The Potential and Risk of Sukuk 201 1

1.0 Introduction

In the modern economy, debt market and bonds are an integral part of the financial sector and effectively supplement the funds provided by the banking sector. From the conventional perspective, bonds can be defined as a long-term contract under which a borrower agrees to make payment of interest and principal, on specific dates, to the holders of the bonds. (Brigham, E. C. and Ehrhardt, M. C., Financial Management, 11th ed., 2005)

According to Longman, bonds are actually certificates or documents of debt issued by a government or an organization for an amount of money they borrow from the bondholders, promising them that it will pay back the money it has borrowed, usually with interest. (Longman, Business English Dictionary, 2000)

1.1

Introduction of Sukuk

Sukuk, plural of Sakk means legal instrument, deed or check. Sukuk is the Arabic name for a financial certificate but may also be considered as Shariah-compliant Bonds. Although Sukuk is generally referred to as Islamic bonds, it is better descrived as an asset-based investment, as the investor owns an undivided interest in an underlying tangible asset which is proportionate to his investment.

The claim embodied in Sukuk is not simply a claim to cash flow but an ownership claim. Monies raised by the issuance of the Sukuk notes are used to invest in an underlying asset, a trust is declared over that particular asset and thereby the certificate holder will own a 1

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beneficial interest in that asset in proportion to his investment. Therefore, the investor is entitled to the benefits that entail, including a proportion of the return generated by that asset (Mohamed Z., Azmi & Associate, 2010)

1.2

History of Sukuk

In classical period Islam sakk (sukuk) & ndash; which is cognate with the European root "cheque" (which itself derives from Persian)- meant any document representing a contract or conveyance of rights, obligations or monies done in conformity with the Shariah. Empirical evidence shows that sukuk were a product extensively used during medieval Islam for the transferring of financial obligations originating from trade and other commercial activities.

The essence of sukuk, in the modern Islamic perspective, lies in the concept of asset monetization - the so called securitization - that is achieved through the process of issuance of sukuk (taskeek). Its great potential is in transforming an asset & future cash flow into present cash flow. Sukuk may be issued on existing as well as specific assets that may become available at a future date. (aibim.com)

1.3

History Sukuk in Malaysia

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The roots of Sukuk in Malaysia are embedded in the Islamic banking and financial system. It began in 1973 with the establishment of Tabung Haji (Pilgrims Fund), the countrys first Islamic financial institution. A decade later, Bank Islam Malaysia became the first full-fledged Islamic commercial bank in Malaysia. In 1993, the government took another bold step and introduced the Interest Free Banking Unit (IBU), which is an Islamic window within existing commercial banks. IBU allows the parallel existence of conventional and Islamic banking systems in a bank. The Islamic money market was established in 1994 as the final major requirement for a complete Islamic banking system. It currently serves as a place to trade Islamic financial instruments. In addition, the establishment of a National Shariah Council, a single source of reference to advice on the legality and compliance of Islamic financial instrument transactions with the Shariah, streamlined the development process. The first Sukuk issuance in Malaysia was for Shell MDS in 1990. A syndicate of financiers arranged a Bai Bithaman Ajil transaction of RM75 million (US$22 million) for a tenure of five years, and another RM50 million (US$14.73 million) for eight years. The next notable development was the RM300 million (US$88.42 million) Sukuk issuance by Petronas Dagangan in 1994. The first Sukuk in Malaysia to be rated, it was assigned a long-term AA1 rating by Rating Agency Malaysia (now known as RAM Rating Services) in February 1994. It was also the first Islamic instrument to be listed on the Kuala Lumpur Stock Exchange (now Bursa Malaysia). The Islamic financial market is one of the fastest-growing capital pools, and is quickly being drawn into the mainstream of the financial system. The Malaysian Sukuk market has successfully outgrown its infancy phase. The viability of Islamic finance is no longer an issue as the success of the domestic Sukuk market within a short period is testimony of the widespread acceptance of Islamic financing principles in the country. In Malaysia, Sukuk constituted 34.24%, or RM212.11 billion

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(US$62.5 billion) of RM619.53 billion (US$182.58 billion) total outstanding debt securities as at the 30th June 2008. Sustaining such growth requires a good legal and price discovery mechanism to enable market participants to be updated on valuation levels and their rights. In this regard, Malaysia has a good legal framework in place, which has shown its impartiality. However, the issue of valuation remains a grey area. In marking-to-market using market price, the last transacted price of the instrument is taken. Market price is reliable only in an efficient market where information infrastructures are established and liquidity is sufficient. In the bond and Sukuk markets, less than 1% of bonds is traded on a daily basis. Furthermore, bonds and Sukuk that were traded may encounter the next trade only after several weeks or months. Hence, the last traded price may no longer reflect the bonds true value as certain pricing factors, such as interest rate and credit environment, have lapsed. Due to the low level of liquidity in the bond and Sukuk markets compared to the equity market, the ability of players to obtain market prices is extremely difficult. Moreover, the non-independence of traditional sources of bond and Sukuk prices in Malaysia, as well as the lack of a comprehensive set of rules and regulations regarding the origination and usage of generated bond and Sukuk prices, create a situation of information asymmetry between market players. Despite the market growing to a substantial size, the ability of market players to obtain independent pricing as well as to compare and evaluate the portfolio performance of fund managers comes close to impossible. To eliminate this impediment to the bond and Sukuk markets, the Securities Commission of Malaysia (SC) decided to create a new capital market infrastructure: the bond pricing agency.

2.0 Types and Principles of Sukuk and Bonds

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2.1

Types of Sukuk and Bonds

2.1.1

Types of Sukuk

Sukuk can be of many types depending on the type of Islamic modes of financing and trades used in its structuring. The following are the common types of Sukuk:

2.1.1.1

Sukuk Ijarah

This is one of the most common Sukuk issuance types, especially for project finance. Sukuk Ijarah is a leasing structure coupled with a right available to the lessee to purchase the asset at the end of the lease period. The certificates are issued on stand-alone as sets identified on the balance sheet.

The rentals rated of return on these Sukuk can be fixed or floating depending on the agreement. The cash flow from the lease including rental payments and principle repayments are passed through to inventors in the form the lease including rental payments and principle repayments are passed through to investors in the form of coupon and principle payments. The Sukuk Ijarah provides an efficient medium-to-long term mode of financing.

2.1.1.2

Sukuk Mudharabah

This is an agreement made between a party, who provides the capital and another party (an entrepreneur), to enable the entrepreneur to carry out 5

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business projects, which will be on a profit sharing basis, according to predetermined ratios agreed on earlier. In the case of losses, the losses are born by the provider of the finds only. Sukuk Mudharabag are used to enhance public participation in big investment projects.

2.1.1.3

Sukuk Musharakah

These are investment Sukuk that represent ownership of Musharakah equity. The structure of musharakah requires that both parties provide financing to the projects. In case of losses, both parties will lose in proportion to the size of their investment. Sukuk Musharakah are used to mobilize funds to establish new projects, or to develop an existing one, or to finance a business activity on the basis of partnership contrats.

2.1.1.4

Sukuk Istisna

This type of Sukuk has been used for the advance of funding for real estate development, major industrial projects or latge items of equipment such as turbines, power plants, ships or aircraft (construction / manufacturing financing) (Mohamed Z., Azmi & Associate, 2010).

2.1.2

Types of Bonds

Bonds can be of many types depending on the type of conventional bonds modes of financing and trades used in its structuring. The following are the common types of Bonds: 2.1.2.1 6 Zero-coupon Bond

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Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount a bond will be worth when it "matures" or comes due. When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment plus the imputed interest, which is discussed below. The maturity dates on zero coupon bonds are usually long-termmany dont mature for ten, fifteen, or more years. These long-term maturity dates allow an investor to plan for a long-range goal, such as paying for a childs college education. With the deep discount, an investor can put up a small amount of money that can grow over many years. (http://www.sec.gov/answers/zero.htm)

2.1.2.2

Government Bond

A debt security issued by a government to support government spending, most often issued in the country's domestic currency. Government debt is money owed by any level of government and is backed by the full faith of the government. Federal government bonds in the United States include: the savings bond, Treasury bond, Treasury inflation-protected securities (TIPS), and others. Before investing in government bonds, investors need to assess several risks associated with the country such as: country risk, political risk, inflation risk, and interest rate risk.

Lending to a national government in the country's own sovereign currency, government bonds, are free of credit risk, because the government can raise taxes or simply print more money to redeem the bond at maturity. But this does not mean risk-free. (http://www.investopedia.com) 7

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2.1.2.3 Corporate Bond

A debt security issued by a corporation and sold to investors. The backing for the bond is usually the payment ability of the company, which is typically money to be earned from future operations. In some cases, the company's physical assets may be used as collateral for bonds.

Corporate bonds are considered higher risk than government bonds. As a result, interest rates are almost always higher, even for top-flight credit quality companies. (http://www.investopedia.com)

2.1.2.4

Municipal Bond

Municipal bonds (also known as munis) are attractive to many investors because the interest income is exempt from federal income tax and in many cases, state and local taxes as well. In addition, munis often represent investments in state and local government projects that have an impact on our daily lives, including schools, highways, hospitals, housing, sewer systems and other important public projects. (http://www.investinginbonds.com/learnmore)

2.2

Principles of Sukuk and Bonds

2.2.1

Principles of Sukuk

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2.2.1.1 Requirement of underlying asset

Under `uqud mu`awadhat or contracts of exchange (such as bai` bithaman ajil, murabahah, istisna` and ijarah), an asset, whether tangible or intangible, must be made available for sukuk to be issued subject to the following: The underlying asset and its use must comply with the requirements of An encumbered asset, such as an asset charged to a financial institution,

Shariah. or an asset that is jointly-owned with another party, can only be used as underlying asset provided the issuer has obtained consent from the chargee or joint-owner. Where receivables are used as the underlying asset, they must be mustaqir (established and certain) and transacted on cash basis (on spot).

2.2.1.2

Asset pricing

Sukuk under`uqud mu`awadhat involves the sale and purchase of underlying assets. When the investors purchase the underlying assets, the purchase price must comply with the following SAC pricing guidelines: The purchase price should not exceed 1.51 times of the market value of In cases where the market value of a particular asset could not be

the asset. ascertained, a fair value or any other value must be applied.

2.2.1.3

Ibra (Rebate)

Provision for ibra may be stipulated in the primary legal document

provided that such provision shall not be part of the pricing section. 9

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Through the application of ibra, variable rate mechanism may be applied

to sukuk BBA, murabahah and istisna` which may be benchmarked to the prevailing market rates. 2.2.1.4 Ta`widh (Compensation)

Ta`widh is permissible under both `uqud mu`awadhat and `uqud ishtirak

only in the event of delay in payment. However, under `uqud ishtirak, ta`widh is limited to the failure of the issuer/obligor to distribute the realised profit on time. Ta`widh does not apply to expected profit. The rate of ta`widh should be as prescribed by the SAC from time to time and is available on the Islamic Capital Market section of the SC website.

2.2.2

Principles of Bonds

2.2.2.1 bill.

All projects in the bond bill must be accomplished and must be

completed within the scope and within the budget as identified in the bond

2.2.2.2

The additional 5% in funding that is intended to cover project

management costs and inflationary increases should be reserved in a separate line item in each individual capital improvement projects budget. The 5% will be held in reserve, and should not be included in the dollar amounts available for design, construction, contingencies, or equipment.

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2.2.2.3 Only the General Assembly has the authority to alter the project

list, including any deletions.

2.2.2.4 sequence.

All bond projects are equally important and no project should be

inordinately impacted by inflation simply because of its place in the overall

2.2.2.5

Each campus and affiliate should have an official project

description and cost estimate for each bond project. As needed, each campus should consult with the Office of State Construction in the North Carolina Department of Administration to define the project scope and estimated cost. Information used to develop the official scope and cost estimate should be consistent with the UNC Capital Study.

2.2.2.6

Each campus and affiliate, in conjunction with the Office of the

President, should prepare a spending plan to fully implement the bond bill package. At the appropriate time and after consultation with the Board of Governors, modifications can be considered to transfer savings achieved from projects expedited in the early years of the plan to projects planned for the out-years to mitigate inflationary impacts or other necessary changes.

2.2.2.7

In cases where a bond project will use not-state funds to

supplement funds appropriated in the bond bill, funds authorized in the bond bill should be spent first, unless this is found to be inconsistent with other state policies or procedures.

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2.2.2.8

Funds included in the bond bill, as a Reserve for Repairs and

Renovations and Cost Overruns, will be placed in a reserve in the Board of Governors capital improvement budget code. The Board of Governors will determine use of these reserve funds, subject to approval of the Director of the Budget.

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3.0

The differentiate between Sukuk and Bonds

Beside Sukuk is followed by Islamic finance terms and Bond is followed by conventional finance term, there have many other different in order to show sukuk is not only term

Sukuk Bonds Sukuk represent ownership stake in an A bond represents the issuers pure debt. underlying asset. Bonds are securities in the form of a debt Sukuk are financial fixed income certificates that will be paid back before a certain date, that are permissible within the provisions of termed the date of maturity, in addition to Islamic Sharia law as they are raised on interest [on this debt]. In short, a bond is a trading in, or construction of, specific and debt security in which borrowed money is identifiable assets [rather than being repaid along with interest at a fixed rate. interest based like bonds]. The income from Sukuk is related to the original legal contract that governs the Bonds also include a fixed rate of interest relationship between the Sukuk provider regardless of loss or gain and the customer [owner of the Sukuk]. *Sources: http://www.asharq-e.com/news.

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4.0 Potential of Sukuk

The global Islamic financial sector has witnessed an encouraging growth over the last decade and is currently estimated to be at around US$1trillion. It is predicted to be the worlds fastestgrowing financial sector for the coming years with an estimated global potential of US$4trillion. Sukuks have turned out to be an important driver to raise finance under the Islamic mode of financing. In todays business practice, the term Sukuk means a claim similar to that represented by a trust certificate. In essence, the Sukuk is a financial instrument that sits above a Shariah-compliant underlying structure which generates an income for the holder of the instrument. Islamic finance has many qualities that could lend themselves to securitization as a means of raising funds. Shariah compliant tools must have asset-driven returns for example, which is a notable feature of securitization. (http://www.sukuk.me/news/articles/73/Globalsukuk-markets.html)

4.1

The Development of Islamic Finance Industry

The growing role of Islamic finance in mobilizing and channeling funds to productive investment activities across borders contributes to more efficient allocation of funds across borders and facilitates international trade and investment. Greater diversification of risk also contributes towards promoting international financial stability. The more recent development in Islamic finance is the growing significance of the Sukuk market to become an increasingly important component of the Islamic financial system. Five major trends are having a significant bearing on the future development of the global Sukuk market.

Firstly, the bond market is now becoming key to meeting the funding requirements for both 14

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the public and private sectors in emerging market economies. This is particularly the case for the Middle East and Asia, which are among the fastest-growing regions in the global economy. This includes financial needs of the private sector following the privatization and implementation of infrastructure projects. The development of the Sukuk market will provide opportunities for the corporate sector, the government agencies, multinational corporations (MNCs) and multinational development institutions to raise funds through the issuance of Sukuk to meet their financing requirements. The Sukuk market also serves as an important platform, complementing the conventional bond market in enhancing the effectiveness and efficiency for the mobilization and allocation of funds within the domestic financial system, as well as in the international financial system.

Secondly, while there has been growing interest in the issuance of Sukuk by corporations, sovereigns and MNCs, the demand for Sukuk significantly exceeds the supply. Today, the global Sukuk market, denominated in international currencies, is estimated to exceed US$50 billion. Although the size of the market is modest by global standards, the Sukuk market is experiencing remarkable growth, increasing at an average rate of growth of 40% a year. The significant demand for Sukuk has also been spurred by the high levels of surplus savings and reserves in Asia and in the Middle East. This has been reinforced by increased liquidity in the international financial system in search of higher returns and greater diversification of risk. Since the issuance of the first sovereign global Islamic Sukuk by the government of Malaysia in 2002, there has been a series of other issues by the governments of the United Arab Emirates, Qatar, Bahrain and Pakistan. An increased number of multilateral agencies have also issued Sukuk to finance development projects. In addition, both government agencies and the corporate sector have considered the Sukuk market as an attractive financing instrument.

Thirdly, there are a great number of global players such as investment banks, Islamic banks and securities firms that are involved in the issuance of Sukuk in the international financial markets. A large number of western banks are also providing Islamic financial services 15

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taking advantage of the opportunities and to provide customized products and services to their customers.

Fourthly, the established international financial centers have also shown interest in promoting the development of the Sukuk market including enacting the appropriate legislative provisions. These developments would augur well for the development of the Sukuk market.

Finally, the regulatory and supervisory paradigm continues to evolve. Indeed, the recent decade has witnessed significant global shifts in the approach to regulation and supervision across many countries. In addition, the harmonization of standards and practices is also important. The establishment of the international standard setting organizations, such as the Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), to formulate appropriate prudential and accounting standards that not only facilitate the process of harmonization but also contribute to the strengthening of the Islamic financial system. IFSB has already formulated the prudential treatment for Sukuk investment by the Islamic financial institutions as stipulated in the capital adequacy standards.

The Islamic finance industry is growth rapidly with the current positioning which, in Middle East and North Africa have 204 million Muslims from GCC countries like, UAE, Iran and Egypt where this is 13% of total Muslim population in the world. GCC countries (excluding Oman) have 17 commercial banks offering Islamic banking and the AUM is USD100 billion.

In South East Asia have 16 million Muslims in Malaysia and 195 million Muslims in Indonesia and 13% of total Muslim population in the world. Malaysia has AUM USD31 billion

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and the Islamic money market in Malaysia ranging from USD8 12 billion monthly. There had issued 60% of the worlds Sukuks in 2006.

Have also 439 million Muslims in India, Pakistan and Bangladesh and 16 million Muslims in United Kindom, United State, Germany and France where it accounted for 41% of the total Muslim population in the world. (Overview of Islamic Finance, Grail Research, 2007.)

This can be seen comparison of the sukuk market in Malaysia ad the biggest issuer in the world and sukuk market in the United Kindom to see how far the development of the global sukuk market.

4.1.1

The Potential of Sukuk Market in Malaysia

Significant progress has been achieved in the development of the Malaysian Sukuk market. In 2007, Malaysia accounted for about two-thirds of the global Sukuk outstanding, amounting to about US$47 billion. Malaysia not only represents the largest Sukuk market in terms of outstanding size, but also in terms of number of issuance. In developing the Sukuk market, Malaysia provides a total solution for Sukuk activities by offering a complete Sukuk issuance and trading platform, supported by four elements: a wide range of Islamic instruments, strong legal and regulatory infrastructure, sound Shariah governance framework and talent supply. These elements are also further strengthened by Malaysias comprehensive Islamic financial system with all the key components of the financial system comprising the Islamic banking, Takaful, Islamic money and capital markets that are now at an advanced stage of development. These different parts of the Islamic financial

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system not only facilitate the issuance and the distribution of the papers but also create a strong demand for Sukuk by providing a broad investor base. There is also a variety of Islamic instruments in the Sukuk market in Malaysia that include currency swaps and Islamic forward contracts available to facilitate hedging and other risk management activities. The Malaysian Sukuk market is also supported by appropriate rules and regulations, and by the pool of experienced global and domestic players as well as the legal and accounting professionals including legal and tax consultancies, as well as documentation in the issuance and trading exercise. Malaysia aim to be as an international Islamic Financial Center (MIFC) , thus develop Malaysia into a center for the origination, distribution and trading of Sukuk to provide further impetus to the development of an increasingly vibrant and progressive bond market in Malaysia as well as in the Asian region. This would reinforce the international dimension of the Sukuk market in Malaysia by providing linkages with international issuers and investors. To deepen and widen the bond and Sukuk markets, Malaysia has further liberalized the foreign exchange administration rules to allow multilateral financial institutions, MNCs and other national corporations to issue both ringgit and non-ringgit denominated instruments in capital market. Malaysia also has in place the financial infrastructure and facilitative rules that contribute towards efficient price discovery and shorter time to market, thus providing an efficient platform for Sukuk issuance and trading activities. The established legal, regulatory and Shariah framework in the Islamic financial infrastructure in Malaysia is reinforced by the supporting financial infrastructure, including the settlement and bond information system. To facilitate an efficient Sukuk issuance process in Malaysia, an MIFC one-stop center is being established as a single contact point for efficient delivery process to facilitate the issuance of Sukuk. To further facilitate this process, there is no restriction on the ability to use international rating services, on the ability to hedge positions and on the ability to swap issuance proceeds into foreign currency. 18

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As part of ongoing efforts to position Malaysia as an attractive gateway for the issuance of Sukuk, a number of legal and regulatory requirements are further customized to reduce the cost of Sukuk issuance. Profits and dividends received by non-resident investors from holding of ringgit and non-ringgit Islamic instruments issued in Malaysia are exempted from withholding tax. Special Purpose Vehicles (SPVs) for Islamic financing purposes via the Islamic capital market are not subject to the administrative procedures under the Income Tax Act 1967. In addition, companies that establish these SPVs are given a tax deduction on the issuance cost of the Islamic securities incurred by the SPV. The issuance cost for all Islamic securities approved by the Securities Commission is also eligible for tax deduction. Finally, there is a stamp duty exemption for 10 years on instruments relating to Islamic securities under the MIFC. These initiatives have positioned Malaysia as a competitive and attractive Sukuk market in the global arena. Malaysia has also put in place an efficient platform for trading of bonds including the Real-time Electronic Transfer of Funds and Securities System (RENTAS), Fully Automated System for Issuance/Tendering (FAST), and Bond Information and Dissemination System (BIDS) to provide post-trade transparency and market liquidity on par with developed markets. Malaysia also has a payment system link with the Hong Kong Monetary Authority on US dollar settlements, while Malaysian government securities can be cleared with Euroclear. Finally, a conducive environment for innovation has been put in place. In 2006, the Malaysian market continued to generate innovative products with the launch of Sukuk using Mudarabah, Musharakah and Ijarah. Landmark issuances, such as the exchangeable Sukuk Musharakah by Khazanah Nasional, marked the worlds first issue of its kind, incorporating full convertibility features common to conventional equity-linked transactions.

4.1.2

The Potential of Sukuk Market in United Kingdoms

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A recent report from Ernst & Young (E&Y)2 shows that between 2007 and 2009 sukuk are still largely originated from Malaysia and the GCC. Issuance from other jurisdictions such as Indonesia is increasing, but at this point in time still negligible. Figure 1 below shows how the issuance compares geographically. (E&Y Islamic Funds and Investments Report, 2009) The exact potential size of the market is difficult to determine, mainly as a result of the fact that the instrument is still relatively new and the number of European listed issues is still fairly low. However, given the characteristics defined in the previous section, 69% of the investment professionals that have responded to the survey have indicated that they would consider investing in a European Sukuk issue. Like any other bond, the issue would have to fit within the overall portfolio and meet the investment requirements associated with, among others, issuer, credit quality and size. The total demand depends on the investor and is often associated with a percentage of the issue size or a percentage of their total holding. The fact that the market is still relatively young has an impact on the perceived risk levels and available liquidity which are in turn reasons to approach investing in a Sukuk with caution.

The potential demand is currently still difficult to assess due to the fact that the market is still relatively young and the total outstanding amount of Sukuk is small compared to the overall bond market. However, where a few years ago the majority of respondents would not have heard of Sukuk, we found that in excess of 85% of the respondents have heard about the instrument and in excess of 50% has invested in them. (European Sukuk Issue, 2010)

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5.0 Risk of Sukuk

5.1 Risk-Rewards Sharing

The development of Islamic Financial products that provides impetus to the economic machinery of a country are no doubt a pleasant initiative. Whether the new Ijarah based and Murabaha based trading contracts have led the Islamic financial institutions to introduce Islamic financial dealings in banking, or the fine tuning of these and other transactions to ensure Shariah compliance, these are welcome signs. Sukuk as equity scrips simply, open huge possibilities to explore and adapt, with the Shariah permissibility (of course, inclusive of fair play and justice to the parties involved). Though currently operating mostly at institutional and sovereign level, with the volumes of transactions breaking the previously set records, quite often, these can also be utilized for small scale investment needs, if the operational costs can be met easily. Sukuk have the flexibility to mould the financial requirements and investment opportunities according to the Shariah requirements, as well as meeting the requirements of investments (demand and supply side). More importantly, these instruments have provided an alternate choice to the market in the form of non-debt based ( like Ijarah sukuk) and equity based and other quasi-equity investments that can also be availed productively However, in the conventional finance perspective , many of the sukuk structures are still considered as an Islamic Debt structure, especially in regulatory treatment. (Jabeen Z. & Javed M. T., 2007)

5.2 Relative Risk Of Sukuk Over Bonds

The governments bonds are always considered to be safe, liquid and in terms of return they provide a lower yield. The sukuks are growing fast along with the government and conventional bonds. The sukuks invest money as per Shariah principles in halal businesses as such they are safer when compared to the conventional bonds. When empirically analysed for sukuks riskinessthe results reveal that they are m oderately risky than 21

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government bonds and less risky than conventional bonds. As risk and return are positively correlated the sukuks provide a lower return. These results support the popularity of the sukuks though yield is less due to their less risky nature. All these results imply that the sukuks are more apt investment for risk averters, whether they follow Islam or any other religion. Investors who choose bond market for investment will be normally risk averse else they will go to stock market which is more risky and with better YRs. (Ramasamy R., Munisamy S., M. Helmi M. H., 2011)

5.3 Risk Assessment of Sukuk

The market for Sukuk certificates continues to grow and an important facet of this growth is the increased number of sovereign issuances typified by those issued by Malaysia, Bahrain and Qatar and, interestingly, Saxony-Anhalt in Germany. These certificates are appealing to global investors without having too much bearing on the underlying Islamicity of the certificates. Accordingly, Islamic secondary markets receive a boost because such sovereign issuances and the subsequent attraction of global investments encourage increased corporate confidence in their private issuances. Nevertheless, Ijarah Sukuks continue to prevail as the most popular manifestation of Sukuk certificates. This is largely in part to their unambiguous Shariah conformity and familiar leasing formulae. However, leasing contracts on underlying real estate properties cannot single-handedly support the growing diversity of Sukuk investors. With increased global investors there will be a myriad of investment needs and thus other avenues of Sukuk issuances should be implemented to satisfy these demands. Istisnaa, Mudarabah and Musharakah certificates are established as part of the AAOIFI standard and can be garnered to offer a plethora of Sukuk structures. The recent Sukuk issuance by the Islamic Development Bank serves as an excellent case study in this regard with their Shariah compliant diversity of investments. With the rapid emergence of Sukuk markets, risk management considerations have also come to the vanguard of the industry. Novel financial instruments bring with them original financial risks. An analogous situation represented itself in conventional financial markets in the early 80s with the emergence of interest rate derivatives to hedge against the financial 22

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risks of bonds. With the globalization of financial markets and increased convergence of Islamic finance and conventional markets, indirect interest rate effects as well as other financial risks will necessitate the development of Islamic financial risk management techniques. Derivatives are inherently against Shariah considerations because of the uncertainty associated with them that amounts to Gharar. However, we have discussed the possibility of extending the functions of embedded options to fit the needs of Sukuk certificates and Shariah considerations. This facility provides a debt structure framework that helps replicate the functions of traditional instruments and in turn benefit from the convexity gains of these instruments. Neftci and Santos (2003) identify two major hurdles in emerging markets for acquiring convexity gains. Firstly, there are no markets for liquid interest rate derivatives. Secondly, interest rate fluctuations lead to significant increases in credit risk and lower the bonds price. Accordingly, investors in emerging markets suffer from the negative effects of volatilities but cannot benefit from the positive effects. Such benefits have been garnered in conventional emerging markets such as Brazil where interest rate volatilities in the 90s warranted a protective cushion against these fluctuations in the form of puttable and callable bonds. These debt structures can be transferred to the Sukuk issuances in accordance to outstanding Shariah concerns. (Tariq A. A., 2004)

5.4 Sukuk vs. Eurobonds: Value-at-Risk Different

The market for Sukuk2 has grown tremendously in recent years, from less than $8 billion in 2003 to $50 billion by mid-2007. Sukuk provide sovereign governments and corporations with access to the huge and growing Islamic liquidity pool, in addition to the conventional investor base. The structure of Sukuk is now well established in several corporate and sovereign/supranational issues in the international bond markets. Sukuk are in many aspects similar to conventional Eurobonds. Sukuk are also considered to serve as security instruments that provide a predictable level of return (fixed or floating); they are traded in the secondary market albeit less than conventional bonds; they are assessed and rated by international rating agencies; and are mostly cleared under Euroclear (listed in Luxemburg). The convergence between Islamic and conventional finance, 23

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particularly in the case of Sukuk, is gaining momentum as foreseen by several scholars (Mirakhor 2007). This said, there are certain differences between conventional bonds and Sukuk. A bond represents the issuers pure debt, while Sukuk represent ownership stake in an underlying asset. For example, an Ijarah (lease) contract that is often used to structure sovereign Sukuk creates a lessee/lessor relationship which is different than a lender/borrower relationship. Investor protection mechanisms for Sukuk remain largely untested. Taxation could also become an issue for certain investors where the legal basis for taxation of Islamic securities is not legislated in the home country (Thuronyi, 2007). (Cakir S. & Raei F., IMF Working Paper, 2007.)

24

The Potential and Risk of Sukuk 201 1

6.0 Conclusion

Sukuks can be used very effectively

25

The Potential and Risk of Sukuk 201 1

Reference

1. 2. 3.

E&Y Islamic Funds and Investments Report 2009 Cakir S. & Raei F., IMF Working Paper, 2007 European Sukuk Issue, 2010 4. http://www.bloomberg.com/news/2011-10-07/malaysian-islamic-banking-assets-rise-15percent-to-123-billion.html 5. http://cms.sb24.com/modules/news/EnglishNews/news10.html?uri=/en/index.html 6. http://cms.sb24.com/modules/news/EnglishNews/news10.html?uri=/en/index.html 7. http://www.mifmonthly.com 8. http://www.sc.com.my 9. Ramasamy R., Munisamy S., M. Helmi M. H., Global Journal of Management and Business Research, 2011 10.Tariq A. A., Managing Financial Risks Of Sukuk Structures, 2004 11.Jabeen Z. & Javed M. T., Sukuk-Structures An Analysis Of Risk-Reward Sharing And Wealth Circulation, 2007

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The Potential and Risk of Sukuk 201 1

Appendix
12.2010 LIST OF SUKUK APPROVED BY SC

Qtr

No.

Issuer

Shariah Principle

Size of Issues (RM mil)

240.00 350.00 5,000.00

Q1 2010

1. 2.

Haluan Gigih Sdn Bhd Lafarge Malayan Cement Berhad Cagamas Berhad

Musharakah Murabahah Ijarah, Wakalah, Bai Bithaman Ajil

Q2 2010

1.

2. 3. 4. 5. 6. 7. Q3 2010 1. 2.

CJ Capital Sdn Bhd Kencana Petroleum Berhad LBS Bina Group Berhad Maju Expressway Sdn Bhd New Pantai Expressway Sdn Bhd Padiberas Nasional Berhad AmIslamic Bank Berhad Bank Pembangunan Malaysia Berhad

Musharakah Mudharabah Mudharabah, Murabahah Musharakah Bai Bithaman Ajil Musharakah Musharakah Tawarruq

114.00 250.00 135.00 550.00 74.00 750.00 3,000.00 2,000.00*

3. 4.

Celcom Transmission (M) Sdn Bhd Malaysia Airports Capital Berhad

Ijarah Ijarah

4,200.00 3,100.00

* Combined issue size limit of RM2.0 billion with Conventional Commercial Papers Programme Q4 2010 1. 2. 3. 4. 5. Aman Sukuk Berhad Alluvium Berhad Gamuda Berhad KNM Group Berhad Konsortium Lebuhraya Utara-Timur (KL) Sdn Bhd 6. 7. 8. Point Zone (M) Sdn Bhd Senai-Desaru Expressway Berhad TTM Sukuk Berhad Murabahah Ijarah Commodity Murabahah 500.00 5,580.00 750.00 Musharakah Ijarah Musyarakah, Murabahah Musharakah Musharakah 10,000.00 615.00 800.00 1,500.00 820.00

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The Potential and Risk of Sukuk 201 1

Table 1: Top 20 Corporate Issuers as on June 2010 (RM billion) Issuer

Cagamas Khazanah Binariang GSM Project Lebuhraya Prasarana Maybank Rantau Abang Capital Bhd Malakoff Corp KL International Airport AM Bank Value Cap 1 Malaysia Development Bhd. Jimah Energy Ventures Tanjung Bin Bank Pembangunan Malaysia Putrajaya Holdings YTL Power International Tenaga Nasional Danga Capital RHB Bank Total Total Outstanding Top 20 as % of Outstanding

CBs
5.11 6.10 1.60 1.60 5.10 1.00 2.20 1.50 0.60 24.81 63.48 39.10%

Sukuks
13.20 3.17 6.57 2.00 2.50 1.70 4.76 1.70 2.15 37.75 70.47 53.60%

Con. MTN
9.30 4.33 2.60 1.70 3.00 20.93 45.48 46.00%

Islamic MTN
8.85 8.28 3.68 2.00 8.00 5.60 5.00 4.77 4.59 0.90 3.65 3.60 58.91 89.40 65.90%

Total
18.15 13.20 11.45 10.25 9.11 8.60 8.00 7.30 6.36 5.93 5.10 5.00 4.77 4.59 4.50 5.35 3.90 3.65 3.60 3.60 142.40 294.65 48.30%

Source: Bank Negara Malaysia Fully Automated System for Issuing/Tendering (FAST).
Types of Sukuk Zero coupon Sukuk Description of Sukuk structure Istisna, Murabahah debt certificates non-tradable Rate of return (Interest rate risk)

Credit Risk Unique basis of credit risks exist, see, Khan and Ahmed

FX risk If all other conditions are similar, FX risk will be the same for all

Price risk Price risk relates to the prices of the underlying commodities

Other risks Liquidity risk is serious as far as thenontradable Sukukare concerned.

Very high due to fixed rate, remains for the entire maturity of

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The Potential and Risk of Sukuk 201 1

cases of Sukuk. However, those Sukuk which are liquid or which are relatively short term in nature will be less exposed. The composition of assets in the pool will also contribute to the FX risk in different ways. Hence this can be very useful tool to overcome the FX risk by diversifying the pool in different currencies. and assets in relation to the market prices. Ijara Sukuk are most exposed to this as the values of the underlying assets may depreciate faster as compared to market prices. Maintenance of the assets will play an important part in this process. Liquidity of the Sukuk will also play an important part in the risk. Salam is also exposed to serious price risks. However, through parallel contracts these risks can be overcome Business risk of the issuer is an important risk underlying Sukuk as compared to traditional fixed incomes.

(2001) Securitized Ijara, certificate holder owns part of asset or usufructs and earns fixed rent tradable Securitized Ijara, certificate holder owns part of asset or usufructs and earns floating rent indexed to market benchmark such as LIBOR tradable Securitized pool of assets; debts must not be more than 49%, floating rate possibility exists tradable Medium term redeemable musharakah certificate based on diminishing musharakah tradable as well as

the issue

Fixed Rate Ijara Sukuk

Default on rent payment, fixed rate makes credit risk more serious

Very high due to fixed rate, remains for the entire maturity of the issue

Shariah compliance
risk is another one unique in case of Sukuk. Infrastructure rigidities, i.e., non-existence of efficient institutional support increases the risk of Sukuk as compared to traditional fixed incomes, see Sundararajan, & Luca (2002)

Floating Rate Ijara Sukuk

Default on rent payment, floating rate makes default risk lesser serious see previous case

Exists only within the time of the floating period normally 6 months

Fixed rate Hybrid/ Pooled Sukuk Musharaka h Term Finance Sukuk (MTFS)

Credit risk of debt part of pool, default on rents, fixed rate makes credit risk serious Musharakah has high default risk (see Khan and Ahmed 2001), however, MTFS could be based on the strength

Very high due to fixed rate, remains for the entire maturity of the issue Similar to the case of the floating rate. This is however, unique in the sense that the rate is not indexed with a

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The Potential and Risk of Sukuk 201 1

benchmark like LIBOR, hence least exposed to this risk

redeemable Securitized salam, fixedrate and nontradable

of the entire balance sheet Salam has unique credit risk (see Khan and Ahmed 2001)

Salam Sukuk

Very high due to fixed rate

30