CONTEMPORARY SUKUK SECURITIES

The current Islamic sukuk funding market in Malaysia was rediscovered about in 1990 when a private-sector firm, Shell Malaysia, issued a sukuk borrowing instrument to raise RM125 million (US$40 million) through a private issue in the Kuala Lumpur capital market (now Bursa Malaysia). Since then, and especially since 2000, this market has grown, with private-sector firms as well as government agencies raising money by issuing sukuk securities in Kuala Lumpur and 11 other countries. The Bank for International Settlements, which deals with both publicly traded and private issues, reports that the sukuk bond market around the world is worth about US$1,200 billion (about 1.2 percent of conventional bond issues).

Private issues dominate this market because the government issues amount to less than US$100 billion in open markets in the same 12 locations. The most active markets are found in just 6 of these locations: Malaysia, Kuwait, the United Arab Emirates (UAE), Oman, Qatar, and Saudi Arabia (in that order). Sukuk issues have grown in 23 years, and there is room for the further growth of this market.

Scholars have different opinions on the character of the assets transferred and jointly owned by the lenders in the form of SPCs. One school of thought is that as long as the assets transferred are not real assets, a sukuk contract is not likely to be secure. The majority opinion is that real assets must back funding contracts. [1] In the last two decades, this provision has been watered down so much that some institutions have gotten the approval of the Shari'ah regulators to consider any assets permissible as long as they are income producing. In practice, usufructs and incomes of financial assets are used as substitutes for real assets.

One school of thought is that the assets must be owned, and the other school is that the assets need not be owned, so that the contract could provide for asset-based contracting. In extreme cases, the assets transferred are recontracted to be owned by the borrower. This issue is addressed separately in Chapters 3 and 9.

The sukuk market has grown very fast in the six countries mentioned above, which offer new sources of funds for investors to fund both private and public projects. All these countries follow the profit-sharing formula and the SPC having ownership of income-producing assets held by the lenders, at least at the start of the lending process. The World Bank has endorsed this form of borrowing for large funds urgently needed to finance infrastructure projects in developing countries. The self-liquidating nature of this form of long-term loan issued mostly in local currencies makes this form of financing cheaper than the megaloans denominated in major currencies structured in the six international bond markets: London, New York, Tokyo, Sydney, and several Swiss cities.

HOW SUKUK SECURITIES ARE PRICED

Thousands of years of financial history have provided human beings with new mechanisms to facilitate their lives through using some form of money. Among the very old practices is the concept of trade; this evolved from the simple mechanism of barter, which developed into the current means of paper currencies and coinage when China invented paper money 1,000 years ago. Paper currencies such as dollar are used to measure the value of virtually every tangible and intangible asset. However, the fundamental, hotly debated issue over time has been how to determine the true value or price of a particular asset.

Sukuk securities, as a relatively new class of financial instrument, are no exception to this concern. Over time, various methods were developed for pricing, which is the valuation of financial instruments leading to price discovery. Four methods are applicable in the case of sukuk securities. These methods are based on the foundation principles of commerce, which suggest that fair pricing should be used. Since there is no conflict between the concepts, general procedures, and rationality of these methods, on the one hand, and the ethical and religious requirements of Islam, on the other, one may apply these mechanisms. However, some adjustments might be required in the way that valuation is done for sukuk. Such adjustments are thoroughly discussed in Chapter 13.

The first method of valuation is the public auction pricing process. This method is based on the economic concepts of supply and demand. It suggests that the price would be a market clearing value in which the supply and demand for an item meets the funds available. We like to call this the cucumber theory: overproduction of cucumbers lowers their price, whereas shortages of cucumbers increase their price.

This method is widely used by practitioners for valuation of publicly traded sukuk securities, which is also similar for conventional bonds. In this process, the issuer, with the intermediation of an investment bank, structures a proposal for an issuance of sukuk. Through the public auction held by the investment bank, the price is discovered by the investors in the bidding, similar to how houses are auctioned to eager buyers. Investors bid for the highest price if they assume that there is value in it for them. Therefore, the sukuk would be sold to the investors with the highest bids.

Private negotiation is the second method of pricing sukuk securities. This method is used in private placements offered to a limited number of private investors. This process can be conducted as an over-the-counter solution offered by investment bankers (as middlemen) to cut a deal between the originator and the investors, or it can be conducted as a direct bilateral negotiated contract between the two parties (in the way a Masai herdsman buys his cattle).

This method is also similar to the bilateral negotiation of a lender and a borrower in a bank loan, but in the case of sukuk with Islamic contracting terms, these bilateral agreements are enforceable legal documents governing the prenegotiated terms of contract between the issuer and the investors. Such a method is suitable mostly for private sukuk placement, in the same way that private debt placement takes place in 125 conventional fixed-income markets around the world.

The third method of pricing is convertible pricing. Some of the sukuk securities have a convertible option feature embedded in their structure (e.g., Telekom Malaysia). Such structures provide their investors with the option to trade in their sukuk certificates with a certain amount of equity shares of the underlying firm (mostly the originator) after a predetermined time. Some of the sukuk placements in markets like London, Zurich, and Luxembourg are originated by firms listed in their local markets.

Hence, there are two special elements visible in such structures. First, their value is tied to the value of an underlying equity share, as a consequence of the convertible options featured in them; and second, the underlying equity share value represents a cross-market firm. Such placements therefore resemble the depository receipts of a foreign firm's stock in the market where the sukuk securities are traded. Thus, the existing mechanisms of pricing depository receipts become handy. Such forms of sukuk securities are, currently, a small fraction of the market; however, there is a growth potential for this form of fund-raising structure.

The first three pricing methods are mainly based on the outcomes of market-driven initiatives such as supply and demand and are therefore called the market value of the security. However, the actual pricing of conventional fixed-income securities are not limited to market price.

Theoretical modeling is the fourth method of pricing conventional debt securities. The absence of a theoretical pricing model has led to a focus on the market forces, and the underlying value of the security is thus partly overlooked. The lack of correct measures causes the mispricing commonly observed in the sukuk security market.

These two categories of methods—market based and theory based— when applied together will result in a more accurate price discovery for sukuk securities. The theoretical valuation modeling of sukuk securities is thoroughly discussed in Part III.

The principles of Islamic finance affect the pricing of Islamic instruments, and then all possible cash-flow patterns of different structures are generated based on their definitions. With the cash-flow patterns in hand, valuation models are developed. In order to develop correct valuation models and to make them more familiar for practitioners, a conventional pricing approach is first selected for experimentation to arrive at theoretical prices.

Sukuk securities that have identical cash-flow patterns as conventional bonds are priced with the same existing models. For instance, one form of ijarah sukuk (a lease contract) is identical to coupon-bearing collateralized bonds, so its price should be computed the same way. On the other hand, musharakah sukuk (profit sharing) is like no other bond security because its payoff is tied to the performance of the underlying firm (or the SPC). Thus, the cash flows are not predetermined, and modeling the security would be much more challenging in ways similar to the modeling of equity shares. These models are developed in the last part of the book.

THE STRUCTURE OF THIS ROOK

Introductory materials to define, describe, classify, and provide the structures of the various debt contracts are presented in Part I. Our aim in this part is to provide both the layperson and the specialist with an understanding of how this new security is designed and to show the structural differences among the six most commonly issued instruments. The theoretical grounds of sukuk markets are described in this part.

In Part II, our aim is to present evidence that the new debt market has a number of features that make it different from the conventional bond market, to which market players refer in trading sukuk securities. We show that sukuk securities yield significantly higher yields than their identical conventional counterparts. The yield differences are, in fact, quite substantial. We explain that this is a result of the higher risk inherent in risk-sharing and profit-sharing contracts, although this connection has yet been empirically verified.

Part III is concerned with the issue of how to map the payoffs in each of the instruments to identify the cash-flow patterns. This part describes a number of core types of payoff structures. These patterns can then be used to identify mathematical solutions as objective valuation models. Another feature of this part is the contribution of a chapter by a specialist in regulation on the issues confronting continued growth from regulatory shortcomings. The book ends with a discussion of the challenges for the continued growth of this form of debt structuring, which is only about 28 years old.

  • [1] U. M. Chapra, "The Major Modes of Islamic Finance," course in Islamic Economics, Banking, and Finance series, Islamic Foundation, Leicester, UK, 1998.
 
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