How Sukuk (Islamic Bonds) Differ from Conventional Bonds - dummies

How Sukuk (Islamic Bonds) Differ from Conventional Bonds

By Faleel Jamaldeen

Modern sukuk emerged to fill a gap in the global capital market. Islamic investors want to balance their equity portfolios with bond-like products. Because sukuk are asset-based securities — not debt instruments — they fit the bill. In other words, sukuk represent ownership in a tangible asset, usufruct of an asset, service, project, business, or joint venture.

Each sukuk has a face value (based on the value of the underlying asset), and the investor may pay that amount or (as with a conventional bond) buy it at a premium or discount.

Rewarding investors for sukuk

With sukuk, the future cash flow from the underlying asset is transferred into present cash flow. Sukuk may be issued for existing assets or for assets that will exist in the future. Investors who purchase sukuk are rewarded with a share of the profits derived from the asset. They don’t earn interest payments because doing so would violate sharia.

Repurchasing sukuk at maturity

As with conventional bonds, sukuk are issued with specific maturity dates. When the maturity date arrives, the sukuk issuer buys them back (through a middleman called a Special Purpose Vehicle).

However, with sukuk, the initial investment isn’t guaranteed; the sukuk holder may or may not get back the entire principal (face value) amount. That’s because, unlike conventional bond holders, sukuk holders share the risk of the underlying asset. If the project or business on which sukuk are issued doesn’t perform as well as expected, the sukuk investor must bear a share of the loss.

Most sharia scholars believe that having sukuk managers, partners, or agents promise to repurchase sukuk for the face value is unlawful. Instead, sukuk are generally repurchased based on the net value of the underlying assets (each share receiving its portion of that value) or at a price agreed upon at the time of the sukuk purchase.

In practice, some sukuk are issued with repurchase guarantees just as conventional bonds are. Although not all sharia scholars agree that this arrangement complies with Islamic law, a product called sukuk ijara may come with a repurchase guarantee.

Ensuring sharia compliance with sukuk

The key characteristic of sukuk — the fact that they grant partial ownership in the underlying asset — is considered sharia-compliant. This ruling means that Islamic investors have the right to receive a share of profits from the sukuk’s underlying asset.

Putting bonds and sukuk side-by-side

When you have the basics about how conventional bonds and sukuk work, it’s time to put them next to each other. This table offers a quick look at the key ways in which these investment products compare.

Distinguishing Sukuk from Conventional Bonds
Conventional Bonds Sukuk
Asset ownership Bonds don’t give the investor a share of ownership in the
asset, project, business, or joint venture they support.
They’re a debt obligation from the issuer to the bond
Sukuk give the investor partial ownership in the asset on which
the sukuk are based.
Investment criteria Generally, bonds can be used to finance any asset, project,
business, or joint venture that complies with local
The asset on which sukuk are based must be
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 based on the issuer’s
credit worthiness (including its rating).
The face value of sukuk is based on the market value of the
underlying asset.
Investment rewards and risks Bond holders receive regularly scheduled (and often fixed rate)
interest payments for the life of the bond, and their principal is
guaranteed to be returned at the bond’s maturity date.
Sukuk holders receive a share of profits from the underlying
asset (and accept a share of any loss incurred).
Effects of costs Bond holders generally aren’t affected by costs related
to the asset, project, business, or joint venture they support. The
performance of the underlying asset doesn’t affect investor
Sukuk holders are affected by costs related to the underlying
asset. Higher costs may translate to lower investor profits and
vice versa.