The authors highlight the growing global sukuk (i.e., Islamic bonds) market and identify the need for better understanding of the instrument for the investor community. They explain the risk–return profile of the instrument, the differences in structuring vis-à-vis the conventional bonds, and the role of the Accounting and Auditing Organization for Islamic Financial Institutions.
The authors explain that the Islamic financial system revolves around the philosophy that all transactions require an underlying asset and that investors share in both the profit and the loss of each transaction. Thereby, the system rejects the concepts of assured returns (i.e., riba) and making money off money. Sukuk holders are, therefore, basically equityholders in the underlying asset, but their claim is asset specific and with specified maturity compared with common shareholders in any entity.
The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) sets the shari’a (Islamic law) standards for sukuk issues and has identified 14 different structures for sukuk so far, providing depth and breadth to this particular market.
How Is This Article Useful to Practitioners?
The authors highlight that Islamic finance is growing at a rate of 10%–15% per year, with more than 300 Islamic banks and financial entities operating around the globe. It is important for investment practitioners to understand the mechanics of Islamic finance because of the huge, largely untapped market of potential Muslim investors as well as the growing role and integration of Islamic financial institutions in global finance.
There is no restriction on investment in Islamic instruments for non-Muslims, and this realization may open new investment opportunities because Islamic instruments offer certain unique characteristics. The sukuk holders become owners of the underlying asset and cash flow, which is a stronger position than the general claim posed by the conventional debt instrument. However, there may or may not be recourse to the issuer depending on the structure of the sukuk. Sukuk are tradable instruments, and the increasing market for Islamic finance has led to some improvement in their liquidity risk, which is a major consideration for investors. Although sukuk are largely not influenced by changes in market interest rates, there is some uncertainty in rate of return because of the profit-and-loss-sharing concept.
The Islamic leasing instrument—sukuk al-ijara—holds a high degree of similarity with conventional leasing instruments. An important aspect to note is that LIBOR is usually used as a reference point for pricing sukuk, as it is for conventional bonds.
Globally, Islamic finance is growing at a fast pace. For investment practitioners, it is a potential venue for investment as well as an enormous, primarily untapped market of potential investors. A thorough understanding of shari’a law is essential to comprehensively understand the underlying risk–return trade-off because it lies beneath the sukuk structure.