The Potential and Risk of Sukuk 2011 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. 1
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The Potential and Risk of Sukuk 2011
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)
1.1Introduction 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
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)
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1.2History 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)
1.3History Sukuk in Malaysia
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 country’s 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
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The Potential and Risk of Sukuk 2011
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
(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
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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 bond’s 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
2.1Types 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:
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The Potential and Risk of Sukuk 2011
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
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’
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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 Zero-coupon Bond
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-term—many don’t
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 child’s 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
4. LBS Bina Group Berhad Mudharabah, Murabahah 135.00
5. Maju Expressway Sdn Bhd Musharakah 550.00
6. New Pantai Expressway Sdn Bhd Bai Bithaman Ajil 74.00
7. Padiberas Nasional Berhad Musharakah 750.00
Q3 2010 1. AmIslamic Bank Berhad Musharakah 3,000.00
2. Bank Pembangunan Malaysia
Berhad
Tawarruq 2,000.00*
3. Celcom Transmission (M) Sdn Bhd Ijarah 4,200.00
4. Malaysia Airports Capital Berhad Ijarah 3,100.00
* Combined issue size limit of RM2.0 billion with Conventional Commercial Papers
Programme
Q4 2010 1. Aman Sukuk Berhad Musharakah 10,000.00
2. Alluvium Berhad Ijarah 615.00
3. Gamuda Berhad Musyarakah, Murabahah 800.00
4. KNM Group Berhad Musharakah 1,500.00
5. Konsortium Lebuhraya Utara-Timur
(KL) Sdn Bhd
Musharakah 820.00
6. Point Zone (M) Sdn Bhd Murabahah 500.00
7. Senai-Desaru Expressway Berhad Ijarah 5,580.00
8. TTM Sukuk Berhad Commodity Murabahah 750.00
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Table 1: Top 20 Corporate Issuers as on June 2010 (RM billion)
Issuer CBs Sukuks Con. MTN
Islamic MTN Total
Cagamas — — 9.30 8.85 18.15
Khazanah — 13.20 — — 13.20
Binariang GSM — 3.17 — 8.28 11.45
Project Lebuhraya — 6.57 — 3.68 10.25
Prasarana 5.11 2.00 — 2.00 9.11
Maybank 6.10 2.50 — — 8.60
Rantau Abang Capital Bhd — — — 8.00 8.00
Malakoff Corp — 1.70 — 5.60 7.30
KL International Airport 1.60 4.76 — — 6.36
AM Bank 1.60 — 4.33 — 5.93
Value Cap 5.10 — — — 5.10
1 Malaysia Development Bhd. — — — 5.00 5.00
Jimah Energy Ventures — — — 4.77 4.77
Tanjung Bin — — — 4.59 4.59
Bank Pembangunan Malaysia 1.00 — 2.60 0.90 4.50
Putrajaya Holdings — 1.70 — 3.65 5.35
YTL Power International 2.20 — 1.70 — 3.90
Tenaga Nasional 1.50 2.15 — — 3.65
Danga Capital — — — 3.60 3.60
RHB Bank 0.60 — 3.00 — 3.60
Total 24.81 37.75 20.93 58.91 142.40
Total Outstanding 63.48 70.47 45.48 89.40 294.65
Top 20 as % of Outstanding 39.10% 53.60% 46.00% 65.90% 48.30%
Source: Bank Negara Malaysia Fully Automated System for Issuing/Tendering (FAST).
Types of Sukuk
Description of
Sukuk structure Credit Risk
Rate of return (Interest rate
risk) FX risk Price risk Other risks
Zero coupon
Sukuk Istisna’, Murabahah debt certificates –
Unique basis of credit risks exist, see, Khan and
Very high due to fixed rate, remains for
If all other conditions are similar, FX risk
Price risk relates to the prices of the
Liquidity risk is serious as far as thenon-tradable
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The Potential and Risk of Sukuk 2011
non-tradable Ahmed (2001)
the entire maturity of
the issue
will be the same for all 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.
underlying commodities 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
Sukukare concerned. Business risk of the issuer is an important risk underlying Sukuk as compared to traditional fixed incomes.
Shari’ah 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)
Fixed Rate
Ijara Sukuk
Securitized Ijara, certificate holder owns part of asset or usufructs and earns fixed rent -
tradable
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
Floating Rate
Ijara Sukuk
Securitized Ijara, certificate holder owns part of asset or usufructs and earns floating rent indexed to market benchmark such as LIBOR –
tradable
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
Securitized pool of assets; debts must not be more than 49%, floating rate possibility exists
– tradable
Credit risk of debt part of pool, default on rents, fixed rate makes credit
risk serious
Very high due to fixed rate, remains for the entire maturity
of the issue
Musharakah Term Finance
Sukuk (MTFS)
Medium term redeemable musharakah certificate based on diminishing musharakah – tradable as well
as redeemable
Musharakah has high default risk (see Khan and Ahmed 2001), however, MTFS could be based on the strength of the entire balance
sheet
Similar to the case of the floating rate. This is however, unique in the sense that the rate is not indexed with a benchmark like LIBOR, hence least exposed to