Basics: Islamic Finance and Bonds (Sukuk)

Bonds are a valuable tool for any investor, oftentimes providing stability to a portfolio. When a person invests in bonds, they are buying the debt of a specific entity that is pre-arranged to pay back in the future – in simplest terms, an IOU. They are used to diversify a portfolio and achieve a fixed income stream, as bonds ordinarily entail the return payment over a fixed time period. This can be compared to stocks, which is when an investor purchases equity and receives partial ownership in a company, with the ability to sell that equity when they so choose.

Bonds were among the first instruments to be transferred to Islamic finance, which uses the term sukuk – literally, legal instruments in Arabic.

Note: This is the fourth part of a series on the basics of Islamic banking.

In a basic conventional bond, the lender, or investor, purchases a bond for a price called the principal, essentially giving the issuing entity a loan. The entity then pays back the loan over a fixed period of time with interest. Sukuk serve the same purpose in Islamic finance as bonds in conventional finance, the primary difference being that with sukuk, both parties take partial ownership of the debt and equity in the company.

One of the reasons that riba (usury, or interest) is forbidden in Islamic finance is because currency is not considered to have intrinsic value, but rather is a way to measure value. If money has no value, one cannot be charged to use it, and thus the concept of interest is moot. Rather, Islamic finance is said to be asset-based, whereby an investment is structured on an exchange or ownership of assets. It follows that interest cannot be charged on bonds, which is at its most basic, lending money. So sukuk must be structured differently.

The most common sukuk replicate the regular cash flow of a bond, but without the definition of interest. Instead, the profit comes from the concept of partial ownership, and the sukuk-holders are paid not interest on their loan but instead, a portion of the profits. It follows that when a sukuk is repaid, it is not the principal and interest, but rather, the current market value of the enterprise or assets.

There are several different type of sukuk, as they can represent partial ownership in a project with mudaraba equity (mudaraba sukuk), ownership in a musharaka equity (musharaka sukuk), ownership in real estate (ijara sukuk), commodities (murabaha sukuk), goods (salam sukuk), projects (istisna sukuk), and hybrid sukuk.

The next article in this series will look at the different types of sukuk.

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