1. CASE STUDY:
ISLAMIC BOND (SUKUK)
PREPARED BY:
ROSWAHIDA BINTI AHMAD SHUBELI 07BB03001
NUR HAYATI BINTI MAISAM 07BB03015
NOR HAFIZATULAINI BT AZIZ 08BB03002
SITI PARHANA BINTI ISMAIL 08BB03004
PREPARED FOR:
PUAN NUZUL AKHTAR BINTI BAHARUDIN
BBFS 8003
PORTFOLIO THEORY AND SECURITY ANALYSIS
7th JANUARY 2011
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2. CONTENT
1. ACKNOWLEDGEMENTS 1
2. INTRODUCTION 2
2.1 How Sukuk Developed
2.2 The Different Between Sukuk And Conventional Bond
3. BODY
3.1 Step And Procedures Of Inssuance Sukuk 4
3.2 Characteristic Of Sukuk 8
3.2.1 Bond holders ownership of enterprise assets
3.2.2 Regular distribution to sukuk holders
3.2.3 Guaranteeing the return of principal
3.3 Advantages Of Issuance Sukuk 11
3.4 Restrictions In Trading Of Notes In Malaysia 13
3.5 Responsibilities Of Issuance And Paying Agent 14
(Authorized Depository)
4. CONCLUSION 16
5. RECOMMENDATION 17
6. BIBLIOGRAPHY 18
7. APPENDIX 19
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3. 1. ACKNOWLEDGEMENTS
All praise to Allah (swt) the most Gracious and most Merciful, by whose grace and blessing to
Nuzul Akhtar Binti Baharudin, our lecture of subject Futures and Options, due to the
opportunities to us in discussing about sukuk.
We also thankfully to our college (Selangor International Islamic University College) for
allowed us to learn and have the knowledge in this subject matter. And to all the Librarians of
our university college in their co-operations helping us regarding some journal and books.
We also take this opportunity, while relying on the instruction of the Prophet to the effect that:
“whoever does not thank people does not thank Allah”
We are indebted to our discussion from online journal, articles and books as supporting to the
idea and get all the information from it while writing the assignment.
We have given all our effort to this paper work and we hope that this paper work will provide
lessons and information which will complete the need of this assignment and also answering all
the question of Islamic derivative.
May Allah (Almighty) reward them all for their contribution and consider our efforts for his sake
only.
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4. 2. INTRODUCTION
2.1 How Sukuk Developed
The word sukuk (plural of the Arabic word sakk meaning certificate) reflects participation rights
in the underlying assets. The term sukuk is already recognize in the traditional Islamic
Jurisprudence.
The design of sukuk is very similar to the process of securitization of asset in conventional
markets where a wide range of asset types of securitized. This asset types include mortgages,
auto loans, accounts receivables, credit card payoffs, and home equity loans.just as in
conventional securitization, a pool of assets is built and securities are issued against this pool.
Sukuk are participation certificates against a single asset or a pool assets.
Sukuk were made as early as in 1978 in Jordan where the government allowed the Jordan Islamic
Bank to issue Islamic bonds known as Muqaradah bonds. This was follow by introduction of the
Muqaradah Bond Act of 1981. Similar effort were made in Pakistan where a special law called
the Mudharabah Companies and Mudharabah Flotation and Control Ordinance of 1980 was
introduced.
Howerver, due to lack of paper infrastructure and transparency in the market this security
activities not successful. The first successful introduction of sukuk was by the
MalaysianGovernment in 1983with the issuance of the Government Investment Issue (GII).
It was not till the late 1990s that a weel-recognizedstructure of an asset-backed security in the
form of a sukuk was developed in Bahrain and Malaysia. This structure is attracting the attention
of borrowers and investors and is considered a potential vehicle to develop Islamic capital
market.
Sukuk market can provide much needed liquidity to institutional investors and financial
intermediaries , who become better equipped with portfolio and risk management.
Finally, in many cases, payoff of sukuk resemble a conventional fixed-income debt security,
which is popular among conventional investors. In this respect, sukuk can also serve as an
integrating tool between Islamic and conventional markets.
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5. 2.2 The Different Between Sukuk And Conventional Bond
The prime difference between sukuk and conventional bonds are the absent of interest element
and the existence of an underlying permissible transaction. There is no annual coupon rate
attached to the sukuk and thus its characteristic is of zero coupon bonds.
For example, if a customer A owes RM 10 million to Bank A, apart from the legal documents, an
“IOU”, a form of promissory notes is created to evidence this debt. In this case, customer A
draws the notes onto Bank A. Bank A may then sell this debt to Bank B, bank C or other
interested institutions.
In conventional banking these tradable certificates or securities are issued for a loan with interest
to raise funds. In additional to this annual coupon rate is introduced for the securities.
Other different between sukuk and conventional bond represents pure debt of the issuer but a
sukuk represent , in additional to the risk on the creditworthiness of the issuer, an ownership
stake in an existing or well defined asset or project. Also, while a bond creates a lender/borrower
relationship, the relationship in sukuk depends on the nature of the contract underlying the
sukuk. For example, if a lease (Ijarah) contract underlies a sukuk, then its create a lessee/lessor
relationship, which is different from the typical lender/borrower relationship.
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6. 3.1 STEP AND PROCEDURES OF INSSUANCE SUKUK
Fund Mobilizing
Entity
Credit
Enhancement
SPM Balance Sheet
Pool of Asset Special Purpose Asset Liabilities
(Ijarah/Leases) Mudarabah Ijarah Asset Sukuk
“SPM”/ “SPV” (Leases) Certificates
Servicing
Investor: IFIs,
Conventional Institutional
investors, pension funds,
etc.
Source: Iqbal (1999)
In above show the process and linkage among the different players involved in
structuring a Sukuk. This process is a generic process and there will be differences
depending on the type of underlying instrument used to acquire the asset. The process
of structuring a Sukuk involves the following step:
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7. Step I: An asset is identified, which is currently held by the entity wishing to mobilize
resource and raise funds. In simple cases, this asset needs to be a tangible asset such
as an office building, land, highway, or an airport. But in other cases, a pool could be
made from a set of heterogeneous assets combining tangible and non-tangible asset,
i.e. financial asset. Once the assets to be securitized are identified, these assets are
transferred to a special purpose Mudarabah (SPM) for a predetermined purchase price.
SPM is established only for this particular purpose and is a separate legal entity that
may not be affiliated to the issuer. By establishing an independent SPM, the certificates
carry their own credit ratings, instead of carrying the credit ratings of its original owner.
Also, by transferring the asset to this special entity, the asset is taken off the issuer’s
balance sheet and is therefore immune to any financial distress the issuer may face in
the future. Thus, the existence of an SPM provides confidence to the investors (Sukuk
holder) about the certainty of cash flows on the certificates and therefore enhances the
credit quality of the certificates. SPM also enjoys special tax status and benefits. SPM is
considered a bankruptcy remote entity.
Step II: The underlying asset is brought on the asset side of the SPM by issuing
participation certificates or Sukuk on its liability side to investors in an amount equal to
the purchase price. These certificates are of equal value representing undivided shares
in the ownership of the asset. The proceeds from the sale of certificates are used to
purchase the asset. The holders of the Sukuk participate in the equity interest of the
SPM’s assets, which are jointly owned.
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8. Step III: The SPM either sells or leases the assets back to a lessee- an affiliate of the
seller, or directly back to the seller itself- in exchange for a future payment or periodic
lease payments. For example, in case of a lease, the asset will be leased to a lessee or
to the issuer who will be responsible for making future rental payment on the lease.
These future cash flows in the form of rental income are passed through to the holders
of Sukuk. The cash flows are subject to deduction of minor administrative, insurance,
and debt servicing fees.
Step IV: In order to make the certificates investment-quality and to enhance their
marketability, an investment bank may also provide some form of guarantee. This
guarantee may be in the form of a guarantee to buy or replace the asset in the event of
default. The investment bank or guarantor charges a few basis points as premium for
the guarantee. This credit enhancement makes the certificates investment grade
securities and therefore makes them attractive to institutional investor.
Step V: During the course of the life of the Sukuk, periodic payments are made by the
benefactor of the asset, i.e., lessee, which is transferred to the investors. These periodic
payments are similar to coupon payment and Sukuk payment is that whereas bond
coupon accrues irrespective of the outcome of the project for which the bond was
issued,Sukuk payments accrue only if there is any income out of the securitized asset.
However, the interesting point is that in the case of lease-based Sukuk, since the
coupon payments are based on rental income and there is low probability of default on
rental income, investors consider these coupons with high expectations and low risk.
Anyone who purchases Sukuk in the secondary market replaces the seller in the pro
rata ownership of the relevant asset and all the rights and obligations of the original
subscriber are passed on to him/her. The price of Sukuk is subject to the forces of the
market and depends on the expected profitability. However, there are certain limitations
to the sale of Sukuk in the secondary market.
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9. Step VI: At maturity, or on a dissolution event, the SPM starts winding up, first by
selling the asset back to the original seller/owner at a pre-determined price and then
paying back to the certificate holders or investors. The price is pre-determined to protect
capital loss to investors. Otherwise, the sale of the underlying asset at the market value
may result in capital loss for the investor, which may not be acceptable to the investor. It
is a common practice that the Sukuk contract embeds a put option to the Sukuk-holders
by which the issuer agrees to buy the asset back at pre-determined price, so that at
maturity the investors can sell the Sukuk back to the issuer at the face value. At the
completion of Sukuk, the SPM is dissolved and it ceases to exist since the purpose for
which it was created is achieved.
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10. 3.2 CHARACTERISTICS OF SUKUK
The characteristic of sukuk is the objective of liberalizing to the none other than to
provide convenience in attracting international investors in investing with the corporation issuing
the sukuk. In liberalizing the characteristics is including the issuance of sukuk in foreign
currencies outside the issuer’s country. It can be facilitated by making available the shariah, legal
framework and conducive tax income.
In sukuk, they have the negotiated that bank shall the principal term and
conditions of facility with customer. The term and conditions of the facility is that shall then
characteristics of facility which usually include the followings:
o The tenor of this facility
o The collateral of facility
o The yield of this facility
o The mode and related subject matter of the permissible underlying transaction to
accommodate the basis for the issuance of sukuk.
In Islamic, the characteristics as we know they are not found in Islamic sukuk at least as directly.
Today the issuer of Islamic sukuk has to attempt to distinguish sukuk but indirectly they are
many same characteristics. The reason is they are developed a variety of mechanism. Theses
mechanism is in light into three points:
 Bond holders ownership of enterprise assets
 Regular distributions to sukuk holders
 Guaranteeing the return of principal
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11. 3.2.1 Bond Holders Ownership Of Enterprise Assets
The bond holders ownership is the majority of sukuk are clearly different in this respect
form interest-based bonds. Sukuk represent generally for the ownership shares in assets that
bring profits or revenue foe example leased asset, commercial or industrial enterprise. That is the
one characteristic that distinguishes sukuk from conventional bonds. However, the market has
witnessed the number of sukuk in which there is doubt regarding their representation of
ownership. For example the asset in sukuk may be share of companies that do not confer true
ownership but which merely offer of sukuk holders to the right return.
Sukuk are no more than the purchase of return from shares and this is not lawful from
shariah perspectives. For example is the certain of sukuk that are based on mix between ijarah,
istisna’ and murabahah contract that are undertaken by Islamic bank or institutions these are the
packaged and sold to sukuk holders who hope to obtain the return from these operations.
3.2.2 Regular Distribution To Sukuk Holders
Based on this point, most of sukuk have been issued are identical to conventional bond with
regard to the distribution of profits from enterprise at fixed percentages based on interest rate
(LIBOR) . In order to justify the practice, the issuer include a paragraph in the contract which
state that if the actual profits from the enterprise exceed the percentages based on the interest rate
but then the amount of excess shall be paid in its entirely to the mudarib or partner or investment
agent as an incentive for the mudarib that manage effectively.
The structured of sukuk that they do not state the such excess will become the right of the
mudarib as an incentive but instead they state no more than the holder of sukuk will be entitled
to a fixed percentages based on upon the rate of interest at the time of regular distribution. If the
actual profit is less than the prescribed percentages based on interest rate, then the mudarib may
take the upon himself to pay out the difference (between actual profits and prescribed
percentages) to sukuk holders, as an interest free loan to the sukuk holders.
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12. 3.2.3 Guaranteeing The Return Of Principal
As the third point, virtually all sukuk issued today guarantee the return of principal to the
sukuk holders at maturity, in exactly the same way as conventional bonds. It means a binding
promise from either the issuer or the mudarib to repurchase the asset represented by sukuk at the
stated price at which these were originally purchased by the sukuk holders at the beginning of
process, regardless of their true or market value at maturity.
Then the mechanism of sukuk are able to take on the same characteristics as
conventional, interest-bearing bonds since they do not return to investors more than a fixed
percentages of the principal based on interest rate. The guaranteeing of return for investors is at
principal maturity. About the mechanism firstly is from the perspective of the Islamic
jurisprudence and second from the perspective of the higher purpose of Islamic finance and
economics. Based on the shariah perspective they are three questions:
1. Stipulating the amount in excess of the price interest for the manager of enterprise under
the pretense this an incentive for good management.
2. The manager commitment, if the actual profits are less than the yield from the fixed rate
of interest during any of the times for distribution to lend the amount of the shortfall to
the holders of sukuk. The amount of such loans will be recovered either through the
actual profits of the enterprise at the times of following distributions or through the sale
of the enterprise assets at maturity.
3. The binding promise by the manager that he will purchase the assets represented by the
sukuk at their face value and not at their market value on the day they are redeemed.
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13. 3.3 ADVANTAGES OF SUKUK
a) Un existent of uncertainty (gharar)
Sukuk is based on an underlying transaction which creates a close link between financial
and productive flows. The financing must be channeled for productive purposes such as project
financing, rather than for speculative activities. Thus, the risk exposure is to the project and not
to the uncertainties or activities that have no real economic benefits. This contributes to greater
stability of the financial system. Moreover, under the risk-sharing principle required, there is an
explicit sharing of risk by the financier and the borrower. This arrangement will entail the
appropriate due diligence and the integration of the risks associated with the real investment
activity into the financial transaction. The real activity is expected to generate sufficient wealth
to compensate for the risks.
In contrast, conventional bonds generally separate such risks from the underlying assets.
As a result, risk management and wealth creation may, at times, move in different or even
opposite directions. Conventional bonds also allow for the commoditisation of risks. This has led
to its proliferation through multiple layers of leveraging and disproportionate distribution, in
turn, could result in higher systemic risks, thus, increasing the potential for instability in the
financial system.
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14. b) Full disclosure and affairs
In addition, transparency represents a basic tenet underlying all Islamic financial
transactions. The profit-sharing feature of Islamic financial transactions imposes a high level of
disclosure in the financial contract. The accountabilities of the respective parties involved in the
transaction are clearly defined in the contract.
Issuing sukuk also give access to a wider investor base as the instruments attract not only
the Islamic investors but also conventional investors. Sukuk is also considered as a new asset
class with a relatively attractive pricing. The growing demand for sukuk is attributed by growing
awareness, increased in petrodollars, wealth and reserves as well as the massive development of
infrastructure projects.
c) Cost Saving
In Malaysia, there in incentive in the form of cost saving in term of Stamp duties
exemption on issuances of Islamic private debt securities including sukuk, therefor it will reduce
the burden of the investor.
d) Diversify Investment
Islamic bonds may be structured in a variety of ways, but typically fall into one of four
categories: Ijarah, or leasing arrangements; Murabaha, a transaction where the seller explicitly
declares his cost-plus-profit margin; Mudharabah, a structure similar to a joint venture where
profits are shared between a fund raiser and investor; and Musharakah, a joint venture where
profits and losses are shared.
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15. 3.4 RESTRICTIONS IN TRADING OF NOTES IN MALAYSIA
The secondary market trading of the notes are confined to the following bodies.
i. Prescribed corporations as defined under Section 38(7) of the Companies Act, 1965.
ii. Insurance companies.
iii. Statutory bodies established by an Act of Parliament or Enactment of any state in this
country.
iv. Pension funds approved by the Director General of the Inland Revenue provided under
Section 150 of the Income Tax Act, 1967.
v. Such other corporations as may be acceptable to the issuer after taking into
considerations the relevant provisions of the Companies Act, 1965.
In addition to the above, there should be no physical delivery of the notes be allowed. All notes
shall be deposited with the authorized depository of the facility. Usually, the authorized
depository shall also act as principal dealer providing two way quotation for the notes.
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16. 3.5 RESPONSIBILITIES OF ISSUANCE AND PAYING AGENT
(AUTHORIZED DEPOSITORY)
The responsibilities of the issuing agent are as follows.
i. An issuing agent shall have to ensure the correct quantity of the executed notes.
ii. An issuing agent shall also ensure such notes are numbered and dated with the
issue number, serial number, the maturity date and the issuing date.
iii. An issuing agent shall ensure that all notes be duly executed by the authorized
signatories of the issuer and the agent.
iv. An issuing agent shall within 10 business days of the issue date or date of
cancellation or destruction of the notes communicates with the issuer by issuing
a certificate confirming the following.
 The number of notes issued
 The face value, serial number, the date of issue and maturity date of such
notes
 The number of notes cancelled and destroyed (if any) and their serial
numbers.
The responsibilities of the paying agent are as follows.
i. A paying agent has to maintain promissory notes register containing full and
complete records of all issuance, redemptions and cancellations.
ii. A paying agent is to ensure the issuer is instructed within two business days of
any maturity date, to place the redemption amount in a designated account at the
latest before 11.00 a.m. on the maturity date.
iii. A paying agent is to pay the face value of the notes to the owners of the notes as
appeared on the promissory notes register on the maturity date.
iv. A paying agent shall cancel and return to the issuer all notes paid and redeemed
within 30 days of the date of cancellation.
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17. v. A paying agent shall only allow replacing notes which are mutilated or destroyed
upon receipt of the following.
 Cost of replacement
 Evidence of destruction or mutilation
 Submission of safe custody receipt
vi. A paying agent shall track out of pocket expenses (legal, cable and postages)
incurred and bill it onto the issuer.
The responsibilities of the authorized depository agent are as follows.
i. An authorized depository agent shall keep track of the security cover which shall
be 130% of the security amounts at all times.
ii. An authorized depository agent shall ensure customer to respond within 7 days
of notice for additional security.
iii. An authorized depository agent can act as market maker for the notes by
providing a two way quotation at all times on inquiry by the public.
iv. An authorized depository agent shall help the notes holder to dispose his notes in
the event he decides to sell.
v. An authorized depository agent shall help the note holder to dispose his notes in
the event he decides to sell.
vi. An authorized depository agent shall ensure that the total number of note holder
does not exceed 10 at any one time and restricted to the following entities as
defined under section 38 (1B) of the Companies Act, 1965.
 Prescribed corporations such as banks and other corporations gazette
by the ministry of finance.
 Insurance companies
 Statutory bodies established under Act or any Enactments
 Corporation incorporated outside Malaysia
 Pension funds approved by director general of Inland Revenue under
section 150 of income tax act.
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18. 4. CONCLUSION
From what have we found, it is clear that the Islamic alternative of resource mobilization through
Islamic bonds is not only possible but also has proven to be practical through the implementation
of several successful projects using Islamic bonds or as tool of monetary management.
However what is more important is that Muslims jurists and economists must intensify their
efforts to explore the different forms of Islamic bonds based on the acceptable types of contract
in Islamic laws for that purpose such as musharakah, muqaradah and ijarah.
Similarly the possibility of having negotiable certificates based on salam should not be excluded
totally and a systematic analysis of the possibility of reselling salam before taking possession
needs to be explores by Muslim jurists especially at the Islamic Fiqh Academy level.
Especially when the whole issue of prohibiting resale before taking possession is based on the
argument that such a sale may lead to gharar or even riba and to what extent this possibility is
present nowadays.
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19. 5. RECOMMENDATION
Controversial of Sukuk trading
In this present we have seen the rapid success of Islamic bond in the market. The success of
Malaysia in Islamic Finance has attracted whole the world eye. Malaysia is the biggest holder of
the sukuk market and it absolutely has encouraged the development of Malaysia economics.
However in the early development of sukuk in Malaysia, the conformity of sukuk with Shariah
principal has being conflict in ulama conversation.
Disagreement among ulama is one of the troubles in trading the sukuk in capital market and
generally, the Muslim scholars have different views on the legality of sukuk trading. Some of the
view said that sukuk is not complied with shariah principal and it just the converted of the
conventional product. Therefore as the initiative Malaysia has develop Sha’riah Advisory
Council (SAC) as the effort to solve the issues. The characteristic of conventional capital market
which is involve the riba(interest) and gharar (uncertainty) is one of the factor that cause some of
the view unconfident with the conformity of sukuk with shariah principal, therefore Sha’riah
Advisory Council is develop to facing this problem trough the research and discussion among the
professional in Shariah Advisory Council. Shariah Advisory Council is the corporations develop
by government by employ all Islamic professional and Ulama as the group in the Sha’riah
Advisory council and this group was responsible to ensure the status permissible of sukuk and
other Islamic finance product.
The success of SAC in the trading of Islamic finance product should be admit because Malaysia
now has being the attraction of whole the world and Malaysia able to be the most success of
sukuk trading in world, however the trading sukuk by Malaysia is still not able to increase its
acceptance among other Islamic country as Mesir and other. The main factor that causes the
problem is because of the different Scholar, as the Sha’fie scholar follower the trading of sukuk
in Malaysia will be quite different compare to other country as the follower of the Hambali
Scholar and Maliki Scholar. As the solution, Malaysia need to have deeper research and
development to increase and develop product that might able have larger acceptance variable of
Islamic bond.
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20. BIBILIOGRAPHY
Dr.Mohd Daud Bakar, D. R. (2008). Essential Readings In Islamic Finance. CERT Publication
Sdn Bhd.
Mirakhor, Z. I. (2007). An intro to islamic finance theory and practice. wiley finance.
Mohd Nasir Mohd Yatim, A. H. (2007). The principle and practices of islamic banking and
finance . Prentice Hall.
Usmani, M. T. (n.d.). Sukuk and their contemporary application .
Yatim, M. N. (2009). sukuk(islamic bonds):a crucial financial instrument for securitisation of
debt for the best-holders in shariah-compliant capital market .
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21. APPENDIX
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