HOW SUKUK (ISLAMIC BONDS) DIFFER FROM CONVENTIONAL BONDS

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As an Islamic robo-advisor one of the most common questions we get asked at COCOA is about sukuk as a sharia-compliant alternative to bonds. These questions are quite understandable given bonds are based on an interest rates and the use of such are not possible within Islamic investing. Below we explain more of the features of a sukuk and compare the main differences between the two products.

Rewarding investors for sukuk

The modern sukuk emerged as an investment with similar characteristics to conventional bond products. There are numerous differences but the key feature being a sukuk is based on part ownership of a tangible asset (service, project, business or joint venture) and is not a debt product. Sukuk can be issued for an existing asset or one that will exist in the future. The owners of the sukuk, as part owner of the asset, are entitled to a share of the profits produced by the asset. Unlike a traditional bond product, they do not receive any interest payments as this would violate sharia principles.

Repurchasing at maturity

Just as conventional bonds a sukuk has a maturity date at which point the issuer (the borrower of money) buys the units back. Unlike a bond, the initial investment is not guaranteed and the investor may not get back the full amount. The reason for this is the owners of a sukuk actually own a portion of the underlying asset and hence share the risk with the borrower. If the business or project that the sukuk is based upon does not perform well both parties will share the loss.

In practice, some sukuk come with a repurchase guarantee although not all scholars agree that this arrangement complies with sharia law.

Ensuring sukuk comply with sharia law

Key to ensuring the sukuk remains compliant with sharia law is the principle that the owner is considered a part owner of the underlying asset and is therefore entitled to receive a share of the underlying profits. The relationship can be compared more to a partnership arrangement rather than a borrower and lender as is the case with conventional bonds.

Bonds and sukuk side-by-side

Now we have looked at the basics it is time we compared bonds and sukuk side by side.

 

Conventional Bonds

Sukuk

 

 

Asset ownership

Based on a debt obligation from the issuer to the bondholder. These instruments do not give the holder a share or right of ownership in the underlying asset, project, business or joint venture.

 

A sukuk provides the owner a partial ownership of the underlying asset, project, business or joint venture on which the sukuk is based.

 

 

Investment criteria

Bonds can be used to finance any asset, project,
business, or joint venture that complies with the local
regulation and laws.
The underlying asset on which a sukuk is based must be sharia-compliant.

 

 

Issue unit

Each bond represents a share of debt.

 

Each sukuk represents a share of the underlying asset.

 

 

Issue price

 

The face value of a bond price is determined by the issuer’s creditworthiness. The face value of sukuk is calculated by the market value of the underlying asset.

 

 

Investment rewards and risks

 

Bondholders receive regular scheduled and often fixed, interest payments for the life of the bond. The principal is guaranteed and will be returned on the bond’s maturity date. Sukuk holders receive a pre-determined share of any profits from the underlying
asset, and accept a share of any loss.
 

Effects of costs

Bondholders are not exposed to any costs related to the asset, project, business, or joint venture they have financed. The performance of the underlying asset doesn’t affect investor rewards.

 

Sukuk holders are affected by costs related to the underlying asset since they are a partial owner. Higher costs may translate to lower investor profits and
vice versa.

 

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