Friday, February 20, 2009

Sukuks: Islamic Debt Instruments

Similar to conventional bonds, sukuks are Islamic debt instruments. Sukuks are also known as “trust certificates” or “participation securities.” Sukuks are part of an emerging Islamic financial market that, per Moody’s Investor Service estimates, will hit $4,000 bn. In the legal academy, sukuks are unfamiliar debt instruments. The purpose of this post is to explain the Islamic law behind sukuks.

Sukuks share some constitutive elements with conventional bonds but they are not the same as bonds. A conventional bond also known as a fixed-income security is a promissory note obligating the issuer to pay to the bondholder a fixed sum of money, including principal and interest. For most bonds, the annual interest rate is fixed in advance at the time the bond is issued. The annual interest rate is also known as coupon rate or nominal rate. The rate varies depending on a host of factors, including the life of the bond (maturity), creditworthiness of the issuer, and the expected inflation during the life of the bond. According to one estimate, fixed-income securities carry investments of more than $10 trillion.

Just like conventional bonds, sukuks too are issued in exchange for loans to the issuer. Both are debt instruments. Both serve as market devices to raise funds. Governments and businesses issue sukuks to obtain monies from investors. Technically, the sukuk too is a promissory note obligating the issuer to pay to the sukuk-holder a sum of money.

The sum of money promised to the sukuk-holder, however, must contain no interest (riba). It cannot be fixed. This is the critical difference between bonds and sukuks. Bonds pay interest. Sukuks cannot pay interest. Islamic law allows extending loans to individuals and businesses. It, however, prohibits charging and receiving riba on loans. Riba is severely condemned, calling it war against God.

To overcome the prohibition of riba, Islamic finance markets must design debt instruments to facilitate loans but without riba. Since Islamic law allows profit on investments, the design of debt instruments can allow profit but not interest. Designing debt instruments compliant with Islamic law has been a practical challenge for Muslim jurists and financial experts. A mere change in name, that is, calling interest profit, will be deceptive and contrary to the letter and spirit of Islamic law. Similarly, debts instruments cannot be designed to conceal the payment of interest. Jurists and experts cannot play games with God’s Law.


Ideas have been presented to make Islamic debt instruments as certificates of secured loans with specific collateral supporting a series of instruments. It is not acceptable that instruments are collateralized with the entire property that the issuer owns. A more specific identification of the collateral supporting debt instruments, whether the property is real or personal, will be more consistent with Islamic law. Furthermore, the collateral must be capable of generating income. When debt instruments are linked to income-generating assets, lenders can share the income that the assets produce. This income may be calculated annually and distributed to lenders. Lenders, however, take the risk that the collateral supporting debt instruments would produce loss, and not profit. In the case of loss, the principal is at risk as well.

Sukuks are modern efforts to structure lending on the basis of Islamic law. While Muslim jurists advise the issuance of these debt instruments, not everyone agrees that these instruments comply with Islamic law. The sukuk market is nonetheless thriving in many Muslim and non-Muslim financial markets.

--LAK

5 comments:

Jason Kilborn said...

This is totally fascinating. In effect, a sukuk is the exact opposite of a negotiable instrument, in that a NI must promise to pay a "fixed amount," whereas a sukuk, in effect, must NOT make such a promise. The amount to be paid in excess of the principal is not only NOT fixed in the sense that it might float UP (a problem that § 3-112(b) solved in the U.S.), but also it might float DOWN, eroding part or all of the principal (?). This underscores the partnership aspect of a loan--indeed, the required sharing of risk/partnership of this deal is the heart of the Islamic law prohibition on riba, as I gather. How home mortgage loans are structured in Islamic finance is particularly illustrative of this, as I understand (I'd love to see a post on this, Ali). Our systems are not so far apart, as many home lenders in particular are finding that their repayment fates are also tied to the borrower's health!

Anonymous said...

Can you please explain how interest on a loan is not "profit on an investment"?

Liaquat Ali Khan said...

Jason, I am studying home mortgage loans under Islamic law and will post my comments. Yes, the sharing of risk/partnership is indeed the foundation of Islamic financing.

Rose said...

Hi,
As I see in your post there is lots of good information available on Islamic finance. Islamic finance has change a lot in the recent few years. Rest of the world specially American and European countries want to get advantage of these change in there own interest. Innovation of sukuk also one of the big reason that non Islamic countries look on the Islamic finance market.
Sukuk is an alternate way of investment where the investor get the benefits of investment and its treated as rent on investment, to avoid the interest on investment which is strictly prohibited in Islam.I have write on same topic check my post : http://portfolioanalyst.blogspot.com/2010/09/islamic-debt-bond-market.html, http://portfolioanalyst.blogspot.com/2010/09/sukuk-bond.html,http://portfolioanalyst.blogspot.com/2010/10/how-big-is-sukuki-bond-market-and-what.html.
I want to write one guest post for your site .If you agree than contact me at roseanderson26@gmail.com

Rose said...

Hi,
As I see in your post there is lots of good information available on Islamic finance. Islamic finance has change a lot in the recent few years. Rest of the world specially American and European countries want to get advantage of these change in there own interest. Innovation of sukuk also one of the big reason that non Islamic countries look on the Islamic finance market.
Sukuk is an alternate way of investment where the investor get the benefits of investment and its treated as rent on investment, to avoid the interest on investment which is strictly prohibited in Islam.I have write on same topic check my post : http://portfolioanalyst.blogspot.com/2010/09/islamic-debt-bond-market.html, http://portfolioanalyst.blogspot.com/2010/09/sukuk-bond.html,http://portfolioanalyst.blogspot.com/2010/10/how-big-is-sukuki-bond-market-and-what.html.
I want to write one guest post for your site .If you agree than contact me at roseanderson26@gmail.com