Are Sukuk the same as Bonds?

Introduction

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We have spoken enough on the appeal of Bonds for the international investor, especially on the ability to derive a consistent stream of fixed income. However, the interest-based payments associated with bonds present a conflict with the religious beliefs of certain investors. Responding to this challenge, a new financial instrument, Sukuk, was created.

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Understanding Sukuk

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Sukuk is an alternative for investors who seek Shariah-compliant lending instruments. Adhering to the principles of Islamic finance, Sukuk circumvents the conventional interest payments associated with bonds. But how is this achieved? To illustrate this, let’s revisit the example of Fujairah Airways.

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Suppose Fujairah Airways (FA), a credible player in the travel industry with a record of high-quality service, plans to expand its operations by adding ten new flight destinations. To realize this, FA needs to acquire ten planes, each priced at $100 million, totaling a required sum of $1 billion.

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FA's financial projections indicate that this investment will generate an annual profit of $200 million. However, FA lacks immediate funds. A traditional route would involve raising $1 billion from global bond investors, with an agreement to repay these funds within five years. The contract also stipulates annual interest payment of 5% to the bondholders. A failure to meet these obligations could result in FA being driven towards bankruptcy, with bondholders given priority during liquidation.

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However, what if FA sought to appeal to Islamic investors by structuring the deal differently? Here's a look at how that could work:

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Instead of issuing bonds, FA sells ten planes to investors for $1 billion, thereby receiving their intended financing. FA then signs an agreement with these investors to lease back the planes for ten years, paying an annual lease of $50 million. This way, investors earn rental income from the asset instead of interest. Additionally, FA agrees to buy back the planes for the same amount of $1 billion after exactly ten years, which constitutes the payback from the deal.

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According to Islamic scholars, this approach adheres to Shariah compliance because it's based on leasing contracts (known as Ijara). Although this structure mirrors that of a bond, the key difference lies in the collateral—in this case, the planes—which the investors hold. If FA defaults on payments, the investors have a claim to the planes, unlike in a bond structure where investors would have a claim on FA's entire assets.

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By investing in Sukuk, the Islamic community can now access fixed-income securities while maintaining Shariah compliance.

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Nonetheless, the Sukuk market presents its limitations. Accounting for less than 1% of the bond market size, it's not nearly as vast or diverse, resulting in lower liquidity and fewer buying/selling opportunities. Furthermore, Sukuk are primarily issued by governments and companies based in the GCC and South-East Asia, limiting geographical diversification for Sukuk investors.

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Conclusion

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In conclusion, Sukuk offer fixed-income securities that serve as a Shariah-compliant alternative to bonds. However, limitations such as lower market liquidity and limited geographical diversification characterize the smaller, less diverse Sukuk market.

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