April 19, 2024

Exploring Sukuk and Profit-Sharing Investments

Sukuk, commonly referred to as “Islamic bonds,” are financial instruments that comply with Islamic law, or Sharia. They differ fundamentally from conventional bonds in that they represent partial ownership in a tangible asset, service, project, business, or joint venture, rather than a debt obligation. This structure is pivotal because Sharia prohibits interest (riba) and mandates that financial dealings be backed by real economic activities and tangible assets.

How Sukuk Works

Sukuk are structured around real assets. Unlike conventional bonds that represent a debt obligation, the issuance process for these instruments involves selling certificates that each represent a proportionate ownership in an underlying asset, a project, or a business venture. The funds raised by these certificates are then used to purchase an asset or finance a venture. This arrangement aligns with the Islamic financial principles that prioritise equity and profit sharing rather than earning interest, which is prohibited. As of the third quarter of 2023, the global sukuk market reached a total value of $823.4 billion, showing a significant annual growth of 9.8% from the previous year​​. This growth is partly driven by increased issuance in core Islamic finance markets, including countries like Malaysia, Saudi Arabia, Indonesia, the UAE, and Turkey. Notably, Malaysia led the issuance with 40% of the total, followed by Saudi Arabia at 28%, and Indonesia at 13%​.

One of the most distinctive features of the Islamic bonds is their method of generating returns for investors. Instead of interest returns, they are profit-driven. These profits can derive from various sources depending on the nature of the underlying asset. For instance, if the asset involves real estate, the income might come from rental payments. Alternatively, profits could come from the earnings of a business venture or from project-specific success payments. This system ensures that the investments are directly linked to economic productivity, aligning with the Islamic prohibition against interest (riba) and promoting financial transactions based on tangible asset performance.

Sukuk are also characterised by their fixed maturity period, at the end of which the issuer typically repurchases the certificates at their original issuing price. This buy-back arrangement effectively dissolves the investment as per the predetermined terms. The fixed term and transparent return mechanism make them a predictable and stable investment option. According to a report by S&P Global, as of 2020, the average maturity for sukuk ranges between 5 to 7 years, indicating its role in medium-term financing.

All sukuk issuances must comply with Sharia law, which is ensured by oversight from a dedicated Islamic law board. This board evaluates the compliance of the investment’s operations and its financial practices, ensuring they do not support prohibited industries like alcohol, tobacco, or gambling. This compliance is not only ethical but also aligns the financial instrument with the social and economic objectives of Islamic law, fostering a broader acceptance among Muslim investors.

Types of Sukuk

Sukuk, serving as a cornerstone of Islamic finance, are structured in various forms to comply with Sharia principles while catering to different financial needs and strategies. Let’s explore  the four prevalent types – each distinguished by its unique financial structure and purpose – namely, Ijara, Mudaraba, Murabaha, and Musharaka.

Ijara: Asset-Leasing Certificates

These certificates function like lease agreements where the sukuk issuer rents out an asset, and the investors receive returns in the form of rental income generated from the asset. This type of Islamic bonds mimics the conventional bond’s fixed income feature while adhering to Islamic laws by avoiding interest.

Ijara sukuk is highly popular due to its straightforward structure and the predictability of its returns.

Mudaraba: Venture Capital Certificates

In this model, investors provide the capital while the issuer, acting as the “Mudarib,” manages the business venture under a profit-sharing agreement. Returns to investors are contingent upon the profitability of the venture, aligning with the risk-sharing principle of Islamic finance.
This type of sukuk appeals to investors looking for potentially higher returns linked to business successes, thus fostering entrepreneurial activities while remaining compliant with Sharia.

Murabaha: Cost-Plus Financing

Murabaha sukuk involves the issuer purchasing an asset and reselling it to the investors at a price that includes a profit margin agreed upon in advance. This structure is frequently used in personal and real estate financing within Islamic banking contexts.

Unlike other types of sukuk, Murabaha does not entail direct asset ownership by the investors but rather involves a promise to purchase the asset. This method ensures compliance with Islamic laws prohibiting uncertainty and speculation in financial transactions.

Musharaka: Joint Venture Partnerships

Musharaka sukuk represent a form of joint venture, where all parties contribute capital and share profits according to a pre-agreed ratio, while losses are distributed based on each investor’s equity participation. This type of sukuk fosters a collaborative investment approach and is highly valued for projects where multiple investors are involved, offering a transparent and equitable profit-sharing mechanism.

As of the latest data, Musharaka sukuk are particularly prevalent in sectors that require substantial capital outlays, such as infrastructure projects.

Future overview

In terms of future projections, it’s expected that the global sukuk issuance volume will be between $160 billion to $170 billion, reflecting a slight decrease from the $179.4 billion recorded in 2022. This adjustment in forecast is due to a combination of factors including geopolitical risks and evolving market conditions which might affect liquidity and interest rates​ (SP Global)​.Moreover, the sukuk market is seeing a diversification in the types issued, including a notable increase in sustainability-linked sukuk as issuers align more with global environmental, social, and governance (ESG) standards. This includes a growth in green sukuk issuances, driven by Islamic finance countries’ strategies to reduce their carbon footprints and align with global climate goals​.