Traditional Bonds vs. Islamic Bonds Called “Sukuk”

The word Sukuk is an Arabic word which means certificate. These are certificates which are offered by corporations and governments which follow Islamic principles. For instance, Saudi Arabia has issued a new tranche of Sukuk in the year 2017. This was done to provide medium-term financing to the government to meet its debt obligations. The Saudi Arabian government has been cash-strapped given the sudden decline in the price of oil which has led to a catastrophic decline in the revenue of the Saudi state.

The word “Sukuk” is used to denote the Islamic equivalent of traditional bonds. However, there are many differences between Sukuk and bonds. This is because any lending where interest is involved is strictly prohibited as per Sharia law. Since Sukuk are Sharia-compliant, they are not really debt instruments.

To the external world, this may seem like a mere technicality. This is why westerners refer to Sukuk as Islamic bonds. However, Muslims hold the prohibition of interest in very high regard. They believe that all the price inflation in the world is happening because of interest. They also believe that interest is a tool used for creating usury and injustice. In fact, interest is also seen as the sole cause of economic misery and the formation of bubbles. This is the reason why Sukuk has been structured to not include interest.

In this article, we will compare the Islamic bonds with traditional bonds and highlight their differences.

Sukuk are Based on Ownership Instead of Debt

Bonds may or not be backed by a real asset. However, Sukuk always has to be backed by a real asset. This is because the Sukuk contract itself provides transfer of ownership of the asset for a short period from the issuer to the buyer.

Sukuk is essentially a repurchase contract wherein the seller of an asset sells the asset at a certain price and then agrees to buy it later at a higher price. Since the loan does not have a fixed interest rate, Sukuk is allowed as per Islamic laws.

The Underlying Assets are Sharia Compliant

Islam also prohibits dealing in or associating with certain types of goods and services. Hence these goods cannot be used as collateral for Sukuk. For instance, liquor companies cannot raise money via Sukuk since the underlying asset is not sharia-compliant. Similarly, pork chops also cannot be used as collateral. The issuer of Sukuk needs to certify that the underlying asset or bundle of assets is Sharia compliant. Also, they need to certify that the proceeds from Sukuk will not be used for any purpose that has been prohibited by Islam.

The Pricing of Sukuk

A loan is not priced on the basis of collateral. The lender does not intend to liquidate the collateral. This is the reason that loans are priced based on the creditworthiness of the borrower. If the borrower has an AAA+ rating, a lower interest will have to be paid on the loan. On the other hand, if the borrower is likely to default, the interest rate demanded is very high.

This is not the case with Sukuk. The Sukuk is priced depending upon the value of the underlying asset. The creditworthiness of the borrower has very little impact on the pricing of the Sukuk. Also if any capital appreciation happens in the asset during the period that the buyer is holding a Sukuk, such benefit belongs to the buyer.

For instance, if Saudi Arabia issues Sukuk backed by its oil and the price of oil doubles, then the profit will belong to the holders of the Sukuk since they are the owners of the asset for that period.

On the other hand, if Russia issues bonds backed by its oil and the price of the oil appreciates significantly, the investors are no better off. This is because they have provided a loan and bore no part of the risks. Hence, they are not entitled to receive appreciation.

Similarities Between Bonds and Sukuk

Bonds and Sukuk are very similar in many ways. Some of the important points have been listed below:

• Sukuk are also subject to credit rating just like bonds. However, the credit rating is about the stability of the underlying asset and the volatility that the buyer may face. The creditworthiness of the borrower is irrelevant. Hence, a Sukuk sold by the Saudi government or even the local trader will be priced in the same manner if the underlying asset is the same.

• Sukuk also has a thriving secondary market just like bonds. Buyers need not hold Sukuk up to maturity. These certificates are liquid instruments and can be encashed whenever required. Malaysia has one of the most thriving secondary markets for Sukuk in the world.

Sukuk provides a better return on investment as compared to bonds in the western world. This may be because relatively few people issue Sukuk. However, there are a large number of investors who are willing to buy these instruments. The westerners are allowed to invest in Sukuk. However, Islam and Sharia prohibit the Muslims from buying bonds.