Sukuk is a Sharia-compliant financial product provided to Muslims as an alternative to traditional bonds. The value of the underlying asset determines its face value. This financial certificate allows the investor to hold a portion of identifiable assets, projects, businesses, or investments. As a result of the undivided asset ownership, the holder receives returns or cash flows in profits, rent, or both.

1. The issuer sets up an offshore SPV.2. SPV sells trust certificates to investors.3. The issuer receives the proceeds from the certificate sale and purchases the sharia-compliant asset.4. SPV purchases the asset from the issuer and pays the asset sale proceeds to the issuer.5. The issuer then distributes proceeds among investors.

Sukuk

Publication Date :

30 Jan, 2022

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Table Of Contents

Sukuk Definition

Sukuk refers to financial instruments issued through a special purpose vehicle as certificates or notes for Muslims. It complies with Sharia, an Islamic religious law, and serves as a viable alternative to traditional interest-bearing bonds. The issuer uses proceeds from the certificate sale to purchase a tangible asset, giving the investor direct partial ownership.

Bonds pay borrowers a fixed or floating interest rate for a set period. But Sharia forbids Muslims from paying or charging interest (riba in Islamic law) as such investments are not halal in Islam. Returns on sukuk might be in the form of profit, rent, or both. In addition, the issuer must buy back the certificate at par value at a later period.

Key Takeaways

Sukuk is an Islamic financial certificate or note issued by a special purpose vehicle. It adheres to Sharia, an Islamic religious code, and substitutes for a standard interest-bearing bond.
The issuer sells the certificate to the investor and uses the proceeds to purchase a physical asset, giving the investor direct partial ownership.
Investors can share the earnings generated by the asset they hold rather than any form of interest. The returns might take the form of profit, rent, or both.
The sukuk types accessible in the market are Sukuk al Murabaha (Debt), Sukuk al Ijarah (Property), Sukuk al Istisna'a (Project), Sukuk al musharaka (Business), and Sukuk al Istithmar (Investment).

How Does Sukuk Work?

Sukuk is not a bond (interest-bearing security), which is not halal under Sharia law. Instead, this financial certificate provides partial ownership in identifiable assets, projects, businesses, or investing activities. As a result, the holder earns returns or cash flows as profits, rent, or both from the undivided asset ownership. The sharia-compliant certificate is issued through a special purpose vehicle (SPV) that the issuer sets up to raise funds.

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The term sukuk derives from the Arabic word ‘sakk,’ meaning certificate. The issuer issues the certificate to the investor and promises the ownership rights in the current or future asset for a specific period. Once the investment is made, the investor is entitled to a portion of profits and losses (not debt obligation or interest) associated with the asset per the terms of the agreement.

Each sukuk has a face value based on the underlying asset's value, which the investor should pay or purchase at a discounted rate. The future cash flow derived from the underlying asset is deposited as the current cash flow.

Sukuk Process

The process of issuing sukuk is as follows:

The issuer, obligator, or originator (business or government) seeking financing forms an offshore SPV, an incorporated entity. It shields the underlying asset from creditors if the originator suffers financial difficulties.
SPV sells trust certificates to investors, giving them partial ownership of the underlying tangible asset and allowing them a share in its profits.
The certificate details the specific asset, project, joint venture, or investing activity and the quantity of the investment, its face value, interest rates, and maturity period.
The issuer receives the proceeds from the sale via a finance contract, which it uses to purchase the sharia-compliant asset.
SPV purchases the asset from the issuer and pays the asset sale proceeds to the issuer. In addition, the former can lease the asset back to the issuer and collect lease payments from the latter.
Lease payments are dispersed as lease income by SPV to investors.
When the lease term ends, the issuer pays SPV face value for the asset.
The proceeds of this transaction will be distributed to investors.

Structure

Asset-based and asset-backed sukuks are both possible. The former requires the issuer to purchase the underlying sharia-compliant asset, invest or lease it on behalf of the investor, and then use the proceeds. On the other hand, the latter entitles the investor to a portion of the tangible asset’s profits or losses.

The certificate can be categorized into the following types based on the form of ownership held by the investors:

Sukuk al Murabaha (Debt)
Sukuk al Ijarah (Property/Asset)
Sukuk al Istisna’a (Project)
Sukuk al Musharaka (Business)
Sukuk al Istithmar (Investment)

Examples

Let us consider the following sukuk examples to understand the concept better:

Example #1

Mehwish, an investor, met Alec, whose company suffered from financial turmoil. Alec called Mehwish to present a proposal and said how profitable his company has been in the past and is likely to continue in the same way in the future. He tells her about his attempt to raise capital by inviting more and more investors into the venture. Alec asked Mehwish to join him.

Being an Islam follower, Mehwish was not ready to invest in bonds. Thus, Alec offered her sukuk certificates and promised profit-sharing as agreed upon by both parties.

Example #2

Indonesia granted $2.7 million for the Maluku Conservation Center under a green sukuk fund for biodiversity objectives in 2020. In addition, the sukuk has been used to fund important infrastructure projects in the country, such as railways, harbors, airports, etc. The investors gain a percentage of the profit from public infrastructure because the government issues the financial certificate.

Sukuk vs Traditional Bonds

The word sukuk is often mistakenly substituted by Islamic bond, which is not an acceptable investment under Sharia law. When a sukuk is stated to be Sharia-compliant, it signifies that it follows the following rules:

The profit earned only through commercial risk-taking and trade is the return on investment.
No financial interests of any type are permitted.
The assets in question must be halal.

When comparing sukuk with conventional bonds, there are many similarities and differences:

Similarities

Investors will receive payouts
Sold to investors with a set maturity period and can be used to raise funds for a variety of reasons
Superior and safer investing alternatives to equities
Issuers sell them, and they can be traded over the counter or on stock exchanges

Differences

Element	Sukuk	Traditional Bonds
1. Ownership	Non-debt market Direct ownership interest in the asset	Debt market Indirect interest-driven debt obligations
2. Underlying Asset	Must be Sharia-compliant	Any asset, business, or project
3. Nature of Investment	Exhibits features of equity and debt	Debt instrument
4. Income	Profit sharing (halal)	Interest payments (riba)
5. Valuation	Face value derived from the value of the underlying assets	Valued as per investor’s credit rating
6. Compliance	Sharia-compliant	Complies with the nation or region of issuance
7. Returns	May increase in value with the rise in the asset’s value	Fixed interests
8. Principal Amount	May or may not return the initial investment	Guaranteed return
9. Intermediary	Special Purpose Vehicle	Underwriter