Sukuk: how Islamic bonds are structured

What you will learn

• What sukuk are and how they legally differ from conventional bonds.
• The steps of an ijara sukuk and the role of the special purpose vehicle.
• The difference between asset-based and asset-backed sukuk, and why tradability depends on the structure.
• How to calculate the distribution and approximate return of a sukuk investment.

Explanation

Bond pricing, yield to maturity and credit spreads are covered in the course "Bonds & Fixed Income in Depth". Here we focus on what makes sukuk different.

Sukuk (singular: sakk) are certificates of equal value that represent undivided ownership shares in assets, usufruct (the right to use an asset), services or a project. A conventional bond is a debt: the holder lends money and receives interest. A sukuk holder owns a share in something real and receives part of the income it generates. AAOIFI's Sharia Standard No. 17 on investment sukuk sets out the main types.

The ijara sukuk step by step

1. The originator (for example a company or government) sets up a special purpose vehicle (SPV), a separate legal entity created only for this transaction.
2. The SPV issues sukuk to investors and collects their money.
3. The SPV uses the money to buy an asset, such as a building, from the originator.
4. The SPV leases the asset back to the originator, which pays rent.
5. The rent is passed to investors as periodic distributions.
6. At maturity the originator buys the asset back under a purchase undertaking (a binding promise), and investors receive their capital.

Other common structures

• Murabaha sukuk: represent a share in a cost-plus sale receivable. Because they represent debt, most scholars allow trading them only at face value, so they rarely trade in secondary markets.
• Musharaka and mudaraba sukuk: represent a share in a partnership or business venture; returns depend on actual profit.
• Wakala sukuk: an agent (wakil) manages a pool of assets for investors for a fee. Pools often mix tangible assets with some receivables.

As a rule of thumb, sukuk may trade at a market price when they mainly represent tangible assets or usufruct. Many structures require a minimum share of tangible assets in the pool for tradability; the exact percentage depends on the Sharia board, so check the prospectus.

Asset-based versus asset-backed

• Asset-based (the large majority): investors own the asset on paper, but in a default they usually rely on the originator's promise to repurchase. Economically the risk is close to an unsecured bond of the originator.
• Asset-backed: investors have real recourse to the asset and could sell it if payments stop. These are rare.

Because asset-based sukuk often promise to return the full face value, critics say they mirror bonds too closely. In 2008 AAOIFI issued a statement criticising, among other points, structures in which the manager of partnership-type sukuk promises to buy assets back at face value. Practice varies, so read how the repurchase price is defined.

A German example: in 2004 the federal state of Saxony-Anhalt issued a euro sukuk of about €100 million, often cited as the first sukuk from a European issuer.

Worked example

Hypothetical example: An ijara sukuk has a face value of €1,000 per certificate, a 4% annual distribution rate paid every six months, and three years to maturity. You buy one certificate at 98.50 (€985). Assumptions: the originator pays all rents and repurchases at face value; no fees, spreads or taxes.

• Semi-annual distribution = €1,000 × 4% ÷ 2 = €20.
• Number of distributions = 3 years × 2 = 6, total €120.
• Capital gain at maturity = €1,000 − €985 = €15.
• Total gain = €120 + €15 = €135.
• Current yield = €40 ÷ €985 ≈ 4.06% per year.
• Solving for the rate that discounts the cash flows to €985 gives about 2.27% per half-year, or about 4.5% per year (nominal).

If the originator defaulted, an asset-based structure would leave you as an unsecured creditor-like claimant, so your return would depend on the originator's credit quality, not on the building's value.

Common mistake

Practice activity

Hypothetical: A wakala sukuk has a face value of €1,000, pays 5% per year once a year, has two years to maturity and trades at 101.00. Assume full payment and repurchase at face value; ignore costs.

1. Calculate the yearly distribution and the total cash you receive.
2. Calculate your total gain or loss.
3. Explain why a murabaha sukuk with the same figures would usually not trade at 101.00.

Key takeaways

• Sukuk represent ownership in assets or usufruct; bonds represent debt.
• Most sukuk are asset-based, so credit risk sits mainly with the originator.
• Tradability depends on whether the sukuk mainly represent tangible assets or debt.
• Check the repurchase terms, the asset pool and the Sharia opinion in the prospectus.

Next step

The next lesson moves from fixed-income certificates to equities and looks at how Sharia-compliant funds and ETFs are built and monitored.