Sukuk vs Bonds: Exploring Halal Fixed-Income Alternatives
What is a bond?
A bond is a financial instrument that involves a borrower (typically a sovereign, a government-related entity or a private corporate) that borrows money by issuing an IoU to an investor or a group of investors. The borrower agrees to pay the amount with the interest over a specific time period to investors.
The global bond market is well established and worth some $126 trillion, with the US bond market alone worth $49 trillion, according to some estimates.
In comparison the global equity market is worth some $124 trillion with the US account for around 42%.
Issuers sell bonds for different reasons including to fund new projects, general corporate purposes, to cover deficits or to refinance existing debt at cheaper rates.
For investors, bonds provide a stable fixed-income over a period of time and are not prone to volatility risks when compared to equities.
Whilst bonds are plentiful, they can be problematic for Muslim investors as well as for issuers looking to raise financing in a Sharia-compliant manner.
The biggest problem is the payment or earning of interest which violates Sharia. Bonds can also be involved (directly or indirectly) with industries or activities that would considered non-Sharia compliant.
What is Sukuk?
Sukuk (singular. sak) are often referred to as Islamic bonds because they resemble similar characteristics of bonds, in that they provide a fixed-income return and are tradeable securities but are Sharia-compliant.
Sukuk represent an ownership or financial certificates to an asset or a pool of underlying assets. Unlike bonds, sukuk pay profits generated from the returns from the asset/s rather than interest.
Sukuk comply and are consistent with Sharia which is derived from Islamic sources including the Holy Qur’an and the Sunnah of Prophet Muhammed (peace be upon him).
To be Sharia compliant sukuk must not be involved or be associated with haram sectors including alcohol, gambling, pork, pornography, weapons and tobacco.
In addition, they adhere to other Islamic finance principles by not involved in Maysar or Gharar. As a result, sukuk are involved in halal sectors and activities linked to the real economy and not the financialization of assets.
Although, tthe concept of sukuk has existed throughout Islamic civilisations, the first modern sukuk came in the 1990s in Malaysia with MDS Shell selling a MYR 125 million ($27 million) note.
Today, Fitch Ratings, estimates that the outstanding global sukuk market is worth around $749 billion (as of 3Q22). Whilst this is still significantly smaller than the conventional bond market, the sukuk market represents a growing asset class.
Since the 2008 global financial crisis, sukuk have become a popular financing instrument among governments and corporates in the Islamic world.
Countries including Saudi Arabia, the UAE, Bahrain, Qatar, Oman, Malaysia, Turkey, Indonesia and Pakistan have all issued sukuk.
In addition, non-Muslim nations including Luxembourg, Hong Kong, South Africa and the United Kingdom have also sold their own sovereign sukuk.
Most recently, the UK sold its sophomore sovereign sukuk consisting of a £500 million issuance in March 2021.
There are different motivations for issuing sukuk, but there are some common factors which make it appealing alternative to bonds for issuers.
Sukuk target Islamic investors (for example Islamic banks, asset managers with Sharia-only mandates) in wealthy regions like the Gulf Cooperation Council (GCC) and South East Asia seeking Sharia-compliant fixed income assets.
Historically, the demand for sukuk outweighs the supply. This provides a pricing advantage over conventional bonds for issuers depending on credit rating.
Sukuk provide investors with a Sharia-compliant alternative to bonds which can be added to a diversified portfolio.
Whilst the sukuk universe remains small when compared to conventional bonds, regular supply from investment grade names like Saudi Arabia as well as fast-growing economies Indonesia offer investors competitive returns.
In addition, new issuers like Bangladesh and Uzbekistan are set to sell their own sukuk over the next few years. Developed issuers like the UK are also set to issue more sukuk in the coming years.
What are the different types of sukuk?
There are different types of sukuk structures, among the most common structures are:
Ijara : is the most widely accepted sukuk structure in the Islamic finance industry.
Ijara a lease financing structure whereby a bank or financial institution buys an asset or item on behalf of the customer and leases it to them for an agreed sum over a specified period of time, transferring ownership of the asset or item upon maturity.
Murabaha: is a financing contract whereby one party buys an asset or item and then sells it on a deferred basis for an agreed marked-up rate, to cover cost and profit margins.
Mudaraba: an agreement between two parties, whereby one party provides the capital (rab al mal) and the other party manages (mudarib) the project. The profit is determined by a pre-agreed ratio. If the project encounters losses, the party providing the capital is solely responsible for those losses.
Wakala: is a contract between two parties in which a principal appoints an agent to manage and/or work on a project.
Are there risks associated with investing in sukuk?
Like other financial instruments there are risks facing investors. The biggest risks facing investors is default by issuer as well as economic performance.
Each investors should evaluate the credit worthiness of the obligor before investing. Some sukuk can also remain illiquid due to the buy-to-hold nature of sukuk buyers and the lack of secondary trading, particularly with regards to high quality liquid sukuk.
Sukuk can also be subject to different tax treatment due to the asset nature but this will depend on specific jurisdictions. This may require a government to amend or introduce new legislation to address these legal challenges.
Another consideration is that Sharia interpretation can vary from jurisdiction to jurisdiction.
This can have an impact on the types of sukuk structure acceptable and available in specific markets. For example, murabaha sukuk is widely accepted in Malaysia but would not be acceptable in Saudi Arabia.
How to buy sukuk?
The majority of sukuk issued in the primary market, particularly investment grade sukuk are only available to institutional investors (like banks, asset managers, pension funds etc).
These sukuk are generally offered through a financial institution like a bank acting as a bookrunner, arranger, primary dealer or agent in a transaction. To purchase sukuk in primary market investors would usually require a minimum of $200,000.
In countries like Saudi Arabia, retail investors can access sukuk via platforms like Sukuk Capital, from as little as 3000 riyals.
With capital at risk, investors can expect annual returns of 10%. Investors can also buy sukuk ETFs like the SP Funds Dow Jones Global Sukuk Index ETF on their brokerage platforms or via robo advisors.