A high level primer on Islamic finance and bonds

Islamic bonds are a relatively small market which has evolved to satisfy investor demand for fixed income-type securities which are still compliant with Islamic law (“Sharia”). Impetus for the development of the market has been provided by the increase in the oil-driven surpluses of many Islamic countries and the need to recycle the capital. Though the total size of the market is relatively small, within some fixed income markets they can comprise a significant proportion of outstanding debt. The following provides a high-level introduction to the broad characteristics of Islamic bonds and the potential risks involved.

Islamic finance and banking

The entire basis of Islamic finance is that it must operate within the rules and principles of Sharia. A prerequisite for any Islamic financial transaction is Sharia compliance to ‘riba’, which prohibits the charging of interest. This is because under Sharia, money is considered a measuring tool for value and is not an asset. As money is not an asset, one should not be able to receive income from money (or anything which has the genus of money) alone. This concept is nicely captured by the following unattributed quote:

“The rule is clear cut: Gold for gold, silver for silver, wheat for wheat … Like for like, payment being made hand by hand. If anyone gives more or asks for more, he has dealt in riba. The receiver and giver are equally guilty.”

This seems clear cut and would appear to preclude the existence of fixed income securities.

There are two other Sharia laws which must be complied with and are worth mentioning in the context of this paper. The first is a prohibition on ‘gharar’, which refers to excessive uncertainty. This is a sophisticated concept that covers certain types of uncertainty or contingency in a contract. Where it becomes more complex is differentiating between what is ‘excessive uncertainty’ and what is the normal level of uncertainty associated with business transactions, i.e. differentiation between ‘gambles’ and ‘decisions under uncertainty’. A distinction is that ‘decisions under uncertainty’ imply evaluating the market value of possible outcomes so that the value of the potential gains more than offset the value of potential losses. This implies that a simple test of gharar could be referred to as the ‘zero-sum’ criteria. Based on this criteria, if an outcome is effectively a zero-sum gain between two parties, it is classified as gambling and is therefore prohibited under gharar. This also implies that certain derivatives would be excluded under this concept. The second is that there is a general prohibition on investing in industries which are halal or unethical, such as casinos, tobacco, sex businesses, etc.

Given the rules under which it must operate, the Islamic financial system has developed some rather unique means of providing finance and raising deposits whilst complying with Sharia law. The purest form of Islamic financing is ‘musharakah’, which is akin to equity investing or financing. This is essentially a partnership where profits are shared per an agreed ratio, whereas losses are shared in proportion to the capital/investment of each partner. In a musharakah, all partners to a business undertaking contribute funds and have the right, but not the obligation, to exercise executive powers in that project. This is similar to a conventional partnership structure and the holding of voting stock in a limited company. From this, alternative structures have evolved to facilitate financing. Many of these structures utilise principles such as (a) the understanding that exists before a contract is sealed (‘Ittifaq dhimniy’), which allows the seller and buyer to have made a prior agreement to sell an asset at a certain price and to buy it back at a certain price and; (b) the ability to impose compensation (rebate) in the event of default or late/early payment of the principle or profit.

It is fair to say that, excluding musharakah, the entire basis of these alternative structures is to provide a means to ‘get around’ Sharia rules. Put another way, the purpose is to advance funds to a counterparty and be effectively compensated for the time value of money without having the advance classified as a loan or the periodic repayments classified as interest. This had led some conservative scholars to conclude that the structures employed in many aspects of Islamic finance do not, in fact, comply with Sharia law as they effectively require payment for the time value of money which in itself is a fundamental test of interest. The essence of these views is that the fundamental characteristic of charging interest is not truly eliminated in Islamic finance but is merely hidden and relabelled. Some refer to these practices as ‘smoke and mirrors’.

What is an Islamic bond?

The discussion has highlighted how Islamic finance evolved to comply with the requirement that financing needs to be raised for trading in, or construction of, specific, identifiable and tangible assets. This requires that returns and cashflows be linked to assets purchased or those generated from an asset once constructed. That such requirements lend themselves to the engineering of asset-backed securities, where there is an underlying tangible asset transaction either in ownership or in a master lease, is obvious. Hence the most recent development in Islamic finance has been the development of Islamic bonds, which are often referred to as a ‘sukuk’. Sukuk is the Arabic name for a financial certificate, though it’s essentially the Islamic equivalent of a ‘bond’. For the rest of this paper, Islamic bonds will be referred to as a sukuk.

In essence, a sukuk is a structured financial instrument based on a specific contract of exchange that can be made through the sale and purchase of an asset based on deferred payments, leasing of specific assets or participation in joint venture businesses. Hence the issuance of a sukuk is not an exchange of paper for money with the imposition of interest. Instead, it’s an exchange of a Sharia-compliant asset for some financial consideration which applies various Sharia principles that allows investors to earn profits from the transactions. The key point regarding sukuks, as they involve the securitisation of assets, is that they are generally issued by bankruptcy-remote special purpose vehicles (“SPV”) (1). Essentially, sukuks are financial securities of equal denominations represented by a portfolio of eligible tangible assets and/or services. They are also tied to an eligible Sharia contract and represent undivided ownership rights to the underlying assets and/or services.

The table below contrasts sukuks and traditional bonds.

Additional risks associated with sukuks

Despite the complexity involved in structuring the underlying assets, sukuks behave much like conventional bonds. Accordingly, they are exposed to the same interest rate, credit and counterparty risks as traditional bonds. However, there are characteristics of sukuks which result in some more unique risks.

Firstly, there are Sharia compliance risks. Compliant sukuk bonds require approval from recognised Sharia advisors to ensure compliance with Islamic rules and principles. As a result, there is the risk that, following the issuance of a sukuk, the issuers may breach their fiduciary responsibilities with respect to compliance with Sharia. This risk is potentially increased due to theoretical ambiguities and may also result in sukuks ‘running foul’ of Sharia jurisdictions.

Secondly, despite the growth in the market, sukuks are not particularly liquid. Therefore, investors may face higher levels of liquidity risk investing in sukuks than they would investing in traditional bonds.

Thirdly, it could be argued that asset risk inherent in sukuks is greater than that found in more traditional asset-backed securities. The reason for this revolves around the very nature of the assets being securitised. Traditional asset-backed issues tend to involve the securitisation of financial claims such as mortgages, credit card receivables and financial leases, etc. The result is that the underlying assets are quite small and homogeneous, which increases the ability of the issuer to construct large, diversified pools of securities. In contrast, sukuks are required to be backed by real assets or transactions. As these tend to be ‘bulkier’ and less fungible than financial assets, there is less scope to achieve diversification in the SPV. The result is that sukuks may often involve greater asset-specific risk than more traditional asset-backed securities.

Finally, there is the potential risk arising from the mismatch of cashflows. To see how this works, firstly consider a traditional mortgage-backed security. Assuming the mortgages are floating rate, then both the inflows into the SPV (mortgage payments) and outflows (payments to security holders) are variable and will tend to move in line with each other. The major risk is that defaults will reduce the size of the pool and therefore the payments to security holders. In contrast, sukuks are often secured against real assets which generate the cashflow needed to pay security holders. This increases the potential that interest rates may rise by enough that, even in the absence of defaults, the cashflows from the underlying real assets may be insufficient to cover the payments to security holders, i.e. greater cashflow risk. Therefore, it’s important to ensure that the security in the SPV is appropriately structured to minimise this risk.

In conclusion, sukuks are just an extension of traditional methods of providing Islamic financing. The key to their development has been their capacity to securitise underlying real exposures. The result is securities which look and behave just like traditional bonds. However, there are some differences which mean that the risks associated with sukuks are potentially greater than those associated with more traditional asset-backed securities. It is these differences that investors need to keep in mind when considering investing in these types of securities.