Development of Sukuk in the Middle East - Research Paper Example

Development of Sukuk in the Middle East Definition of Sukuk Sukuk is considered as similar to bond in case of Western Finance and it is regarded as an Islamic certificate. The structure of sukuk mainly complies with the Islamic religious law which is known as Sharia. Sukuk is considered as financial certificate of Arab. Sukuk is a certificate that is being sold to the investor by the issuer who returns it back to the issuer on lieu of a predetermined amount of fees. The issuer of sukuk enters into a contractual agreement or promises to buy back the bonds at a par value on future date. The concept and the structure of Sukuk has been introduced and developed because the structure of payment of bond on the basis of western method is not allowed or permissible in Arabian countries. Sukuk establishes a relationship between the return and the cash flow from financing of the assets. The financing in case of Sukuk is applicable only in case of identifiable assets. The structure of Sukuk is developed in such a way that it provides adequate return to its investors without violating the rules and regulations of the Islamic law. There are varieties and different types of structure of Sukuk that is associated with the underlying asset. The most well known and familiar type of Sukuk is related to the partial ownership of the asset and it also includes the other types of bonds that is related or associated with the partial ownership of debt, business, project or investment. Sukuk can also be defined as the undivided shares that is related or associated with particular projects or special investment. The investor of Sukuk has common share that is related to the investment in the ownership of the asset but it does not represent or deals with the debt that is owed to the issuer of the instrument. History During the period of classical reform of Islam the concept of Sukuk has derived from the word cheque which represents or signifies the document which resembles a contract or a right or obligation that is entered by the parties and it has been introduced complying with Shariah. The evidence resembles that Sukuk is used extensively during the Islamic period for transferring the financial obligations or liabilities that has originated from the trade and other commercial activities. The importance and the need or requirement for the use of Sukuk has increased gradually in the perspective of modern Islamic culture and it deals with the concept of monetization of the asset and it is commonly known as securitization of asset which is attained through the process of issuance of Sukuk. The potential or the objective of Sukuk is related to the transformation of future cash flow of the asset into the present cash flow of the asset. The Sukuk that is issued on the basis of the existing asset or on the basis of the specific asset that is available at future date. Since the beginning of the year 2000 Sukuk has become an important and essential financial instrument for raising fund for the contribution towards the financing of long term project. Sukuk was first introduced in Malaysia in the year 2000 then it was introduced in Bahrain in the year 2001. And with the introduction of Sukuk it has been used both by the states and the corporate sector as a medium or the source for alternative financing. The issuance of Sukuk is affected severely by the global financial crisis in the economy. Sukuk has started gaining popularity from the year 2001. Principle Sukuk has been structured in relation to the various techniques. The principle for Sukuk is widely used for determining the uncertainty that exist in the contractual terms and conditions and the uncertainty that exist in case of the underlying assets in case of the contract when the application of derivative is taken into consideration. Sukuk also includes the concept of maslahah which denotes public benefit that can be explained as doing something for the benefit and welfare of the public. This category may also include the mitigation, hedging and avoidable business risk. The main guiding principles of Sukuk is that the investors generally has undivided interest on the underlying assets and it focuses on the enhancement of liquidity and the facility of providing credit and it is based or guided by the principle of musharakah, ijarah, mudaraba, salam and mixed pools and in terms of the credit Sukuk is issued for representing the risk that is similar to that of the issuer or guarantor. Sukuk is gaining its popularity as an alternative source of financing in the Islamic finance. Countries using Sukuk The countries that are using Sukuk are Malaysia, south East Asia and Middle East who are considered as the main countries for the use of Sukuk and they are known as the key centers. And sukuk is also issued in the countries such as Germany, Japan, Pakistan, Britain and Philippines. Sukuk is mainly used by the Muslim countries as a paper or the document that represents the financial obligations. Bonds Definition Bonds are referred to as the fixed incomes securities and they are regarded as one of the part or classes of securities. The bond is considered as the debt investment in which the investor mainly lends the money or amount to an entity which includes the corporate and government which mainly borrows the fund at affixed interest for a definite period of time. The bonds are mainly used by municipalities, companies, states and the foreign government for financing the variety of activities and activities. The issuer mainly issues the bond which states the interest rate that is required to be paid and the funds are to be returned on the maturity of the bond. The interest that is charged on bond is payable after every six months that is it is paid on the semiannual basis. The main types or classification of bonds are municipal bonds, corporate bonds, treasury bonds and bills. The two main features or characteristics of bonds are the duration and the credit quality and the interest rate of the bond. In case of this conventional bond the issuer of the3 bond has the obligation for making payment to the bond holders on a specific and particular date or period of time including the principal and the interest. Bond is considered as the negotiable instrument since the ownership of the instrument can be transferred in the secondary market (Jackson, 2007). History Like the financial instruments bonds too have long history. In the 14th century the purchase and the trade of the various securities has provided the owner an annuity at a specified rate. Britain decided to combine or consolidate all its long term liabilities and obligations for paying dividend to its owner without the expiry of its date. The unexpected loss that is faced by the bonds also has long history and past. The first bond was issued in Netherland in the year 1517 and since Netherland did not existed at the time of issuance of band therefore the bonds were used by Amsterdam. In United Kingdom the bonds are considered as the gift and the issue of the older bonds is named as the treasury stock and the issue of the new bonds is named as the treasury gift. Presently the bond market is mainly operated and occupied by the market in United States. And from the year 2009 the function of the bond market has become more familiar and popular. The most important form of bond is the government bond since it is more liquid and big in size as compared to other types or classes of bonds. The period of the 1980 is the period for the expansion and divergence of the international bond market. The share of the bond market has ranged from 4% to 11% in case of the bond in the advance market scenario. The bond in the international market has been able to attract the borrowing of the private sector. During the period of 1980 the popularity and the use of the foreign bond market in case of Japan and France has expanded and developed significantly and rapidly. In the year 1990 the Euro bond market has accounted for more than three quarters of the international bond (Brigham and Ehrhardt, 2011). Principle The fundamental or the basic principle for valuation of bond is that the value of bond is equal to the present value of the cash flow that is expected in the future and the process of valuation of bonds mainly includes the estimation of the cash flow that is expected, the determination of the interest rate for providing discount on the cash flows and calculating the present value of the cash flow that is expected that is by using or applying the interest rate. For the computation of the bond it is required to determine the future cash flow. The present value is mainly dependent on the interest rate. The price of the bond will become close to par when the bond approaches towards its maturity date. When the bond move towards the maturity date the discount rate changes along with it and this is attained with the net change in the price of the bond that will reflect the change in the maturity period resulting in the change in the discount rate. When the coupon rate of bond is more than the yield that is required in the market then the bond will be traded above the par value or at a premium and this will prevail because the investors of the bond will desire for making payment at a higher price for achieving the additional yield on bond. When the investors continues or decides to buy or purchase the bond then the yield of the bond will decrease till the time the bond reaches its equilibrium position (Stimpfle, 2011). Countries using bonds The countries that mostly use bonds are US, UK, Netherland, Switzerland, Sweden, Finland, Austria, Denmark, Canada, Greece, France, Ireland, Italy, Japan, New Zealand, Portugal, Spain and Belgium. Among these countries US makes the most efficient use of the bonds. How Sukuk Differ from Conventional Bonds The main differences between Sukuk and conventional bonds are Sukuk is mainly associated with the ownership of asset and bond is associated with debt obligation. The certificates that are issued in case of Sukuk are required to comply with the laws and regulation of Islam whereas the bond is related to the bond certificate which is supported or backed by the assets. The modern Sukuk has been developed to fill the gap or the difference that exist in the global capital market therefore the Islamic investors desires to establish a balance between the equity portfolio and the products like bonds. Since the sukuk are the assets that are supported or backed by securities and not debt instruments therefore the sukuk fit to the bill. The sukuk is generally referred to as the ownership in the tangible assets. The sukuk has a fair value at which the investors pay the amount or they can also buy it at a discount or at a premium (Mohammed, 2014) Putting bonds and Sukuk side-by-side By putting the sukuk and the bonds side by side the difference between them can be classified on the basis of various classes or categories which can be clearly explained with reference to the table given below. Conventional bonds Sukuk On the basis of Asset ownership The bonds do not provide the share of ownership in case of their asset, joint venture, support, and project and in case of business. The conventional bond can be better explained as the debt obligation that is transferred from the issuer of the bond to the holder of the bond. Sukuk in terms of the asset ownership provides partial ownership in the asset on which it is based. Investment criteria On the basis of the investment criteria in case of the conventional bond it can be defined or explained that it is generally used for financing the asset, joint venture, project and the business complying with the legal legislation The investment criteria in case of the Sukuk can be explained as the asset on which it is based must comply with Sharia. Issue unit The issue of unit in case of conventional bond can be explained or defined as the bond that represents each share of debt Unlike the conventional bond in case of the sukuk the unit is issued on the basis that each sukuk determines the share of the underlying assets. Issue price The issue price of the conventional bond can be defined or explained as the face value of the bond price which deals with the credit worthiness of the issuer that mainly includes the rating. The issue price of Sukuk can be explained as the face value of Sukuk is mainly based or deals with the market value charged on the underlying assets. Investment rewards and risks On the basis of the investment rewards and risk in case of conventional bond it can be explained as the bond holders generally schedule regularly the interest payment that is charged for the life of the bond and the principal amount is required to be returned at the maturity date of the bond. On the basis of the investment rewards and risk in case of the Sukuk it can be explained as the holders of Sukuk generally receives the profit that is derived from the underlying assets. Effects of costs The effects of cost in case of the conventional bonds can be explained as the. Bond holders are not affected and influenced by the cost that is associated or related with the business, project, joint venture and asset. The activities of the investors of the underlying asset do not affect and influence the reward of the investors On the basis of the effects of cost the holders of Sukuk is affected by the cost that is mainly related or associated with the underlying of asset. The increase or the rise in the cost will result in lowering the profit of the investors. The conventional bond is defined as the contractual debt obligation where the issuer of the bond is bound to pay to its bond holders on a specific period of time and on the basis of the specified principal and rate of interest and on the contrary the sukuk bonds holders generally claims for the undivided ownership for the assets that is underlying . The sukuk holders have the responsibility of sharing the revenue or the profit that is generated by the assets of sukuk and it is also entitled to share the revenues that are generated from the assets. The most important and peculiar feature of Sukuk is that the certificates in case of Sukuk determines the debt to the holders of the instrument and the certificate of sukuk is not traded in the secondary market and therefore it is held till the maturity and it is sold at par (Cakir and Raei, 2007). Ensuring sharia compliance with Sukuk The compliance of Sharia with Sukuk can be explained as the technique that is developed in UK in the current years and in the current years UK has decided to pass a legislation with the aim and objective to overcome the challenges or the difficulties which have recently restricted the shariah compliance with the process of securitization and the issue arising out of Sukuk that is operating in UK. The advantage of the Sharaiah property in financing the market has traditionally restricted the ability of the banks to provide the funds readily and instantly to its customers. Figure 1: Traditional residential mortgage backed securities. The process or the method that is adopted by the conventional banks to free the capital for starting the new business or venture is securitizing the new and the existing loans before the consideration and formulation of new laws and rules and regulations that has made the Islamic securitization process uneconomic in nature and in the situation of the credit crunch which has affected the sukuk, many of the investors have attempted to reap the advantages or the benefit with the intention or the objective to diversify or expand their portfolio. The changes that were undertaken have provided an opportunity for the issuance of property that is supported or backed by Sukuk and therefore in order to start the business, the UK government has decided to issue Sukuk. Theory and practical use of Sukuk bonds Theory of Sukuk bonds The growth and development of the use of the Sukuk as the means of Islamic finance has started with the issue of Sukuk bonds in Baharain. The Sukuk bonds are mainly classified into two types that is asset based sukuk bonds and asset backed sukuk bonds. The Asset based Sukuk bonds can be defined as the means of raising finance in which the principal comprises of the capital value of the assets but the repayment or the return provided to the Sukuk holders are not related and influenced directly through the financing of the assets. The method or the process of financing or the acquisition of the assets or the process of rising of capital in case of Sukuk through the lease and sale can be explained with the help of the diagram given below Figure 2: Asset based sukuk The asset backed securities can be defined as the means or the process of raising finance in which the principal is mainly determined by the capital value of the assets but the repayment or return provided to the holders of Sukuk bonds directly which is financed through the use of these assets. Figure 3: Asset backed securities of Sukuk The asset backed sukuk is mainly used in case of securitization and leasing of portfolio. The asset backed securities have the features or the characteristics of equity financing and the assets are mainly owned or possessed by the special purpose vehicle. Practical use of Sukuk bonds Companies that uses the bonds as a means to raise the finance to start the new venture or to expand the business was restricted under the Islamic law and therefore the Sukuk bonds have been introduced and linked with the underlying asset so that it can become the partial owner and receive the profit or the revenue generated out of it. References Brigham, E. and Ehrhardt, M. (2011). Financial Management: Theory and Practice. Boston: Cengage Learning. Cakir, S. and Raei, F. (2007). Sukuk Vs. Eurobonds: Is There a Difference in Value-at-Risk. Middle East: International Monetary Fund. Jackson, J. (2007). Financial Management. New York: Cengage learning. Mohammed, N. (2014). Five Important Differences Between Sukuk and Traditional Bonds. Asset Islamic Finance and Sukuk Ltd. Retrieved from: http://www.sukuk.com/education/important-differences-sukuk-traditional-bonds-2207/ > Stimpfle, A. (2011). Islamic Finance made in Germany: The 2004 Sukuk Issue by the State of Saxony-Anhalt.London: GRIN Verlag. Read More