Sukuks Can Enhance Your Portfolio
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Originally Posted On: https://www.linkedin.com/pulse/sukuks-can-enhance-your-portfolio-kunle-fadeyi-cfa-caia/
Sukuks are sharia-compliant investments that can benefit both Muslim and non-Muslim investors by offering ethical investment options.
A diverse portfolio is one of the most important factors when balancing your investments. When you have more diversity in your portfolio, you spread the risk and can increase your chances of solid returns. Including a range of different investment products in your portfolio helps to make it more diverse and balanced and can deliver a number of other benefits too.
Sukuks are an investment option that any investor should consider when looking to diversify their portfolio. Designed to be compatible with the teachings of Islam, they are also an excellent investment option for non-Muslims. They offer social and sustainability benefits, which makes them a good choice for anyone looking for ethical investments.
This guide will outline what sukuks are, how they work, and how they can be a great addition to your investment portfolio.
What are sukuks?
Sukuks are fixed-income capital markets instruments that are compliant with sharia law. This makes them a suitable investment for Muslims, but they are also an interesting option for anyone who doesn’t follow Islam. Sukuks are intended to create returns that are similar to those from bonds and other fixed-income instruments.
Sukuks are not the only sharia-compliant investment available. However, they are one of the most popular in both majority-Muslim countries and in places with large Muslim communities. Other types of sharia-compliant investments include a variety of options through Islamic banks and investing in companies whose activities align with the requirements of Islamic law. Even some large firms such as Google and Facebook are sharia-compliant, so options are not limited. There are some indices that are designed to help investors find companies that comply with sharia investment principles, such as those from FTSE Russell and MSCI.
Many sharia-compliant investments can be difficult to access for investors. However, we are helping to make sukuks accessible to investors of all types so that they can benefit from an effective way to develop their portfolios.
How do sukuks work?
Sukuks are designed to be sharia-compliant, which means that they must be compatible with a number of rules. This means that any profits must only come from commercial risk-taking and trading and that any form of conventional interest is not allowed. Additionally, the assets involved in the funding arrangement must be halal (permissible in Islam).
Investments that comply with sharia principles must come from companies that are not involved with a number of activities. This includes conventional finance, alcohol, pork-related products, gambling, adult entertainment, tobacco, and weapons and defence. Due to these requirements, sukuks are also an excellent option for anyone who is looking for ethical investments. In fact, they are often considered to be a special type of ethical investment and can be compared to other types of ethical investing, which try to follow certain principles regarding various social, environmental, and other benefits.
In terms of risk and return, sukuks are often compared to conventional bonds. However, unlike other fixed-income investment instruments, sukuks are not debt obligations. A sukuk represents an interest in an underlying funding arrangement, which entitles the holder to a proportionate share of returns, as well as return of the capital at a defined date.
What types of sukuks are there?
Sukuks generally come under two different categories, either asset-backed sukuks or asset-based sukuks.
An asset-backed sukuk represents a true sale of assets. The underlying funding arrangement is transferred to a Special Purpose Vehicle (SPV). The asset remains separate from the originator and the sukuk holders have complete claim over the asset.
An asset-based sukuk is structured so that the investors only have beneficial ownership in the underlying asset and no legal ownership. Assets are usually sold to the SPV in the form of a trust and trust certificates are issued to investors. The proceeds are used to enter into a funding agreement with the obligator. The investor gets a distribution income as a share of the return from the underlying assets. The rights of the SPV as financier are held under English law trust in the certificate holders’ favour.
Trust certificates are one of the most common forms of sukuks, but the SPV needs to be created in an offshore jurisdiction where these trusts are allowed. When that’s not possible, a sukuk can be structured as an alternative civil-law structure. In this case, an asset-leasing company is set up in the company of origin so that the asset can be purchased and leased back to the organisation that needs financing. For example, Turkey has created specific legislation relating to sukuk so that these asset-leasing companies can be created.
The diagram below gives a basic idea of how a sukuk works, although there are different types of sukuk that work in slightly different ways.
The main structures of sukuks include lease agreements (ijara), sales agreements (murabaha, istisna, salam), and equity type structures, including investment management (wakala, mudaraba) and partnership (musharaka) structures.
Some of the most common forms of sukuks are ijara, murabaha, and musharaka. Here are some short descriptions of how some of the different types of sukuk work, including who is involved and what their roles are.
● Sukuk al-ijara – Derived from the ijara lease financing structure, the originator sells assets to an SPV, which issues a sukuk to finance the purchase of the assets. The SPV holds the assets in trust and the sukuk holders all have interest in them. The SPV leases the assets back to the originator or an affiliate and uses the lease payments to pay the sukuk holders.
● Sukuk al-salam – The originator enters into a sale and purchase agreement with an SPV and the original agrees to sell the assets for deferred delivery, with the SPV paying the purchase price in advance. The proceeds of a sukuk issuance are used to purchase the assets, which are held in trust for the sukuk holders. The SPV leases or sells the assets back to the originator and makes payments to the sukuk holders.
● Sukuk al-musharaka – Using a joint venture or partnership structure with the two partners being the originator and the SPV. They enter into a management agreement with the originator operating the assets and investing the cash in accordance with the musharaka agreement and sharia. The profits are shared between the SPV and originator according to agreed percentages, with losses shared in accordance with their initial investments. The SPV pays sukuk holders with its share of the profits.
● Sukuk al-mudaraba – The party seeking financing (mudareb) enters an agreement with an SPV to manage assets owned by the SPV. The SPV buys the assets using proceeds from a sukuk issuance. The mudareb receives a fee for managing the assets but the SPV is liable for any losses. The mudareb sometimes receives a portion of the profits too. The SPV pays sukuk holders using its profits.
● Sukuk al-murabaha – An SPV buys an asset that the borrower has identified and finances the purchase with the proceeds of a sukuk. The SPV sells the asset to the borrower for the purchase price plus an agreed profit, with the borrower paying in instalments. The borrower then sells the asset on the spot market, keeping the proceeds and giving them immediate access to the cash but with the obligation to pay the purchase price to the SPV deferred.
The different structures of sukuk can be interesting to consider when thinking about investing. Whether the SPV permanently holds the underlying assets is an important thing to know. The investor should know whether they have legal recourse to the underlying asset, which is the case with an asset-backed sukuk) or if they only have recourse against the obligor, as with an asset-based sukuk.
Examples of Sukuk
There are many examples of sukuk investments that can demonstrate how they work and how they are being used not just by Muslim investors but also around the world by non-Muslim investors too.
One prominent example is the $2.7 million green sukuk fund that Indonesia granted for the Maluku Conservation Centre in 2020. The sukuk has also been used to find infrastructure, with the investors gaining a percentage of the profit from the public infrastructure through the financial certificates issued by the government.
The governments of Bahrain, Qatar, and Malaysia also issue sukuk. The Central Bank of Bahrain, which operates on behalf of the government, issues Sukuk-Al-Ijara and Sukuk Al-Salam to finance infrastructure projects. Malaysia launched a Global Sukuk in 2002, which was backed by an Ijara lease on government property. Qatar also has the Qatar Global Sukuk, issued partly to finance the construction of Hamad Medical City.
Outside of majority-Muslim countries, other governments have also got involved in sukuks. In the German region of Saxony-Anhalt, a €100 million sukuk was issued, with the Federal Republic of Germany guaranteeing the debts of the state. The underlying transactions were buildings owned by the Ministry of Finance with a master lease sold for 100 years to a special purpose vehicle incorporated in the Netherlands, which then rented the least back to the Ministry of Finance for five years. The Saxony-Anhalt Sukuk was the first sovereign sukuk from a non-Muslim country, but various others have followed, including the United Kingdom, Singapore, Luxembourg, and Hong Kong.
The UK issued its first sovereign sukuk in 2014, followed by a second in 2021. The £500 million second sukuk offers 5-year maturity and is more than double the size of the first issuance. Using the Al-Ijara structure, it is underpinned by rental income from central government office properties. Also in the UK, Al Rayan Bank, the UK’s largest Islamic bank, became the first bank in the world to issue a public sukuk in a non-Muslim country. At the time, it was the largest Sterling sukuk that had been released. It was secured by a portfolio of Home Purchase Plans originated by Al Rayan Bank.
Not all sukuks are issued by governments or national banks. Another prominent example is a sukuk by the Dubai property developer Nakheel Group, the developer behind the palm-shaped islands. In 2006, the group sold the world’s largest sukuk at the time.
What is the difference between sukuks and bonds?
Sukuks are often referred to as Islamic bonds, although they are not actually the same as bonds. They do share some similarities with bonds, but there are also various differences. Both bonds and sukuks provide income streams for the investors. While bonds generate interest payments for investors, sukuk investors receive profit generated by the underlying asset. Both are issued to investors and can be used to raise capital for a firm, and both are considered to have less risk compared to other investment options, such as equities.
However, while bonds are debt obligations, sukuks involve asset ownership. A sukuk can appreciate along with an asset but the yield from a bond is tied to its interest rate. Sukuks are backed by halal assets, but bonds are often not sharia compliant. Additionally, the valuation of a sukuk is determined by the asset backing it, whereas the price of a bond is largely based on its credit rating.
Sukuks have several advantages over bonds when it comes to returns. While the returns may not always be as significant compared to bonds, one of the benefits of sukuks is the stability that they offer. They have fared well in recent years when other asset types have been affected by volatility. They can also provide better returns compared to conventional bonds in some cases.
A short table comparing Sukuks to equity and debt can be found in this post.
What are the benefits of investing in sukuks?
Investing in sukuks can have a range of benefits for all types of investors. If you are looking for ways to diversify your portfolio with an investment product that is lower risk than many others, sukuks could work for you. They’re not just for Muslim investors, although they obviously provide a great benefit to anyone looking for investments that comply with sharia law and can add to any investor’s portfolio.
One of the benefits of investing in sukuk is that they offer an alternative to conventional bonds. They bear a similar level of risk and return, but they have the added benefit of following sharia rules so they’re available for both Muslim and non-Muslim investors. Instead of only paying interest, they offer investors a stake in the underlying assets, meaning ownership of underlying projects, properties, or investments.
Because sukuks follow certain requirements, they can also appeal to ethically minded investors who are looking to invest in responsible ways. Investors looking for environmental, social, and governance (ESG) alternatives to other types of investments can find that sukuks are a good choice for them. ESG investments and sukuk Islamic investments essentially follow the same criteria, but for different reasons. While one focuses on a particular ethical philosophy, the other follows the same criteria for religious reasons.
Sukuk investment is a great option if you want to diversify your investment portfolio too. It’s a different type of investment that you can add alongside other investment options that has a low correlation with other fixed-income products. Sukuk is also an excellent option if you want to invest in Southeast Asia and the Gulf Cooperation Council (GCC), which are fast-growing and often not as easy to invest in when looking at traditional bond indexes and funds. Investing in both different markets and a different type of investment product can bring valuable diversity to your portfolio.
Investing in sukuks can also provide stability for investors. Islamic banks and institutions support the global sukuk market, which has helped to insulate this investment type against market volatility. The performance of sukuks on secondary markets has remained fairly stable even during wider economic instability due to investors holding their investments until maturity. There was a drop in sukuk issuances in 2020, but it’s predicted that the supply will be stable in the next few years. Sukuks have seen good returns compared to other fixed-income asset classes over the last five years.
The Dow Jones Sukuk Total Return Index had 5-year annualised returns of 4.74%, while the S&P Global High Yield Sukuk Index had returns of 5.67%. In comparison, S&P Global Developed Aggregate Ex-Collateralised Bond Index (USD) experienced returns of 2.48%.
How can investors get access to sukuks?
Investors who are interested in investing in sukuks can browse a range of options in the UK and abroad. Followers of Islam will want to ensure that any investments they make are sharia-compliant and that they are able to ethically invest in financial vehicles that will work for them. Non-Muslims can also find sukuks and other investments designed for Muslims that can offer a more ethical way to invest compared to some other investment options.
If you want to invest in sukuks, you might be unsure at first about how to identify the right investment opportunities and how you can access sukuk investments. Investors can look for options in the UK, as well as considering foreign markets, where more options may be available. The London Stock Exchange is a key global venue for sukuk listings and more than $50 billion has been raised by nearly 70 sukuk issuances on the exchange. They offer sukuks on the International Securities Market and the Main Market. Important names in the Islamic financial industry such as the Islamic Development Bank use the LSE to list sukuks on their markets.
To access the markets on the London Stock Exchange, you will need a stockbroker. If you want to invest in sukuks, a broker can help you to access funds that offer a number of Islam-friendly investments. Some examples of sharia-compliant funds include BNP Paribas Islamic Hilal Income, offering sukuk fixed income, and Oasis Crescent, which combines stocks, sukuk fixed income, and property funds.
Of course, investors can also consider the option of making foreign investments. This makes it possible to explore sukuks in Muslim countries or non-Muslim countries that are getting involved in the market. This might be done through a broker in the UK or by finding a local broker in the country that you are interested in to get help with investing in sukuk.
Available sukuk investments and other sharia-compliant products are still growing in the UK. Although there is a sizeable and establish Muslim community in the country, there are still limited options when it comes to easily investing. Demand for Muslim funds has the potential to increase, not just from Muslims in the UK but also from non-Muslims who might be interested in the benefits that these investment options could offer them. In 2021, Islamic mutual funds grew faster than their global mutual fund counterparts over the previous 5 years. While Islamic funds had 84% nominal and 13% annualised growth rates, global mutual funds had 68% nominal and 11% annualised growth rates.
Previous sukuk issuances such as the Government’s two sukuk and the first sukuk from Al Rayan Bank have seen great demand and even oversubscription. This shows that there is a great demand for these kinds of investment products. However, one of the reasons they might not be growing as fast could be that they are not being marketed as ethical investments. This means that perhaps only Muslim investors might find them, and even they may be more likely to focus on other sharia-compliant investments, such as investing in property or gold. Recognising the ethical nature of sukuk investments makes them more appealing to a range of investors.
At Yieldtrust, we are working to make sukuks more accessible to investors. We can help you to find the right sukuk products to invest in, whether you are a Muslim looking for investments that comply with your beliefs or a non-Muslim looking for ethical investments, or just a way to make your portfolio more diverse. By raising awareness of the benefits of sukuk to all types of investors and making them easier to access, we can help them to diversify and improve their portfolios.