09 Sukuk.pptx, A bond is a long-term debt

A bond indenture is the legal document that specifies the rights of the bondholders and the duties of the issuer
Bond indentures usually include some restrictive provisions that seek to protect the bondholders’ interest
Sinking-fund requirements aim to systematically retire the bond thus reducing risks
A third party trustee is usually appointed to monitor the issuer to ensure compliance to agreed terms and provisions
Some bonds are convertible
Allows bondholders to convert each bond into a stated number of shares of common stock
Most bonds have a call feature
Allows the issuer to repurchase the bond prior to maturity

1. Sukuk ISF 1101 Foundation of Islamic Finance

2. What is a Bond? A bond is a long-term debt instrument indicating that an institution has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms General characteristics Usually long term (10 to 100 years) The borrower is called the issuer , and typically comprise large corporations or governments The lender is called the investor or bondholder, and typically comprise financial institutions, governmental bodies and high net worth individuals Bonds are not retail instruments given its significant minimum denomination Bonds are commonly traded , providing investors liquidity A bond is an instrument of where funds are channeled directly from surplus units to deficit units without intermediation

3. Bonds : Other Features and Characteristics A bond indenture is the legal document that specifies the rights of the bondholders and the duties of the issuer Bond indentures usually include some restrictive provisions that seek to protect the bondholders’ interest Sinking-fund requirements aim to systematically retire the bond thus reducing risks A third party trustee is usually appointed to monitor the issuer to ensure compliance to agreed terms and provisions Some bonds are convertible Allows bondholders to convert each bond into a stated number of shares of common stock Most bonds have a call feature Allows the issuer to repurchase the bond prior to maturity

4. Bond Valuation Basic elements which affect the valuation of a bond are, Principal , or amount borrowed, typically in denominations of $1,000 Periodic interest payments at a predetermined rate, called the coupon rate Duration or tenor of the bond (maturity) Required rate of return or the discount rate There are essentially two types of cash flows Periodic (yearly or semiannually) interest (coupon) payments Repayment of principal at the end of the duration of the bond (maturity)

5. Sukuk Sukuk has been positioned as the Shari’ah compliant version of conventional bonds It is a means of raising long-term capital for businesses, financial institutions and governments It is an alternative source of capital to raising equity (issuing shares) AAOIFI definition of Sukuk Certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of) the assets of particular projects or special investment activity

6. How is Sukuk Different from Bonds? Sukuk structures are designed to be Shari’ah compliant Islamic nominate contracts are used in the structure – murabahah , ijarah , musharakah , etc. Underlying assets used must be Shari’ah compliant Philosophically (or ideally), Sukuk represents ownership of specific assets, and not merely a loan (as in the case of bonds) Sukuk is also more than just collateralized debt, as Sukuk cash flows originate from and are tied to the specific assets (again, in theory)

7. Categories of Sukuk Asset-Based Asset-Backed More debt-like structures, “similar” to conventional bonds More equity-based Murabahah , ijarah Musharakah , mudarabah True sale does not occur, ownership merely “on paper” Sukuk holders genuinely own identified assets In event of default, Sukuk holders do not have recourse to specific assets In event of default, Sukuk holders have recourse to specific assets Cash flow typically fixed or tied to a benchmark (LIBOR) Cash flow varies with actual performance of Sukuk assets Have been criticized as mere replication of conventional bonds Deemed by some as “more Islamic” The majority of Sukuk on issuance today are of this category There are very few asset-backed Sukuk

8. Example of Asset-Based Sukuk: Malaysian Global Sukuk Al-Ijarah Special Purpose Vehicle (SPV) [Malaysian Global Sukuk Inc.] Malaysian Government Investors (1) Sell hospital for $600m (2) Pay cash $600m (3) Issue sukuk $600m (4) Cash proceeds $600m (5) Lease hospital (6) Rental payment $100m (7) Rental income $100m (8) Sell back hospital for $600m (9) Cash payment $600m (10) Sukuk redemption $600m

9. Example of Asset-Backed Sukuk: Pasir Gudang Municipal Mudarabah Sukuk Investors (Sukuk holders) PG Municipal [SPV] PG Local Authority (Administrator) Invest capital Capital Management and administration of municipality Use capital for development and operational costs Tax collection Profit from tax collection shared according to agreed ratio between administrator & investors Rabbal-Mal Mudarib Intermediary

10. Some Concepts and Issues Securitization and Sale of Debt Bay al- dayn and its Shari’ah permissibility Use of Special Purpose Vehicle (SPV) Bankruptcy remoteness and ring-fencing, tax purposes Event of default Recourse to Sukuk assets Interpretation of Shari’ah rules/clauses by Western legal system (governing law is English Law) Lack of secondary market trading Demand exceeds supply Most Sukuk held to maturity Data on market prices not available, affects research and efforts to improve efficiency of Sukuk market Arguably, there exists a liquidity premium, making Sukuk more costly

11. Innovative Structures Financial engineering, coupled with market demand, has resulted in the issuance of sukuk and Islamic securities which can be characterized as having “innovative structures” For example, the Zam Zam Tower Sukuk Al- Intifa ’ Project manager Munshaat Real Estate Projects Co. was awarded the contract to construct one of the six towers on waqf land adjacent to the Grand Mosque of Makkah The asset in this case is usufruct ( manfa’ah ) More specifically, the right to benefit or enjoyment ( haq al intifa ’ ) in the form of time-sharing The issuer sells 24-year sub-leases on time-sharing basis to investors The sukuk al- intifa ’ ( timeshare bonds ) are fully negotiable through the issuance of further sub-leases Investors participate by purchasing the sukuk and paying their value in advance, plus payment of annual charges for maintenance and managerial services Such a structure was conceived given that the property was on waqf land and hence transfer of ownership cannot be effected To finance the construction of the property, the contract of forward lease ( al-ijarah al- mawsufah fi al- dhimmah ) was adopted That is, investors pay rental in advance

12. Zam Zam Tower Sukuk Al- Intifa ’ Land Owner ( waqf ) Property Developer Sukuk Investors 1. Ijarah contract on use of land 2.Lease of rights of future use of units on chosen timeslots 3.Payments of Lease Rental ( Sukuk proceeds) Proceeds from sukuk sales 4.Payment for lease of land Commercial and Hotel Complex 5.Development costs 6.Time-use by sukuk -holders (upon completion of property)

13. Issue: Equity-based Sukuk with Pre-determined Rates of Return In early of 2008, Muhammad Taqi Usmani , Chairman of AAOIFI’s Shari’ah committee sent shockwaves across Islamic capital markets when he commented that 85% of contemporary Sukuk were not Shari’ah compliant He was referring in particular to equity-based Sukuk ( musharakah / mudarabah ) The key points Shari’ah contract used was musharakah or mudarabah If actual return for a given period was higher than a specified rate (say LIBOR +1%), excess return is given to Sukuk issuer as “ performance incentive ” If actual return for a given period was lower than the stipulated rate, the shortfall is made up via a loan from the Sukuk issuer to the Sukuk holder This loan is recovered in subsequent periods when actual return exceeds the said rate The issuer makes a promise ( wa’d ) to buy back underlying asset at maturity at a pre-determined price (Purchase Undertaking)

14. The end effects of these contractual stipulations are: Periodic payments to the Sukuk holder is fixed at a margin above an established pricing benchmark (LIBOR) Return of the principal amount at maturity is guaranteed Thus the Sukuk musharakah / mudarabah has the economic cash flows of a conventional floating rate bond Of course this structure could also be applied in such a manner to mimic a conventional fixed rate bond By stipulating a fixed rate instead of a fixed margin above LIBOR The primary objection was not whether the cash flows were fixed or floating We can structure ijarah sukuk with fixed or floating rental payments and even include buyback of assets at predetermined prices at maturity The problem was that the structure contained elements of deception Branding the Sukuk as equity-based but resulting cash flows do not reflect risk sharing principles Issue: Equity-based Sukuk with Pre-determined Rates of Return (2)