Sukuk vs. Traditional Bonds: A Comprehensive Comparison
Sukuk is the Arabic term for financial certificates, and it is the plural of Saak. It is considered a substitute or equivalent to conventional bonds in many financial systems.
Debt markets play a vital role within financial institutions, providing an important source of funding alongside the banking sector.
In emerging economies, these markets are still in the early stages of development. According to Islamic law, the payment and receipt of interest (Riba) is strictly prohibited, which is why traditional debt instruments like bonds do not flourish in countries with large Muslim populations.
Therefore, there is a significant demand and need for developing Shariah-compliant alternatives to traditional debt instruments that align with Islamic law.
As a result, Sukuk was introduced to meet this demand, providing a practical Shariah-compliant alternative to conventional bonds while fulfilling the financing needs of clients.
What is Sukuk?
Sukuk is an Islamic financial certificate that represents the holder's ownership in specific tangible assets or services.
Instead of earning interest like conventional bonds, sukuk holders receive proceeds based on their ownership of specific units.
The underlying contract or structure of sukuk must comply with Islamic law. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in its Shariah standard no. 17 has defined "investment sukuk" as "certificates of equal value representing undivided shares in ownership of tangible assets,
usufruct, and services or (in the ownership of) the assets of particular projects or special investment activity."
Meanwhile “the Securities Commission (SC) of Malaysia defines Sukuk as certificates of equal value that signify shared ownership or investment, in accordance with Shariah principles and regulations, as authorized by the Shariah Advisory Council (SAC).”
What are traditional bonds?
Traditional bonds are debt instruments that allow investors to lend money to governments or companies in exchange for regular interest payments.
These are also known as fixed-income products because the investor receives both the principal amount and interest, regardless of whether the borrower makes a profit or incurs a loss.
What are different types of sukuk?
There are different types of sukuks, the most common amongst them are:
1- Sukuk al Murabaha
Sukuk al Murabaha are certificates of equal value issued to fund the purchase of a Murabaha commodity, with the commodity being owned by the Sukuk holders.
2- Sukuk al Musharakah
Sukuk al-Musharakah are partnership certificates representing projects or activities managed under a partnership arrangement, with one partner or an appointed party overseeing the management
3- Sukuk al Mudarabah
Sukuk al-Mudarabah are partnership certificates representing projects or activities managed based on Mudarabah, with the Mudarib appointed from among the partners or others to oversee the management.
4- Sukuk al Wakalah bil Istismar
Sukuk al-Wakalah bil Istismar are partnership certificates representing projects or activities managed through an investment agency, with an agent appointed on behalf of the Sukuk holders to handle the management.
5- Sukuk al Salam
Sukuk al-Salam are certificates of equal value issued to raise working capital for Salam transactions, with the subject matter of the Salam owned by the Sukuk holders.
6- Sukuk al Istisna
Sukuk al-Istisna are certificates of equal value issued to raise funds for the production of goods, with the finished goods owned by the Sukuk holders.
What are different types of bonds?
There are different types of bonds, which are as follows:
1- Corporate bonds
Corporate bonds are issued by companies to raise working capital, with the company promising to repay the principal along with interest to the bondholders. Different types of corporate bonds are:
1.1- Investment grade
Investment grade is a type of corporate bond issued by the company with a high credit quality.
1.2- Speculative grade
these types of bonds are issued by the companies with low credit quality and high-risk default.
2- Callable bond
In this type of bond the issuer can repay before the maturity date.
3- Guaranteed bond
bonds that are that are guaranteed by another corporate to decrease the risk of default.
2- Government bonds
Government bonds are the debt securities issued by the government to raise funds for its activities with a promise to repay the principal with interest.
Types of government bonds are:
2.1 Fixed-rate bonds
these are the type of government bond issued with an interest rate that doesn't change over the life of the life of the bond.
2.2 Floating-rate bonds
bonds that are issued with the interest rate that fluctuates over the life of the bond.
2.3 Treasury-bills
short term debt obligation with the maturity of one or less than one year.
3- Municipal bonds
Municipal is the debt security, issued by local government to raise the fund for the public project with a promise to repay the principal with interest to the bond holder.
Types of Municipal bonds are:
3.1 General obligation bond
This is the type of municipal bond (also known as GO bonds), issued by the government entities and secured by issuing taxing power. These bonds are generally riskier but providing a high yield.
3.2 Taxable Municipal Bond
This is the type of municipal bond, issued by the government and represent a small segment of the municipal bond market and are not tax exempted. These bonds are issued to finance the project that do not provide a significant benefit to the general public.
What are the main differences between sukuk and bonds?
The most common differences between sukuk and bonds are:
i -Sukuk represent the ownership of the holder in underlying assets or projects, in compliance with Shariah principles, while bonds are debt obligations where the borrower (usually a government or corporation) borrows money from investors with the promise to repay them with interest.
ii -Sukuk generate revenue based on profit-sharing or rental income, while bonds provide fixed income based on interest, which is prohibited in Islam.
iii -Sukuk are structured based on various Shariah-compliant contracts, such as Sukuk al-Musharakah, Sukuk al-Murabaha, and Sukuk al-Ijarah, with no elements that violate Shariah principles.
In contrast, bonds are based solely on interest, which is considered haram according to Quranic verses and Hadith.
How are the returns calculated for sukuk?
There are different types of Sukuk, with the returns of some based on profit-sharing, while others are based on rental income.
In Sukuk al-Musharakah, the returns are calculated based on the profit generated by the Sukuk management authority, which can fluctuate over time.
On the other hand, in Sukuk al-Ijarah, the returns are calculated based on the rental income generated by the Sukuk management authority, which is generally fixed for most of the time.
What are the advantages of investing in sukuk over the bonds?
Following are the advantages of investing in sukuk over the bonds:
- 1- Shariah compliance, ensuring that there is no Shariah impermissible factor which violate the Shariah rules and principles.
- 2- Return is based on the performance of the entity, not fixed and tied with the specific rate so in case of no return there will be no obligation on the issuer to pay the return.
- 3- Sukuks are asset backed, which ensure the level of stability and security, while the bonds are unsecured debt obligation.
Read more about: Sukuk Funding vs. Traditional Financing
How to invest in Sukuk?
There are several steps for investing in the sukuks:
1- Opening the Shariah-compliant account with the licensed broker.
2- Choosing the sukuk offering that align with the investment goal.
3- Reviewing the Shariah compliance detail.
4- Placing the order through the broker.
5- Monitoring the investment regularly.
References:
https://aaoifi.com/ss-17-investment-sukuk/?lang=en
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
