 57