CHAPTER 2-CONCEPT OF SUKUK

2.1 INTRODUCTION OF SUKUK

2.1.1 HOW SUKUK DEVELOPED
Sukuk refers to an Islamic investment certificate, which allows investors to have
rights of ownership of the asset, including the cash flow and risks associated with such
ownership. Sukuk offers risk diversification for Investors for their portfolios and Sukuk are
asset-backed, tradable, and Shariah compatible trust certificates. Moreover, Sukuk (plural)
and sakk (singular) means legal instrument, deed, and check. It is the Arabic name for
financial certificates.

It is also an Islamic debt instrument and can be referred to as

securities, notes, papers, or certificates, with features of liquidity and tradability. Sakk is
believed to be the source root of the European Check and is referred to any certificate
representing a contract or conveyance of financial rights, obligations, or money transactions
that is Shariah compliant.
Sukuk were made as early as in 1978 in Jordan where the government allowed the
Jordan Islamic Bank to issue Islamic bonds known as Muqaradah bonds. This was follow by
introduction of the Muqaradah Bond Act of 1981. Similar effort was made in Pakistan where
a special law called the Mudharabah Companies and Mudharabah Flotation and Control
Ordinance of 1980 was introduced.
However, due to lack of paper infrastructure and transparency in the market, these
security activities are not successful. The first successful introduction of Sukuk was by the
Malaysian Government in 1983 with the issuance of the Government Investment Issue (GII).
It was not till the late 1990s that a well-recognized structure of an asset-backed
security in the form of a Sukuk was developed in Bahrain and Malaysia. This structure is
attracting the attention of borrowers and investors and is considered a potential vehicle to
develop Islamic capital market.
Sukuk market can provide much needed liquidity to institutional investors and
financial intermediaries, who become better equipped with portfolio and risk management.
Finally, in many cases, pay-off of Sukuk resembles a conventional fixed-income debt
security, which is popular among conventional investors. In this respect, Sukuk can also
serve as an integrating tool between Islamic and conventional markets.

2.1.2 TYPE OF SUKUK

1) SUKUK BASED ON SHARIAH CONTRACT

SUKUK BASED ON SHARIAH

CONTRACT

Sale-based

Bai Bithaman
Ajil

Murabahah

Salam

Istisna

Lease-based

Ijarah mawsufah fi
al-dhimmah

Partnershipbased

Mudarabah

Musyarakah

Ijarah muntahiyah
bi al-tamlik

Ijarah

Agencybased
Wakalah bi
al-istithmar

2) SUKUK BASED ON COMMERCIAL FUNCTION

1. Corporate
Issuers are incorporated companies which are non-goverment entities
2. Sovereign
Issuers are government or sovereign entities
3. Exchangeable and convertible
Sukuk may be converted into shares(equity) at maturity or other trigger event
4.Subordinated
The repayment of the sukuk is subordinated to the creditors or depositors
5. Stapled
Two instruments are attached together and cannot be traded separately
6. Asset-backed
Securities are backed by an income-generating asset with stable cash flow. This
involves true sale securitisation where the recourse is to the asset and not the
originator.
7. Project
financing
Proceeds of sukuk is used to finance a project. Repayment to investor comes from
cash flow generated from the project.

2.1.3 REASONS FOR ISSUING SUKUK

There are various reasons why we should issue Sukuk. First is growing demand from
investors to place their funds in accordance with Shariah compliant principles. This enables
diversification of portfolios, competitive yields, and better results. Then, Governments or
corporates are able to raise funds for their working capital or project financing for
infrastructure and development projects under a Shariah compliant framework instead of
debentures or loans with high interest rates.
The funds collected also serve the purpose of liquidity management for financial
institutions and individuals undertaking Shariah compliant business because it complies with
their internal monetary and regulatory policies.
In addition, they have options whereby for during excess liquidity they may purchase
Sukuk and when they are short of liquidity and need immediate funds, they may sell their
Sukuk into the secondary market. Both Islamic and conventional investors are comfortable
with Sukuk due to their innovative structures, competitive returns, and tradability.
After then, Sukuk investment involves the funding of underlying tangible assets. It is
also largely associated with economic development, real estate, and infrastructure related
assets, which are long term projects.
In other hand, long-term investment through Sukuk is preferred by institutional
investors due to its stable returns, positive effects for growth and because it promotes
financial market stability. Hence, investors feel safe as the probability of short term
speculative fund movements and potential financial crisis is very remote.

2.2 COMPARISON BETWEEN SUKUK AND BOND

Definition

SUKUK

BOND

Sukuk are financial certificates

Bonds are proof of debt and

representing beneficial ownership

not a share of ownership in

of real assets. It gives the investor

the asset. It is a debt

proportional beneficial ownership

obligation from the issuer to

in the asset on which the sukuk

the bond holder

are based.
UNDERLYING ASSET

The asset on which sukuk are

Bonds are issued to finance

based must be tangible and in

almost any purpose that

compliance with the Shariah and

complies with local

Islamic principles.

regulatory legislation.

ISSUER

In sukuk, the issuer is not a

Bonds are debts, whereby

REPRESENTATION

borrower, but can either be: A

Issuers are the borrowers

buyer in a sale contract; A lessee

from the investors (bond

in a lease contract; A partner in a

holders).

partnership contract.
ISSUE UNIT

ISSUE PRICE

Each sukuk represents a share of

Each bond represents a

the underlying asset.

share of debt

The face value of sukuk is based

The face value of a bond

on the market value of the

price is based on the issuers

underlying asset.

creditworthiness (including
its rating).

RETURN SHARING

Returns are termed as dividends

Returns are termed as

and will depend on the underlying

coupons. Bond holders

Shariah contract used. Sukuk

returns can be ascertained

holders receive a share of profits

and they receive regularly

from the underlying asset (and

scheduled (and often fixed

accept a share of any loss

rate) interest payments for

incurred). The amount of profit

the life of the bond

cannot be ascertained, it could be

regardless of Issuers loss or

fixed or vary as it is based on the

gain.

sharing of profit and loss.

CAPITAL

The capital is not guaranteed for

The bond principal amount is

GUARANTEE

sukuk holders.Upon maturity,

guaranteed upon and

Sukuk is valued based on the

payable upon maturity date.

market value, a pre-arranged

figure (agreed upon by the two
parties) or a fair value.

2.3 STEP AND PROCEDURE OF SUKUK

Fund
Mobilizing
Entity

Balance Sheet
Pool of Asset
(Ijarah/Leases
)

Credit
Enhanceme
nt

SPM
Asset
Liabilities

Special Purpose
Mudarabah
SPM/ SPV

Ijarah Asset
(Leases)

Sukuk

Servicin
g

Investor: IFIs,
Conventional
Institutional investors,
pension funds, etc.

Source: Iqbal (1999)

In above show the process and linkage among the different players involved in structuring a
Sukuk. This process is a generic process and there will be differences depending on the
type of underlying instrument used to acquire the asset. The process of structuring a Sukuk
involves the following step:
Step I:

An asset is identified, which is currently held by the entity wishing to mobilize

resource and raise funds. In simple cases, this asset needs to be a tangible asset such as
an office building, land, highway, or an airport. But in other cases, a pool could be made from
a set of heterogeneous assets combining tangible and non-tangible asset, i.e. financial
asset. Once the assets to be securitized are identified, these assets are transferred to a
special purpose Mudarabah (SPM) for a predetermined purchase price. SPM is established
only for this particular purpose and is a separate legal entity that may not be affiliated to the
issuer. By establishing an independent SPM, the certificates carry their own credit ratings,
instead of carrying the credit ratings of its original owner. Also, by transferring the asset to
this special entity, the asset is taken off the issuers balance sheet and is therefore immune
to any financial distress the issuer may face in the future. Thus, the existence of an SPM
provides confidence to the investors (Sukuk holder) about the certainty of cash flows on the

certificates and therefore enhances the credit quality of the certificates. SPM also enjoys
special tax status and benefits. SPM is considered a bankruptcy remote entity.
Step II:

The underlying asset is brought on the asset side of the SPM by issuing

participation certificates or Sukuk on its liability side to investors in an amount equal to the
purchase price. These certificates are of equal value representing undivided shares in the
ownership of the asset. The proceeds from the sale of certificates are used to purchase the
asset. The holders of the Sukuk participate in the equity interest of the SPMs assets, which
are jointly owned.
Step III:

The SPM either sells or leases the assets back to a lessee- an affiliate of the

seller, or directly back to the seller itself- in exchange for a future payment or periodic lease
payments. For example, in case of a lease, the asset will be leased to a lessee or to the
issuer who will be responsible for making future rental payment on the lease. These future
cash flows in the form of rental income are passed through to the holders of Sukuk. The
cash flows are subject to deduction of minor administrative, insurance, and debt servicing
fees.
Step IV:

In order to make the certificates investment-quality and to enhance their

marketability, an investment bank may also provide some form of guarantee. This guarantee
may be in the form of a guarantee to buy or replace the asset in the event of default. The
investment bank or guarantor charges a few basis points as premium for the guarantee. This
credit enhancement makes the certificates investment grade securities and therefore makes
them attractive to institutional investor.
Step V: During the course of the life of the Sukuk, periodic payments are made by the
benefactor of the asset, i.e., lessee, which is transferred to the investors. These periodic
payments are similar to coupon payment and Sukuk payment is that whereas bond coupon
accrues irrespective of the outcome of the project for which the bond was issued, Sukuk
payments accrue only if there is any income out of the securitized asset. However, the
interesting point is that in the case of lease-based Sukuk, since the coupon payments are
based on rental income and there is low probability of default on rental income, investors
consider these coupons with high expectations and low risk. Anyone who purchases Sukuk
in the secondary market replaces the seller in the pro rata ownership of the relevant asset
and all the rights and obligations of the original subscriber are passed on to him/her. The
price of Sukuk is subject to the forces of the market and depends on the expected
profitability. However, there are certain limitations to the sale of Sukuk in the secondary
market.

Step VI: At maturity, or on a dissolution event, the SPM starts winding up, first by selling the
asset back to the original seller/owner at a pre-determined price and then paying back to the
certificate holders or investors. The price is pre-determined to protect capital loss to
investors. Otherwise, the sale of the underlying asset at the market value may result in
capital loss for the investor, which may not be acceptable to the investor. It is a common
practice that the Sukuk contract embeds a put option to the Sukuk-holders by which the
issuer agrees to buy the asset back at pre-determined price, so that at maturity the investors
can sell the Sukuk back to the issuer at the face value. At the completion of Sukuk, the SPM
is dissolved and it ceases to exist since the purpose for which it was created is achieved.

2.4 CONCLUSION OF CHAPTER 2

This chapter is explaining about the concept of Sukuk start with development of
Sukuk. Sukuk were made as early as in 1978 in Jordan where the government allowed the
Jordan Islamic Bank to issue Islamic bonds known as Muqaradah bonds, however, this
security are not successful because of lack of paper infrastructure and transparency in the
market. The first successful introduction of Sukuk was by the Malaysian Government in 1983
with the issuance of the Government Investment Issue (GII).
After then, we disclosed the types of Sukuk according to classifications which are Sukuk
based on shariah contract and Sukuk based on commercial function. In Sukuk based on
Shariah contract have four types of Sukuk, first is sale-based (Bai Bithaman Ajil, Murabahah,
Salam and Istisna), second is lease-based (Ijarah, Ijarah muntahiyah bi al-tamlik and Ijarah
mawsufah fi al-dhimmah), third is partnership-based (Mudarabah and musyarakah) and
fourth is agency-based (Wakalah bi al-istithmar). In Sukuk based on commercial function
have seven types which are corporate, sovereign, exchangeable and convertible,
subordinated, stapled, asset-backed and project financing.
In addition, we also released the reason for issuing Sukuk. This means that there are many
advantages when we issue the Sukuk. The issuing Sukuk give access to a wider investor
base as the instruments attract not only the Islamic investors but also conventional investors.
Sukuk is also considered as a new asset class with a relatively attractive pricing. The
growing demand for Sukuk is attributed by growing awareness, increased in petrodollars,
wealth and reserves as well as the massive development of infrastructure projects.
In this chapter, we also know what the different between Sukuk and bond. There are various
differences between Sukuk and bond that shown these securities offer quite different
solutions to the same financial problem. The conventional bonds are structured on the basis

of debt while Sukuk are equity based instruments. The other different is about issuer
representation, issue unit, issue price, return sharing and capital guarantee.
At the last of this chapter is about step and procedure of Sukuk. The process will be different
depending on the type of underlying instrument used to acquire the asset.