Understanding the Risk Management of the Islamic Bonds - Annotated Bibliography Example

Date: Institution: Islamic Bond Islamic Bond has of recent turned out to be an attraction to both Islamic and non-Islamic states notwithstanding the manner in which it works and the regulations involved. An annotated bibliography of some prominent works highlights some facts about Islamic bond Annotated Bibliography Sophastienphongn, Kiatchai, Mu, Yibin & Saporito, Carlotta. South Asian Bond Markets: Developing Long-term Finance for Growth.World Bank Publications. 2008. This particular book appears in the World Bank e-library. The book is also cited in many other articles. The authors of this book are all distinguished writers. Kiatchai Sophastienphongn is a senior Financial Sector Specialist. At the World Bank South Asian Region, he oversees planning, measures regarding poverty reduction/mitigation, economic development, finance as well as private-sector development. Dr. Yibin Mu is also the Senior Financial Economist and Senior Capital Markets Specialists in the same organization, World Bank. Carlotta Saporito is however not a senior but a Junior Professional Associate within the World Bank’s IFC (International Finance Corporation). This book offers an analysis of the financial sectors within the South Asia Region while providing a comprehensive summary of the main bond markets within the South Asia Region. The book highlights areas that indeed need a reform. Apart from providing more knowledge of bond market, this book will assist in this essay through a significant contribution towards identification of potentials. Abdo, Hafez &Wakkas, Firas. Islamic Finance: Understanding the Risk Management of the Islamic Bonds, Sukuk. LAP Lambert Academic Publishers.2011. This book is among the notable books discussing Islamic bonds. It is available as an e-book and appears in the e-library. The book is cited in many other articles and books. Hafez Abdo stands out as one of the most promising 21st century writers featuring in numerous journal articles and books. Firas Wakkas is also among the most renowned writers. Both of the authors are thus prominent writers. This particular work offers a critical and detailed assessment of the sukuk as an Islamic bond. It places special emphasis on the Sukuk’s financial structures that are basically intrinsic. While deeply engaging in sharia Law’s contributions towards Islamic Bonds, it provides a basis for the essay to point out some structures, regulatory factors and considerations. Adam, Nathif & Thomas, Abdulkader. Islamic Bonds: Your Guide to Issuing, Structuring and Investing in Sukuk. Euromoney Books. 2004. This particular book discusses Sukuk (Islamic Bond) in relation to how that has become the helm of creativity in the Islamic finance. The book is Authored by Nathif Adam and Abdulkader Thomas who are famous authors internationally and whose work feature in most articles. The book analyses Islamic financing while also highlighting the manner in which the potential of sukuk has not been fully achieved. This work will be crucial to the essay in that it will assist with information regarding the continued development of the Islamic bond market not only for the new investors but also the issuers World Bank. Global Financial Development Report 2014: Financial Inclusion. Washington: World Bank Publications, 2013. This outstanding work is attributed to the world renowned World Bank. World Bank is a financial institution that controls most funds used for development purposes. This book details more about financial inclusion as an interesting subject whereby it also highlights how many nations have assimilated into their system strategies involving explicit financial inclusion. Apart from detailing financial inclusion, this particular work provides the actual basis for data regarding financial transactions globally. Safieddine, Assem. "Islamic Financial Institutions and Corporate Governance: New Insights for Agency Theory." Corporate Governance: an International Review. 17.2 (2009): 142-158. This particular review remains indebted to Safieddine M. Assem. The review focuses on methods of stimulating Islamic Banking to improve the current governance practices. Besides delving on sharia principles, this work highlights most Islamic Banks that have been surveyed as recognizing the significant role of governance hence instituting basic mechanisms. Further, the work points out basic flaws derived from the need for complying with sharia law. The work is quite relevant to the essay given the various issues it highlights regarding the Sharia Law and Islamic banking.   Introduction Bonds are without a doubt quite significant to the 21st century financial markets. While bonds may vary widely, there has been one notable kind that has attracted significant attention globally. Islamic bond, also referred to as ‘Sukuk’, has stood out as a challenge to the conventional and ordinary bonds even in the face of the global financial meltdown/financial crisis. It is basically a type of security mainly used in Islamic states since it complies with the Islamic sharia laws as well as the associated investment principles prohibiting individuals from being charged a fee or paying any interests1. In contrast, this is more of a paradox to bonds such as fixed incomes and interest bearing bonds that are often charged in non-Islam nations; such are not permitted in Islamic states. In fact, Islamic states avoid paying or being charged interest by involving assets that are tangible within their investment. The purpose may be accomplished when the bond owner is given part of the ownership such as a property that has been built by the company investing. The bond owner then gets the chance to collect profit in form of rent, an action that is acceptable in Islamic law. The purpose of this paper is to discuss Islamic bond including what it is, how it works, and the countries that have adopted it, its rules and how it works with the Islamic law. The paper will also provide an annotated bibliography addressing pertinent issues presented by Islamic bonds Islamic bond has undoubtedly commanded significant attention owing to its significant characteristics. Islamic bond is often compared by how it differs from conventional bonds. When specific characteristics are put into focus, the manner in which Islamic bond is distinguishable from other bonds becomes quite evident. In actual fact, the main three characteristics that distinguish the Islamic bond from other bonds include the principle of participating in both profit and loss. According to this principle, the owner is given a part of the profit and not the proportion of the nominal value predefined. Another characteristic pertains to the issuance of documents on behalf of the owner of categories of equivalent value. This is because they are a representation of common shares in the assets of special investment activities. The final characteristic is the issuance of bonds in accordance with the Islamic laws. The Islamic mode of finance among other controls directs the circulation and issuance in regards to contract and legal basis of Islamic laws. According to the World bank 2 in its article on global Islamic financial report, Approximately $ 1.813 trillion of possessions are managed based on the principles of Islamic investments, the actual principles that form the sharia law. In addition, it is estimated that about twenty percent of the customers of various banking institutions would rather choose financial products that are Islamic over conventional ones with profiles of similar risk returns. Likewise, Outsiders are similarly portrayed as finding religious-inspired non-interest systems of loan to be mystifying. It is thus worth noting that criteria that are based on ethical and moral considerations often tend to limit investable securities. The Fewer chances actually prevent conventional investors from participating in the Islamic market given that Islamic finance is a part of the global market Islamic bonds work in various ways while ensuring that they comply with the sharia laws3. One of the qualities of Islamic bond is to give part of ownership in the primary asset. This is in compliance with the sharia law4.This ruling is an agreement that it is a right for Islamic investors to a share profit from the underlying asset of the Islamic bond. Therefore gives them the chance to share. Additionally, the securities in Islamic bonds tend to be bought and held, this then result in the securities entering the secondary market where they are traded. The Islamic bonds allowed to enter in this market are public sukuk since they are the ones listed in the stock exchange. The secondary market also tries to develop with the trading done at institution level. For instance, in 2007 $55.5 million of sukuk was traded. On the other hand, the European Islamic investment banking also indicated that in the first half of 2008, compared to 2007, the volume of the trading market seemed to have contracted. Similarly, there is an estimate by HSBC of about $822bn of Islamic debt in the world. The principle of Islamic bond also works in other different ways whereby different techniques are used to achieve Islamic bonds with the desirable qualities. While conventional bond remains a promise to repay the loan, Islamic bond incorporates partial rights in a debt. The most used Islamic bonds duplicate the cash flows of conventional bonds. The structures are listed on London stock exchange markets and Luxembourg stock exchange which are in basically Europe-based. Conventional organizations thus make it possible to trade. However, from the sharia perspective, death certificates are not tradable. While many structures may be there, Sukuk Al Ijara is the most acceptable tradable structure. An Islamic view regarding death certificates involves death certificates being purchased before any issue of finance then being apprehended to maturity. As well, an individual is not supposed to get his income from money as the Islamic law considers money to be a tool for measuring value and not necessarily an asset. The Islamic law does not permit the trading and selling of debt, lending of conventional loans, receivables and credit cards. The incorporation of ‘Maslahah’ or public benefit is often given due priority. It actually symbolizes that something is tremendously in the public good. In such a case, hedging the risk may then apply since it may be yet to be transacted5. Repurchasing Islamic bond at maturity is similarly a method by which it works. As with bonds that are conventional, Islamic bonds are subjected at precise maturity dates. The sukuk issuer, through middle man (a special purpose vehicle), buys the bonds at the set date of the maturity. However, with sukuk, the initial investment is not a guarantee. The Islamic bond holder may either get or not get the principal amount. This is because the sukuk investor accepts Islamic bond holders to share the risk of the basic asset which is unlike conventional bond holders (A share of the loss if the project on which the Islamic bonds were based do not perform well). It is unlawful to have Islamic bond managers, agents or partners to repurchase Islamic bonds for the principal amount6. Rather it is lawful to repurchase the bonds on the net price of the original asset or at a cost agreed upon at the time the sukuk was bought. Just as conventional bonds, some sukuk are issued practically with repurchase guarantees. This arrangement is not in agreement with what most sharia scholars agree on. In fact, according to such scholars ‘sukuk Ijara’ may come with a guarantee to repurchase. Most of the countries using the Islamic bond are Asian countries. There are signs everywhere that the frontiers of Islamic finance are expanding7. While other countries plan to enter Islamic bond, a number have already joined. Most Asian countries have not engaged and for those that have engaged, they still have much to do to get their benefits. Among the countries using Islamic bonds include Malaysia, Bahrain, Egypt, Qatar, United Kingdom, Singapore, Somalia, Turkey and Hong Kong. Hong Kong is among the countries that jumped on board to join the move. Its main reason to join was to boost and to enable them compete globally in matters concerning finance while also boosting corporation8. Its reason was also to capitalize on a rising demand by pushing to become regional center for Islamic finance. The push to issue a $1bn debut deal would lead to the establishment of nontraditional locations of financial centres like the UK. It would also boast deals between cross boarders i.e. between Hong Kong and Malaysia that begun in 2012 to 2013. The commitment by Hong Kong towards Islamic bonds would create ways in mainland china where there is a higher population of Muslims compared to Malaysia. Property management, private equity and private banks are among the potential growth areas9. Even with the limiting legal systems, there have been changes in the legislation of Hong Kong Islamic bonds. Despite this, the biggest pioneer to dominate the issuance of Islamic bond globally and pioneer the modern finance industry of the Islam is Malaysia. About $490bn out of $673bn (about 73%) is Malaysia’s borrowing. However, $475bn of the above estimates belongs to the local shareholders. In fact, there are targets set by the Malaysian government for the Islamic banking possessions to reach 40% of the whole industry by 2020. This is considered possible to achieve since they emerged from one digit share in the market and in 10 years had reached 22%. Malaysia has become the force behind the regulation and innovation of Sukuk in the Asian world. It has also applied an influence on countries that do not practice Islamic bond such as United Kingdom and Turkey. Iran is another country using Islamic bond. In 2005 and 2010, the Iran security market laws were enacted. Development laws in the new instruments and financial institutions were made to create means for the development of the country by such financial systems. In January 2011 the first Ijara Sukuk was issued to finance Mahan Airline Company in the capital market of Iran. The value issued was 291,500 Riyals. Singapore was also the first majority non-Muslim country to issue an independent sukuk . It was referred to as MAS sukuk locally. its issuance was through a subsidiary which was owned wholly by Singapore’s monetary authority. There is a similarity in how Singapore MAS sukuk and Singapore government security are treated. This is in areas that need to comply with the liquid requirements. The issuance of Islamic bond locally and internationally in Singapore has increased over the years. In 2009 the first Ijara sukuk was issued to Singapore city development. In 2010, SG1.5bn was issued by Khazanan to finance its attainment of parkway holdings. Singapore listed companies (Swiber and Valianz Holdings) were given an arrangement of two new programs. Similarly, Somalia is another country practicing Islamic bonds The national bourse for Somalia is Somalia stock exchange (SSE). There was a memorandum of understanding signed by SSE in 2012 to assist in technical advancement. Part of the arrangement was the identification of appropriate expertise and support and Part of the deal for the development of Islamic bond in this country included complying with sharia and halaj equities. Turkey is another potential country using Islamic bonds. In 2012 there was a debut by turkey to use Islamic bonds. The issuance of October 2012 was a double one. The US Dollars issued in 2012 October was one while the other one was Turkish Lira still in October 2012. There was an oversubscription of the US Dollars that had initially been planned to be $1B which was increased to $1.5 bn due to a rise in demand by the Middle East countries. The United Kingdom became the first non Islamic country to issue Sakk on 25th June in 2014. The issue was two hundred million Euros to be oversubscribed 11.5 times. The sukuk was issued at an equivalent rate with that of the bonds belonging to UK government which was 2.036%p.a. it was connected to the UK’s government rental income. Indonesia is a promising growth in the Asian Islamic finance market. 85% of the 250 m people are Muslims. However most of the populates are unbanked , the $703m has been issued by the country’s Islamic bond holder from commercial borrowers. Its retail side offers an infinite level of possibility. Their population compared to that of Malaysia is seven to eight times bigger predominated by Muslims. According to IFIS in 2013 there was a sale of $4.71 worth of Islamic bonds inclusive of a deal worth $1.5bn. $1.98 bn has been sold 10. The sale was reported to have a recording of $1.7bn offer on retail. The prospects to issue sukuk have been examined by the Asian development bank (ADB). Given the benefits opportune to the region, there is possibility for it to enter the market. The ADB sees Islamic finance as a way to reach communities that cannot access conventional finance sources. Financing that complies with sharia and technical help have been provided to support the development of the sector. ADB focus is to make Islamic bonds work as a part of the financial toolbox. The story in some of the Asian countries is unfulfilled11. Since 2005’s $600m of five year agreement, there has not been any international sukuk by Pakistan. There has recently been 5 and 10 year international curves on conventional bonds. India, with little headways, has also flirted with Islamic finance. Given the large Islamic population, bankers say these countries have the potential to grow12. There is need in creating more awareness in India. This is because Islamic banking is still new and there is room for growth. With the natural fit, there seem to be growth potential in central Asia and South Asia Region13. Islamic bonds are made in such a way that they comply with religious laws14. Islamic finance makes it possible for corporations in the world of Muslims to raise capital in ways that comply with sharia laws. Since Islam does not divide the spiritual from the secular, the domain of financial matters is arrived at properly. Looking at how the Islamic law works with the Islamic bonds there are many things that unfold and are completely different from the traditional bonds. One is that Islamic bonds work with no interest. Other bonds accumulate interest with time. Islamic religion forbids the making of money from money. In order to produce profit, one has to generate economic activities. Rather than possession, money is seen as a means of exchange. Islamic finance is based on equity as opposed to other traditional banking. The rate of return is not allowed since interest payment is not allowed in the Islamic culture15. Therefore investors put their money in different activities in order to generate income. The investor receives a margin of the profit that is equivalent to the interest received in a conventional bond. In order to determine the profit charged the same benchmarks as that of interest rates is used. Libor determines the rate at which revenue is returned. This means that the shareholder ends up getting the same rates they would have gotten for a conventional bond. The most transparent theory is thought to be Libor. Islamic law also works with Islamic bonds through profit banking where the financial institution shares the profit and loss of the underwritten business.There is the idea of gharar which is the risk. Financially, it is the sale of an item without certainty of its existence. Examples include purchasing premiums to insure against things likely or not likely to occur. It can also be used to hedge against outcomes likely to occur. Equity financing of companies is permitted if the companies are not involved in restricted types of business like producing alcohol, weaponry or pornography. The permissible financial arrangements encountered in Islamic finance include contracts on the sharing of profit and loss. This is also called mudarabah. With the assumption of a share in the profits and loss the Islamic bank pools investor’s money. This is agreed upon with the depositors. In order to determine if there is prohibition of any sources of income, a balance sheet is made. It is checked against if the debts held by the company are many or if the company is engaged in activities that are prohibited. To add on mutual funds that are active, there is an existence of passive ones and indexes such as Dow Jones Islamic Market Index and FTSE international Islamic index. Musharakah which is the partnership and joint stock ownership is a crucial financial agreement. The structures here include declining balance shared equity which commonly finances a home purchase. The bank and the shareholder jointly buy the home. This then leads to the investor of the institution giving its equity portions to the home owner’s equity. Lease to own is the second structure of partnership and joint stock ownership. It is similar to the above described declining balance its difference being most of its financial balance being put up and the money arrangement being agreed upon with the owner of the home to sell the house to him when the fixed term is over. The lease gets a portion of the payment while the rest towards the buying price of the home. The final structure under fixed income funds is murahaba which is the installment sale. Intermediaries with titles that are free and clear buy homes. The intermediary investor together with the prospective buyer agrees on sale. The sale price is with an inclusion of profit. The purchase is either outright or through installment payments. This however is not to be confused with an interest bearing loan since it is a form of finance that is acceptable. Another arrangement includes Islamic forwards which are also known as salaam or istisna. They are unique business forms used for a specific type of business. The items upon prepayment are delivered at the definite point in upcoming date. For such a contract to be legal there are conditions that must be adhered to, for this to be possible it is important to involve an Islamic legal advisor. The advisors advices the concerned parties and ensures that the activities carried out comply with sharia. In Malaysia, the Bank Negara Malaysia (BNM) has the National Sharia Advisory council in advising them on aspects that operate in the institution in their products and services and they comply with sharia principles. The same purpose is served by the Ulama in Indonesia. This has consequently led to the spread of sharia advisory firms hence institutions offering Islamic services now have access to sharia advisory services easily. It is also of importance to look at the primary investment vehicles that can guide individuals into knowing the permissible types of investment in Islamic investing. This assists in understand how the Islamic law works with Islamic bond. The first type of investment involves equities. According to sharia laws, as long as the company does not engage in business not allowed by the law like selling of pornographic films, then investment in the company’s share is allowed. This investment might be in either shares or direct investment. Most permissible companies either borrow or use excess investment cash therefore a concern to Islamic scholars. Some companies that are excluded include those that have debt in the interest bearing, receiving interest, and incur debts during trade that is more than their initial investment. Others not mentioned include companies whose debt total ratio over total asset ratio add up to 33% and companies with interest income that is not operating. Fixed income funds form another type of investment, with retirement investment being a branch in it. Retirees face a dilemma given that they want their investment to comply with the Islamic laws yet it includes ribs which are forbidden in the Islamic laws. To avoid running afoul with the Islamic laws, one could opt for a certain type of investment, either in a securitized fashion or directly. Sukuk or Ijara sukuk is another branch other than retirement investment. The financial certificate is sold to an investor group who then own such and later through the issuer return to get a rental return that are predetermined. The rental rate may either be fixed or floating rate just like the LIBOR. There is a promise by the issuer to buy the bond at an upcoming date at par value. Intermediaries’ in the transaction include special purpose vehicle. Sukuk sometimes may be a new lending or a replacement of conventional bond by sharia. It may gain a lot by either listing locally, regionally or globally in the markets. A novel way to look at how the sharia law works with Islamic bond is through primary insurance vehicles. In managing risk, Islamic law does not allow traditional insurance. This is because it allows commodities to be purchased with incomes that are not certain. Another reason is that insurers use fixed income as part of their way to satisfy their liabilities in portfolio management. The rule to this is mutual insurance. In this case, the funds contributed by subscribers to the pool comply with sharia. To satisfy claims, funds are got from the pool whereby Policy holders also enjoy getting unclaimed profits. Conclusion From the above discussion it is evident that Islamic bonds are preferred compared to other bonds. This is seen from its increasing expansion globally despite the non-Muslim countries struggling to debut it. The most advantageous characteristic of this type of security bond over others is that there are no interest charges coming along. The Sharia laws, which control how the Islamic bond operates, are often followed unquestionably. This controls and dictates the practices that are not permissible in the sharia law, hence not practiced while using Islamic bonds. Works Cited Abdo, Hafez &Wakkas, Firas. Islamic Finance: Understanding the Risk Management of the Islamic Bonds, Sukuk. LAP Lambert Academic Publishers.2011. Adam, Nathif & Thomas, Abdulkader. Islamic Bonds: Your Guide to Issuing, Structuring and Investing in Sukuk. Euromoney Books. 2004. Safieddine, Assem. "Islamic Financial Institutions and Corporate Governance: New Insights for Agency Theory." Corporate Governance: an International Review. 17.2 (2009): 142-158. Sophastienphongn, Kiatchai, Mu, Yibin & Saporito, Carlotta. South Asian Bond Markets: Developing Long-term Finance for Growth.World Bank Publications. 2008. World Bank. Global Financial Development Report 2014: Financial Inclusion. Washington: World Bank Publications, 2013. Read More