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Islamic SukukConcept & Applications
Muhammad Faisal ShaikhHead,Corporate & Product
Development BankIslami Pakistan Ltd
Ramadan 13, 1428September 26, 2007
Islamic Sukuk-Introduction
Bonds are important part of overall financial system.
Well developed bond markets ensures stable financial system as it minimize over-reliance on financing from the banking sector.
The development of the bond market allows for access to funding with the appropriate maturities, thus avoiding the funding mismatches. It also allows for the diversification of risks by issuers and investors.
Islamic Sukuk-Introduction
Dealing in Bonds is not permissible according to Shariah because of two aspects.
Firstly, they represent a portion of Debt payable by the issuer. Earning any kind of profit falls under the category of RIBA as defined in the Hadith
“Every loan that draws any premium is Riba”.
Hadith is reported by Hazrat Harith ibn Abi Usamah in his Musnad. (See Supreme Court Judgment December 23, 1999)
Islamic Sukuk-Introduction
Second aspect pertain to the trading of Bonds.
Shariah prohibits trading of debts (Bai Dayn) as it involves Gharar.
Sukuks( ) are developed as alternative of Bonds.
A Sukuk represents proportionate actual or beneficial ownership in an Asset or a Pool of identified assets.
For a defined period the Risk and Return associated with such Assets belong to Sukuk holders which makes their return permissible for the holder.
Islamic Sukuk-Introduction
Trade of such Sukuks is permissible, because it will be equivalent to the sale/ purchase of holder’s proportionate share in the assets.
However, trading of Murabahah and Salam Sukuks is not permissible.
Islamic Sukuk-Introduction
Islamic Sukuk-Difference with Bonds
Sukuks Represents the direct
pro rata ownership of the holder in the assets of the pool.
Sukuk holder generally earn return from income generated through the asset
Conventional Bond The bond stands for a
loan repayable to the holder in any case, and mostly with interest.
Today, the global Sukuk market, denominated in international currencies, is estimated to be $18 billion. If domestic sukuk issuance is included, it has now exceeded $50 billion.
Although the size of the market may seem modest by global standards, the sukuk market has been registering an average growth of 40% per annum.
Islamic Sukuk-International Overview
Source:Dr Zeti Akhtar Aziz, Governor, Bank Negara Malaysia, Sukuk Summit 2007, London Khaleej Times (June 22, 2007)
High levels of surplus savings and reserves in Asia and Gulf region has further boosted demand for Sukuks. Asia has a savings rate which is higher than any other region in the world and is expected to remain between 30 and 40 per cent of GDP for many years to come.
The Middle East and in Asia, two of the fastest growing regions in the global economy are expected to spend $500 billion and $1 trillion respectively on infrastructure over the next five years — Islamic capital market, in particular the sukuk market, will serve as an important avenue to meet these funding requirements.
Source:Dr Zeti Akhtar Aziz, Governor, Bank Negara Malaysia, Sukuk Summit 2007, London Khaleej Times (June 22, 2007)
Islamic Sukuk-International Overview
In Pakistan, the first Islamic Sukuk was issued in 2002 when Sitara Chemicals Industries issued its MTFC.
However, the market really started in FY 2005 and since then Sukuks worth at least Rs. 30 billion has been issued or are in the process of issuance.
Market is growing at a very healthy rate as large corporates and conglomerates such as WAPDA, Engro Chemicals, PEL, EDEN Developers, Maple Leaf Cement, etc are using Sukuk to fund their requirements.
Islamic Sukuk- Local Overview
The issuance of Sukuk requires an exchange of a Shariah compliant underlying asset for a financial consideration through the application of various Islamic commercial contracts such as the Mudarabah, Musharakah, Ijarah, Istisna, Salam and Murabahah.
The equity-based nature of Mudarabah and Musharakah Sukuk exposes investors to the risks connected with the performance of the project for which the financing is raised.
Islamic Sukuk-Types
In contrast, issuance of Sukuk on principles of Ijarah and Murabahah yields deterministic receivable and hence result in predictable and somewhat fixed returns for the prospective investors.
Islamic Sukuk-Types
Sukuk Al Ijarah
Ijarah is an Islamic alternate of conventional leasing.
Issuing certificates of ownership of assets, leased to a particular customer is known as Sukuk Al Ijarah or simply Ijarah Sukuk.
Ijarah Sukuk concept is one of the most popular concepts among issuers of global Islamic Sukuk.
A simple process is explained next.
Islamic Sukuk-Sukuk Al Ijarah
If a Company requires, for example, Rs. 500 million for the purchase of land, real asset, equipment etc it can issue Ijarah sukuk equaling that amount in small denominations, say Rs. 500,000 each.
After collection of funds from the investors the company either purchases the asset on behalf of the Sukuk investors or transfers the ownership of the already acquired asset to sukuk holders usually by establishing a Special Purpose Vehicle (SPV), which owns the underlying assets.
Islamic Sukuk-Sukuk Al Ijarah
The investor or sukuk holders owns the asset held by SPV as Trustee in the form of Sukuk. The asset is then leased to the firm and the lease proceeds from the asset is distributed to the sukuk holders as return/dividend.
The returns on the sukuk certificates could be either fixed or floating. As the expected returns (pre-determined rental payments) are fixed and can be treated as predictable like the coupon payments of a conventional bond.
Islamic Sukuk-Sukuk Al Ijarah
Ijarah sukuk can be issued through a financial intermediary, a bank or a brokerage house or directly by the users of the lease asset. A third party can also guarantee rental payments.
Since the yield is predetermined and the underlying assets are not liquid but tangible and secured, thus the Ijarah certificate can be freely traded in the secondary markets at par, premium or discount.
Islamic Sukuk-Sukuk Al Ijarah
Sukuk Al Ijarah
Structure
ABC Ltd. wishes to purchase a new asset and plan to raise finance through issuance of Islamic Sukuk.
ABC
Ltd.
(Corporate)
Supplier
ABC
Ltd.
Supplier of the Asset is identified and negotiations is finalized by ABC Ltd.
Supplier
ABC
Ltd.
SPV is created by ABC Ltd. as a limited liability Company.
Issuer
SPV (LLC 100% owned
ABC Ltd.)
SPV issues certificates and receives proceeds which are used to purchase asset
from the supplier
Sukuks
Proceeds
Payment made to SupplierTitle is
transferred to SPV
SupplierIssuer
SPV (LLC 100% owned
ABC Ltd.)ABC
Ltd.
Investors
ABC
Ltd.
SPV holds Asset as Trustee and leases the plant to ABC
Ltd. as per rules of Ijarah
Issuer
SPV Investor
SPV holds Plant/ Asset as Trustee
SPV leases Plant to ABC Ltd. on Ijarah
ABC Ltd.
(Lessee)
Periodic Lease Rentals
Semi-annual coupon distribution amounts
Issuer
SPV
Investors
ABC Ltd. (Lessee) pays periodic rentals to SPV for tenors & amounts matching the
coupon & tenor of the Sukuks
Redeems the Trust Certificates at dissolution
Exercises the purchase undertaking. Asset transferred to ABC Ltd.
Pays the exercise price at dissolution
•ABC Ltd (Lessee) give the SPV an irrevocable purchase undertaking to purchase the Asset at maturity.•Exercise Price = Initial Purchase Price of Asset + service costs.•Asset is transferred back on maturity, upon payment of the Exercise Price to the SPV / Sukuk Holders.
ABC Ltd.
(Lessee)
Issuer
SPV
Investors
Ijarah Sukuk represents the holder's proportionate ownership in the leased asset.
The holder will assume the rights and obligations of the owner/lessor to the extent of his ownership.
As owner the holder will have the right to enjoy a part of the rent according to his proportion of ownership in the asset.
Islamic Sukuk-Sukuk Al IjarahImportant Conditions
In the case of total destruction of the asset, holder will suffer the loss to the extent of his ownership.
SPV rules in Pakistan does not allow SPV to hold actual tangible assets, therefore, the asset is shown on the books of the client itself instead of SPV.
Islamic Sukuk-Sukuk Al IjarahImportant Conditions
Islamic Sukuk-Sukuk Al Ijarah
Essential ConditionEssential Condition
“It’s essential that the Ijarah Sukuks are designed to represent real ownership of the leased assets, and not only a right to receive rent.”
In Pakistan essentialy the same structure has been used to develop Sukuks based on Diminishing Musharakah.
Islamic Sukuk-Sukuk Al IjarahInnovation in Pakistan
There are two basic differences in Diminishing Musharakah Sukuks:
Underlying Assets is jointly owned by investors and issuer according to specified percentage.
Ownership is also transferred periodically to the issuer.
Ijarah is essential part of a Diminshing Musharakah transaction under Shirkatul Milk.
Islamic Sukuk-Sukuk Al IjarahInnovation in Pakistan
Documents executed in a Sukuk Issue based on Diminishing Musharakah (under Shirkat-ul-Milk arrangement) are:
1. Investment Agency Agreement2. Asset Purchase Agreement3. Musharakah Agreement4. Service Agency Agreement5. Payment Agreement6. Undertaking to Purchase Sukuk Units7. Undertaking to Sell Sukuk Units8. Trust Deed9. Letter of Hypothecation/Other Security Documents
Islamic Sukuk-Sukuk Al IjarahDocumentation
1. Investment Agency Agreement
Through this Agreement, all Participating Islamic Financial Institutions ('Investors') appoint a Bank/FI as 'Investment Agent' to carry out all actions (including entering into all Sukuk related Transaction documents) for and on behalf of all Investors in respect of Sukuk Issue.
Islamic Sukuk-Sukuk Al Ijarah
2. Asset Purchase Agreement
Investment Agent (acting for and on behalf of Investors) buys undivided beneficial ownership in specified fixed assets ('Musharakah Assets') in partnership with Issuer at a pre-agreed price (equivalent to the Sukuk Issue Amount) via the Asset Purchase Agreement.
Legal title of the assets remains with the Issuer and only the beneficial title will remain with the Investors.
Islamic Sukuk-Sukuk Al Ijarah
2. Asset Purchase Agreement
Musharakah Assets can be:
(i) Already existing, and owned by the Issuer. This would become a Sale and Lease Back (SLB) case. SLB cases are done only after approval of Shariah Adviser and are undertaken mainly to settle existing conventional banking loans of Issuer.
(ii) New, and would be purchased from third party. E.g. fixed assets purchased for expansion projects.
Islamic Sukuk-Sukuk Al Ijarah
3. Musharakah Agreement
Investment Agent (acting for and on behalf of Investors) and Issuer will enter into a Musharakah Agreement to jointly own Musharaka Assets.
Each Investor’s entitlement to the Musharakah Assets will be undivided and shall for the purpose of more particular determination constitute of ‘Sukuk Units’. Share of each Co-Owner will be specified in the Musharakah Agreement.
Islamic Sukuk-Sukuk Al Ijarah
4. Service Agency Agreement
Issuer is appointed 'Service Agent' via signing of Service Agency Agreement between Investment Agent (acting for and on behalf of Investors) and Issuer.
Service Agent will be responsible for:
(i) Ensuring all major maintenance of the Musharakah Assets;
Islamic Sukuk-Sukuk Al Ijarah
4. Service Agency Agreement
(ii) Paying ownership related expenses and taxes; and (iii) Arranging Takaful/Insurance of the Musharakah Assets.
Such ownership related expenses/taxes incurred by Service Agent on behalf of Musharakah Co-Owners will be reimbursable from Investment Agent.
Islamic Sukuk-Sukuk Al Ijarah
5. Payment Agreement
Investment Agent (acting for and on behalf of Investors) will allow Issuer to use Investors' share of the Musharakah Assets against periodical KIBOR-benchmarked Rental Payments in terms of the Payment Agreement.
From Shariah perspective, this is basically an Ijarah Agreement. The tenor of the Payment Agreement will be matched with the Musharakah tenor.
Islamic Sukuk-Sukuk Al Ijarah
6. Undertaking to Purchase Sukuk Units
Undertaking to Purchase Sukuk Units is a promise undertaken by Issuer in favor of the Investment Agent for: (i) the periodical purchase of Sukuk Units (representing Investors' undivided beneficial ownership in the Musharakah Assets); and
(ii) the purchase of all outstanding Investors' Sukuk Units in case of an Event of Default.
Islamic Sukuk-Sukuk Al Ijarah
7. Undertaking to Sell Sukuk Units
Undertaking to Sell Sukuk Units is a promise undertaken by the Investment Agent in favor of Issuer granting a call option to Issuer to purchase all or part of the Sukuk Units.
In SLB cases, purchase/sale of Sukuk Units will only start after at least one year from the Musharakah Commencement Date/Asset Purchase Date.
Islamic Sukuk-Sukuk Al Ijarah
8. Trust Deed
Trust Deed will be executed between Trustee (appointed by Investors for the Sukuk Issue) and Issuer detailing the responsibilities of the Trustee during the tenor of the Sukuk Issue.
Islamic Sukuk-Sukuk Al Ijarah
9. Letter of Hypothecation/Other Security Documents
Letter of Hypothecation and Other related Security Documents will be executed by Issuer in favor of Trustee for security purposes.
Islamic Sukuk-Sukuk Al Ijarah
Sukuk Al Salam
Islamic Sukuk-Sukuk Al Salam
Salam is an Islamic mode of finance. Under a Salam transaction the seller makes an advance payment for goods which are to be delivered later provided the goods are defined and the date of delivery is fixed
Government of Bahrain first issued Salam Sukuks as an alternate to short term government treasury bill.
Islamic Sukuk-Sukuk Al Salam Under the transaction Government took
an advance payment from the investors for a future delivery of Aluminum ingots. A paper was issued as an acknowledgment of receipt which is known as Salam Sukuk.
Upon delivery of Aluminum ingots to the investors at the time of completion of Salam contract, Government sold ingots to third parties as agent of the investors.
The difference between Sale and Purchase price was the profit of the investors.
Islamic Sukuk-Sukuk Al Salam On the same lines Government of
Pakistan can also issue Salam Sukuks to cater to the short term liquidity management issues of Islamic Banks.
A proposed structure is discussed next.
Islamic Sukuk-Sukuk Al Salam On behalf of Govt. of Pakistan, Zarai
Taraqiati Bank Limited (ZTBL) may sell the commodity to the buyers on Salam basis which in this case would be Islamic Banks.
In this transaction, various banks may
participate in the Sukuk and one Bank would act as trustee nominated to represent other banks wishing to participate in the Al Salam contract.
Islamic Sukuk-Sukuk Al Salam As consideration for advance payment,
ZTBL will undertake to supply a specified amount of a commodity say wheat at a future date. ZTBL would arrange the commodity by providing Shariah compliant funding to farmer e.g. It may purchase wheat on the basis of Salam from the farmers.
Simultaneously a third party such as PASSCO may provide an undertaking to the Trustee to purchase wheat at an specified higher price thus ensuring profit of the investor banks.
Islamic Sukuk-Sukuk Al Salam Upon delivery Trustee would appoint
PASSCO its agent to take delivery from ZTBL.
After taking delivery its premises PASSCO will inform the Trustee which would sell the wheat to PASSCO.
Payment received from PASSCO would be distributed among the investor banks along with the profit.
Banks may also provide funding on the basis of Murabahah to PASSCO for the purchase of same wheat.
Islamic Sukuk-Sukuk Al Salam
Salam Sukuk represent investors shares in the Advance Price paid to the seller.
Since its a dayn, it cannot be traded in the secondary market.
Important Conditions
Islamic Sukuk-Sukuk Al Murabahah Sukuks can also be issued against a
Murabahah transaction. Under the transaction investors would provide funding to purchase some assets for the issuer. Acknowledgment of their investment would be regarded as Murabahah Sukuk.
The asset would be purchased from its supplier and would be immediately sold to the issuer against deferred price.
Profit earned from the transaction would be distributed among the investor proportionately.
Murabahah Sukuk represent investors shares in receivable from the purchaser
Since its dayn, it cannot be traded in the secondary market.
Islamic Sukuk-Sukuk Al MurabahahImportant Conditions
Sukuk Al Musharakah
Musharakah is a mode of financing against which Sukuks can be issued.
If a comapany required financing for any of its project through Musharakah it can issue Sukuks against which investors would provide funding as per the rules of Musharakah.
Islamic Sukuk-Sukuk Al Musharakah
Every Sukuk would represent holder's proportionate ownership in the assets of the Musharakah.
Once the majority of the cash amount is converted into fixed assets, these Musharakah Sukuk can be treated as negotiable instruments in the secondary market.
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Islamic Sukuk-Sukuk Al Musharakah
Profit earned by the Musharakah is shared according to an agreed ratio between the Issuer and Investors at an agreed ratio.
Loss is shared on pro rata basis.
Profit & Loss is shared between the investors as per investment ratio only.
Islamic Sukuk-Sukuk Al MusharakahImportant Conditions
To ensure tradability of the Sukuks following condition should be adhered to:
All the assets of the Musharakah should not be in liquid form.
At least 20% of the value of Portfolio should be invested in non-liquid assets.
Islamic Sukuk-Sukuk Al MusharakahImportant Conditions
Musharakah Sukuks can be used for number of purposes including:Construction of Projects and
factoriesExpansion ProjectsWorking Capital Finance
Sitara's Musharakah's TFC advised and arranged by Meezan Bank Ltd. is an excellent example of a Musharakah Sukuks.
Islamic Sukuk-Sukuk Al Musharakah
Musharakah Term Finance Certificates
bySitara Chemicals Industries Ltd
Sitara Chemical Industries Limited
Incorporated In Year 1981, Listed on
All Stock Exchanges in Pakistan.
Commencement Of Commercial
Production in 1984.
The Company’s Core Business is
Manufacturing of Caustic Soda -
Largest Producer Of Caustic Soda In
Pakistan.
Islamic Sukuk-Sukuk Al Musharakah
Issuer Sitara Chemical Ind.
Total Issue Size Rs. 360 Million
Private Placement Rs. 255 Million
Public Issue Rs. 105 Million
Tenor 5 years (Aggregate)
Profit Payment Six monthly
Based on profit and loss sharing on the
Operating profits of the Chemicals Division
Islamic Sukuk-Sukuk Al Musharakah
Issue Value of Rs 360 Mn
PSR for 1st Rs 100 Mn Operating Profit Level
-1
For each Subsequent Rs 100 Mn of
Operating Profit
MTFC Holders
Company MTFC Holders
Company
100% O/S 43% 56.8% 7.2% 92.8%
67% O/S 28.9% 71.1% 4.8% 95.2%
33% O/S 14.3% 85.7% 2.4% 97.6%
Profit was linked to the Operating Profit of the Chemical Division.
Level 1 Profit: On First Rs. 100 Million
Operating Profit @ 12% p.a. of the
Outstanding Principal.
If Operating Profit is less than Rs. 100
Million then:
Actual profit entitlement rate = (Actual
Operating profit/
Rs.100 million)* 12%
Profit & Loss Sharing
Islamic Sukuk-Sukuk Al Musharakah
Level II Profit:
2% p.a. of the outstanding principal on
each subsequent Rs. 100 million
operating profit(over and above first Rs.
100 Million).
If operating profit falls between the two
brackets of Rs. 100 million then:
Profit entitlement rate=(Actual operating
profit/Rs. 100 Million) * 2%
Profit & Loss Sharing
Islamic Sukuk-Sukuk Al Musharakah
The Company formed and maintains
Takaful Reserve during the tenor of the
TFCs to mitigate the risk of loss for the
TFC holders.
TFC holders also contributed 25%
(1/4th ) of their level II Profit to
Takaful reserve annually during the
tenor of the TFCs.
Profit & Loss Sharing- Takaful Reserves
Islamic Sukuk-Sukuk Al Musharakah
The Company transfered Rs 50mm in the
reserve.
In case of no losses during TFCs tenor the
amount contributed by the company and
TFC holders will be paid on final settlement.
Profit & Loss Sharing- Takaful Reserves
Islamic Sukuk-Sukuk Al Musharakah
Islamic Sukuk-Other types
Sukuks are also issued under other Islamic mode of finance and currently much focus is given Sukuk Al Intefah which is transfer of usufruct instead of ownership of the asset.
Other types include Sukuk Al Muzar'a (sharecropping), Sukuk Al Musaqa (irrigation), Sukuk Al Mugharasa (agricultural) etc.
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Islamic Sukuk-Other types
Sukuks are also issued under hybird structures where number of Islamic modes of finance are used to issue a single Sukuk.
Under these structures each of Islamic mode is applied at different intervals to cater to different requirements of the issuer.
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Islamic Sukuk-StandardizationAAOIFI has also issue Shariah
standards for Sukuks and its expected that issuance of these standards would help reducing differences in fatwas issued for Sukuks.
Islamic Sukuk-Criticism
Some Sukuks are criticized for their close resembelence with conventional bonds.
Many times these closeness is created to adhere to the tax and other regulatary laws of the country.
For example, in Pakistan SPVs cannot hold actual assets. For this reason assets cannot be carved out from the balance sheet of the issuer which creates complexities in identification of the assets and only a hypothecation charge ensures bank's benefical ownership in the Musharakah assets.
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Islamic Sukuk-Criticism
Similarly, concept of the Diminishing Musharakah financing is not there in the stamp duty laws of Pakistan, which compels banks to sell share in assets without any legal registration.
It should be noted that concept of Diminishing Musharakah is recognized in British stamp duty laws since April 2003.
Nevertheless, not all of this criticism is incorrect, and therefore it should be ensured that unesseccary usage of artificial structures should be avoided as much as possible.
Islamic Sukuk-Criticism
The problems could be resolved by Shariah rating systems
This will help investors in making informed decisions regarding the authenticity of the Shariah structure of the Sukuk.
Islamic Sukuk-Benefits
Sukuk can be used very effectively as a halal alternate to conventional bonds for provding funding for matching maturities and without relying too much on commerical banking sector.
Another aspect of Sukuks which make them more effective than bonds is there ability to mobilize and motivate investors to work for the overall benefit of the issuer.
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Islamic Sukuk-Benefits
Sukuks based on Ijarah can be used very effectively to finance Government projects.
If general public is involved in the construction of these project through issuance of Sukuks, it can give them sense of ownership.
Effective usage of such Sukus would increase the ratio of success and ratio of sustainbility of the projects by many folds.
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Sukuks for Government Projects
Islamic Sukuk-Benefits
Corporate Sector can also benefit from unique characteristic of Sukuks.
Musharakah Sukuks can be used to associate general customer with the company.
Sense of ownership and share in the profit of the company can be used as a marketing tool for the products of the company especially in FMCG sector.
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Sukuks by Private Sector
Islamic Sukuk-Benefits
“The more company earns the more return investor would get” concept can revolutionalize sales.
Even Sukuks Al Ijarah would help the companies to position themselves as an caring member of the society by involving community in the business of the company.
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Sukuks by Private Sector
Islamic Sukuk-Conclusion
Sukuks can be used very effectively to obtain Shariah Compliant funding which surely bring Allah's blessing and barakah for the business.
Issuers can also benefit from the huge increase in liquidity in the Islamic world, and can tap on these new sources of funds. Raising funding from the Islamic bond market in the current environment has been 10 to 20 basis points lower than mainstream bonds.
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Islamic Sukuk-Conclusion
...And whosoever fears Allah and keeps his duty to Him, He will make his matter easy for him... (Surah Al
Talaq Ayat 04)
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