© Reuters. What is a Sukuk? UBS experts break down Sharia-compliant bond-like instruments
The international sukuk market has garnered increased attention from both Islamic and conventional investors in recent years. In this piece, we look at sukuk structures, performance, and associated risks.
What is a Sukuk?
In essence, a sukuk is a Sharia-compliant debt instrument or Islamic investment trust certificate. It was developed to fill the need of Sharia-compliant investors, who are adhering to Islamic principles and avoid earnings interest.
“They do not pay interest, but generate income to investors by paying a share of their profit or rental income by including underlying assets, typically in the form of tangible assets, in their structures,” analysts at UBS’ CIO of Global Emerging Markets, said.
The return received by sukuk holders is derived from the profit generated through a sale, rent, or a combination of both. Unlike conventional bonds that involve interest payments, sukuk adhere to Sharia principles by focusing on profit-sharing arrangements or asset-backed structures.
In the broader fixed-income landscape, sukuk has gained popularity among conventional investors as well, according to data from UBS.
“Most international sukuk are designed as “asset-based,” meaning the holders of sukuk have no rights or preferential claim over the underlying assets,” the analysts added.
“The holders of such sukuk do not have exposure to the performance or market value of the underlying assets. Instead, they are exposed to the unsecured credit risk of the obligator, who is responsible for payment of all amounts due on the sukuk.”
Sukuk products are now included in widely followed credit indices, offering defensive characteristics, diversification benefits, and alignment with sustainable investing principles.
Types of Sukuk
There are 14 different types of sukuk. The most common types of sukuk, according to UBS, is Sukuk Al Ijara.
“These certificates are sale-and-leaseback structures that use revenues from an underlying asset, mostly real estate, to pay investors. The sukuk holders are entitled to receive a share of the lease rentals proportional to their shares in the leased assets.”
Other popular types of sukuk also include Sukuk al Murabaha, Sukuk Al Wakala, and Sukuk Al Mudarabah.
Major credit rating agencies, like Moody’s and S&P, do not treat sukuk differently when it comes to assessing the risk of credit events. According to Fitch, the cumulative default rate on all globally issued sukuk was 0.24% as of Q1 2023.
Who are the Key Issuers of Sukuk?
Sukuk issuers are concentrated in countries with a substantial Muslim population. The sukuk market denominated in U.S. dollars or other G10 currencies is predominantly led by ten countries: Bahrain, Egypt, Indonesia, Kuwait, Malaysia, Oman, Qatar, Saudi Arabia, the United Arab Emirates, and Türkiye.
These issuers encompass sovereign entities, corporations, and financial institutions. Notably, oil-exporting nations play a significant role in sukuk issuance, and fluctuations in oil prices can influence the volume of sukuk issued in the market.
Sukuk vs Bonds
UBS’ analysis shows that the sukuk portion of the J.P. Morgan Middle East Composite Index (MECI) had smaller drawdowns than the BBB-rated portion of the index both in March 2020 and throughout last and this year.
“When compared to conventional bonds, sukuk appear to exhibit defensive features,” the analysts noted.
“With demand for sukuk often outstripping their supply, Islamic investors are often less inclined to exit their existing holdings, including at times of increased volatility in the markets, as they might find it hard to rebuild their positions at a later point.”
What are the Risks?
Sukuk instruments share common risks with conventional bonds issued by the same entity, in addition to risks unique to sukuk structures. These risks may arise due to regulatory changes or pertain to the Sharia compliance of the instruments.
Specifically, the risk emerges if an obligator seeks to evade its sukuk payment obligation in the event that the sukuk is deemed non-Sharia compliant during its tenure.
The international sukuk market, drawing attention from Islamic and conventional investors, has become increasingly popular in recent years. Islamic investors adhering to Sharia restrictions, along with conventional investors seeking diversification and inclusion in credit indices, favor sukuk, which is basically Sharia-compliant debt instruments.