Sukuk: An Islamic Finance Alternative For A Conventional Bond

Sukuk: An Islamic Finance Alternative For A Conventional Bond

One of the major sectors of Islamic finance is the Islamic capital market. This market has evolved in recent years with the listing of shariah-compliant stocks and the growing issuance of Sukuk by both corporate and sovereign issuers on a global scale.

According to the Shariah standard issued by the Accounting and Auditing Organisation for Islamic Financial Institution (AAOIFI), Sukuk are certificates of equal value representing undivided shares in ownership of tangible assets, usufructs or services (or in the ownership of) the assets of particular projects or special investment activity…..”

The Sukuk market has come a long way since its inception in 1990 when the first corporate Sukuk was issued in Malaysia. Following this, Sukuk has since gained an unprecedented global acceptance even among non-Muslim majority countries such as the United Kingdom (UK) and Singapore. Also, Nigeria, a west-Africa country has witnessed four tranches of Sukuk issuances in recent years with the latest issuance (in the year 2020) recording an over-subscription rate of 446%. The development of Sukuk arose as a result of the market demand for a Shariah-compliant financial instrument which could offer financing and investment benefits similar to that derivable from a conventional bond. However, to fully appreciate the uniqueness of Sukuk, an appreciable understanding of the conventional bond is required. This understanding would set the foundation for an eventual understanding of Sukuk.

Understanding Bond

According to Investopedia, a bond is a fixed income investment in which an investor loans money to an entity (corporate or government) that borrows the fund for a defined period. In exchange for cash delivery to the borrowing entity, a certificate of indebtedness is issued to the investor which is usually tradeable even before the maturity of the bond. From this definition, the following characteristics of a bond are to be noted:
  1. The relationship between the investor and the entity issuing bond is in substance that of a lender-borrower relationship;
  2. The investor is paid back through a periodic interest (coupon) repayment and principal value repaid upon final redemption of the bond. 
  3. The investor relies entirely on the bond issuer’s credit risk rating in repaying both principal and interest.
  4. The investor has no say over the use into which the money is put or deployed.
Why Conventional Bond is Not Shariah-Compliant

An insightful look at some of the features above would reveal to anyone knowledgeable in basic Islamic finance principles that a conventional bond is not Shariah-compliant. For the sake of brevity, I would only highlight three key reasons in this article.
  1. Firstly, the bond contract includes an element of interest (usury) which is unacceptable in Islamic finance.
  2. Also, because of feature (d) above, the bond issuer could invest or deploy the fund into unethical ventures not acceptable from an Islamic viewpoint. This would typically include investment in lotteries, gambling, pork, breweries, and other similar ventures.
  3. Lastly, conventional bonds are purely debt assets in the book of the investor. The implication of this is that bonds cannot be sold or traded to a third party as obtained in conventional practice as Islamic principles generally prohibit buying and selling of debt.
Having established the deficiencies of conventional bond from an Islamic perspective, we shall then take a look at Sukuk. The Sukuk has been structured in such a manner that all the deficiencies of the conventional bond noted above are eliminated to make it Shariah-compliant. To begin with, let us examine the parties to a Sukuk transaction.

Parties to a Sukuk

Any Sukuk being issued would typically have three principal parties. There is a need for us to identify these parties and know the roles they play in a Sukuk transaction. The parties and their roles are summarized below:
  1. Obligor: This is the entity seeking to raise funds from the Sukuk capital market. This is the borrower in a conventional bond. An obligor could either be a corporate entity or a sovereign entity.
  2. Investors: These are persons who subscribe to the Sukuk offer and trade their money in return for a Sukuk certificate which evidence their share of ownership in the Sukuk asset.
  3. Special Purpose Vehicle (SPV): A Special Purpose Vehicle (SPV) is an entity specifically created for the purpose of the Sukuk. In practice, it serves as an intermediary between the obligor and the investors and through which the Sukuk fund is channeled to the obligor via an appropriate Islamic finance structure. It is created by the obligor and is charged with the task of raising capital from both local and international investors. The SPV also issues the Sukuk certificate to the investors.
Introduction to Sukuk Structures

In creating a Sukuk, it is very important to choose the appropriate contract type which would form the basis of the Sukuk transactions. The primary difference between a conventional bond and the way a Sukuk is structured is the presence of an underlying asset. In other words, Sukuk investors (subscribers) have beneficial title and ownership rights in the underlying asset as opposed to a bond where the investors are owners of a debt certificate. It is this ownership of an underlying asset that makes the Sukuk certificate tradeable in the capital market.

Sukuk are usually classified according to the nature of involvement with underlying assets. Thus, we have the Murabaha Sukuk, Mudaraba Sukuk, musharaka Sukuk, Wakala Sukuk, Ijara Sukuk and perhaps some other ones. However, the explanation of these various sukuk is beyond the scope of this discourse.

It is noteworthy that Sukuk Ijara (sale and lease-back) is the most common and the most widely accepted Sukuk structure. Unlike some other forms, its legality and Shariah-compliance is undisputed among all juristic views. Therefore, the discussions in this write-up would tilt more toward the Ijara Sukuk.

For ease of illustration and understanding, let us consider the “Federal Government of Nigeria N100billion 7 years 16.74% Ijara Sukuk” issued in the year 2017 and which matures in 2024. This Sukuk fund was to be used for the construction and rehabilitation of key economic roads across the nation. In this very case study, the FGN is the obligor and the “FGN Road Sukuk Company Plc” is the Special Purpose Vehicle specifically created for the purpose of Sukuk issuance.  Annual rental payment is arrived at by applying 16.74% on N100billion and this gives us N16.74billion.

Sukuk Ijarah

This type of Sukuk is structured using a sale and lease-back contractual arrangement. A key requirement for the adoption of this structure is the ownership of an asset (in this case land comprising roads worth exactly N100billion) by the obligor which would be dedicated for the contract.  In the first instance, the SPV buys the asset (land) from the obligor and thus maintains ownership of the asset with this purchase. In return for the asset, the Sukuk fund (100 billion naira) is transferred by the SPV to the obligor.

The next step is to lease the asset (land on which roads would be constructed) back to the obligor in an Ijara contract for a period equivalent to the tenor of the Sukuk coupled with a promise to buy back the asset at the end of the Sukuk tenor. Subsequently, the obligor engages this asset in an economic activity for the purpose of profit generation. In return, the investors earn rental income through a periodic rental repayment by the obligor.

This rental payment (N 16.74billion) is made annually into the SPV transaction account from where it is eventually distributed to the investors. As earlier noted, this is one of the distinctive features of Sukuk; the investors earn rental income/profits as opposed to interest payment obtainable in the conventional bond.

So, what happens at the maturity of the Sukuk?

At maturity, the Sukuk investors receive their original investment sum of N100billion which is similar to what is obtainable in a conventional bond.  We should not forget that the underlying asset (land worth N100billon which is the Sukuk issuance) is being held by the obligor (lessee). For the investors to get back their original sum of N100billion at the maturity of the Sukuk, the obligor (in this case the Federal Government) needs to buy back the land from the SPV by offering the SPV the sum of N100billion and taking back ownership of the land. The entire process is called redemption.

A key issue arises here, and this is with respect to the worth or market value of the land at the point of maturity. For instance, given that the land has appreciated and is now valued at an amount above N100 billion (which is the Sukuk size), the investors/SPV would not be willing to sell the land at N100 billion. On the contrary, given that the land depreciated and is now worth less than N100 billion at the maturity of Sukuk, the FGN also would not be willing to pay N100 billion for the purchase of the land from the SPV.

What is the solution?

To safeguard against fluctuation in the value of the underlying asset and its attendant implications, a purchase and sale undertaking is signed by the obligor and the SPV/issuer respectively at the inception of the lease. The obligor (FGN) would undertake to purchase the land (now roads constructed across the country) at N100billion which is the par value of the Sukuk. Likewise, the SPV (FGN Road Sukuk Company Plc) would also undertake to sell the land asset to the FGN at N100billion at maturity regardless of any increment in the value of the land.

This form of undertaking is one of the modern applications of Wa’ad (literally: promise) in Islamic finance.

With the sale and purchase occurring between both parties, the Sukuk is redeemed, the investors receive their original principal investment and the Sukuk tenor is ended.


From the above, it may be seen that the cash flows in both conventional bonds and Sukuk look similar to each other. Likewise, the investors earn a periodic rental rate in the case of Ijara Sukuk just the same way they receive a coupon in the conventional bond. It should be noted that this similarity of cashflow and reward does not make Sukuk a conventional bond. In fact, they are very different and distinct from each other.

The Sukuk investors earning periodic rentals on their investment is based on their shared ownership and risk in the underlying asset. Sukuk are backed by tangible assets and are thus priced based on the value of the asset. On the contrary, bonds (even when backed by assets) are purely debts and are not directly linked to any asset or economic activities. As a result of it being linked to tangible assets, Sukuk has over the years proven to be of great relevance in the global real economy. It is undeniably a veritable instrument for real wealth generation as evident in its growing global issuances.

This article was written by
YUSUF, Opeyemi Toyeeb
Audit Associate at KPMG Nigeria

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