Islamic Capital Market Instruments: Moving Beyond the 'Ijara Sukuk'
There has recently been a flurry of interest in Islamic capital market instruments. Many articles have been published on the subject and it has been the topic of choice at numerous finance conferences. One of the key rules of the Shari’ah(Islamic law) is the prohibition on charging interest(or ‘Riba’) on money. Traditional capital market instruments such as bonds, commercial paper and medium term notes all have a fundamental interest and principal component. Does this not make Islamic capital market instruments a contradiction in terms? How can a structure get around such a fundamental rule?
A reasonably well-established Islamic financing structure, known as the Ijara, which has been considered acceptable by Islamic scholars for other financing transactions, seems to overcome this problem.
The Ijara (which is a word derived from the term ‘rental’ in Arabic) is a structure that utilises an asset’s rental stream to produce a return to the owner of the asset. A classic example would be if two parties (‘A’ and ‘B’) wished to enter into a financing of an asset. For example, A would like to purchase a car but does not have the money to buy it. A can approach B (who does have money) and ask B to purchase the car and lease it to A and eventually sell it to A. A and B can structure the arrangement between them so that periodic payments by A to B include both the lease component and the purchase price for the car which will be fully paid up at the end of the term.
This arrangement is shown in the diagram below:
This arrangement works and operates like an amortising loan in many respects, however, Islamic scholars have become comfortable with the arrangement being a sale and lease of an asset as opposed to a loan under which principal and interest are payable. This traditional Ijara structure was in use for some time before Islamic capital market instruments started to appear in the market. How can this Ijara structure be used and adopted for an issue of instruments that have similar cash flow qualities to standard capital market instruments? What if the party seeking the finance does not wish to own an asset but needs financing for other purposes?
A good example of successfully adopting the Ijara structure for a truly global capital market issue was the Malaysian government’s issue of Sukuk Trust Certificates (‘Sukuk’ is an Islamic finance term used to describe Islamic capital market instruments) in August 2002. The structure used for the transaction was clean and simple in order to appeal to the broadest possible base of investors. In this instance, a special purpose company was incorporated in Labuan called the ‘Malaysian Global Sukuk Inc.’ (MGS).
MGS is owned by a Malaysian state entity. MGS issued Sukuks to investors. MGS used the funds raised from investors to purchase a number of parcels of land in and around Kuala Lumpur from another Malaysian state entity. MGS then leased those parcels of land to the Federation of Malaysia. At the expiry of the term of the lease, the Malaysian government has agreed to purchase the parcels of land from MGS at the face value of the initial issue amount of the Sukuks.
Pursuant to a declaration of Trust, the land parcels are held by MGS in favour of the Sukuk holders. All returns made on the land parcels are conveyed to the Sukuk holders (including lease payments and the final repurchase proceeds to be paid by the Federation of Malaysia). The cashflow produced is similar to any bond cashflow. The lease payments are like coupons and the repurchase proceeds paid at the end of the term are like the principal component of a bond.
The MGS issue was rated by Moody’s and Standard and Poor’s. The Sukuks were listed on the Luxembourg Stock Exchange. The lease payments are determined based on a spread over LIBOR. The Islamic scholars are comfortable with the use of LIBOR as a lease pricing reference mechanism and not as a means of calculating interest. A floating lease price has been considered acceptable by Islamic scholars as landlords and tenants (in the traditional sense) can agree on raising or lowering lease payments on land over the period of a tenancy.
A simple diagram of the structure is shown below:
As trading in debt above or below par would obviously breach the Islamic finance principle of not charging interest and the ability to trade freely in capital market instruments is critical to investors, there is a potential further problem. However, since the Ijara Sukuks represent an interest in the underlying assets and not debts, they can be traded above or below par freely without breaching any Islamic principles.
Islamic scholars have broadly accepted the Ijara structure. Despite its simplicity and broad acceptance it suffers from some major commercial disadvantages for the issuer, namely:
To overcome the limitations of the Ijara Sukuk structure, innovative structures are being developed by various financial institutions. Pooling of investor funds on a ‘Mudaraba’ basis (an Islamic financing term referring to participation financing) in order for the funds to be invested in various Shari’ah-compliant transactions that meet set criteria is an option. The return to the investors will be linked to the underlying Shari’ah-compliant transactions and their performance. However, this structure is not viable for many potential issuers that do not have the required Shari’ah-compliant transaction portfolio for the funds to be invested in. Furthermore, because of the need for some genuine risk participation, the return cannot give investors the certainty of being fixed or floating. However, while the return on such a structure is based on the performance of the issuer and the underlying transactions, making the return calculation very different to standard capital market instruments, these products can be structured to give a return that is very similar to an ordinary bond.
Alternative structures are being contemplated based upon other well-known Islamic financing methods (such as Istisna, Musawama, Murabahah, Musharaka). The biggest challenge that these potential structures face is producing an instrument that can be traded freely in the secondary market without breaching the fundamental Islamic principle of not trading in debt above or below par. The Ijara structure cleanly gets around this problem by producing instruments that represent an interest in an underlying asset that can be traded. To overcome this problem some of the structures being contemplated are extremely complex and document intensive. However, there seems to be a strong will to come up with a structure that will open the Islamic capital markets to issuers that cannot or do not necessarily want to provide assets to their borrowing structures.
Given the desire in the Gulf region and in the Far East to invest in Shari’ah-compliant investments and the attraction of this market to Islamic and non-Islamic institutions as a potential source of funds with pricing advantages, it is only a matter of time before a viable structure is developed that does not suffer from the commercial disadvantages of the Ijara Sukuk and is widely accepted by Islamic scholars and the Islamic and international bond market.