Course: Sukuk Management (5449)
Semester Autumn 2021
Level: Associate Degree
Assignment no 2.
Q1 How are sukuk bonds different from conventional bonds in your view? Discuss with examples.
Answer.
Although a common starting point for explaining sukuk is to use bonds as a comparison point, it is important to understand that there are certain fundamental differences.
Sukuk adhere to an Islamic view of finance, avoiding Riba (generating money from money, i.e. interest or usury), bonds are securities that are very Riba due to the fact that they have a fixed interest.
There are five important differences between sukuk and traditional bonds:
- Sukuk indicate ownership of an asset. Bonds indicate a debt obligation.
- The assets that back sukuk are compliant with Shariah. Assets backing bonds may include products or services that are against Islam.
- Sukuk are priced according to the value of the assets backing them. Bond pricing is based on credit rating.
- Sukuk can increase in value when the assets increase in value. Profits from bonds correspond to fixed interest, making them Riba.
- When you sell sukuk, you are selling ownership in the assets backing them. The sale of bonds is the sale of debt.
Sukuk are backed by tangible assets, rather than by debt. Sukuk ownership indicates ownership of an asset that has value. Although, a bond may also indicate this, the real definition of a bond simply indicates a debt obligation. At its root, the relationship between the issuer of a bond and the consumer is very different from the relationship between the issuer of sukuk and the purchaser of sukuk. In the case of a bond, the consumer is acting as the loaner and the bond issuer as a loan recipient. In this case, the loan has a fixed interest, therefore being Riba. In sukuk, the purchaser is purchasing an asset that has value rather than participating in an implicit loan agreement.
Another important difference between bonds and sukuk is that the assets involved in sukuk certificates comply with all laws of Islam. In the case of bonds, the bond certificate may be backed by assets that are not compliant with Shariah, which may be bundled together with other types of assets without the consumer’s knowledge. The consumer of sukuk is assured that the value of the certificate corresponds to assets that are in the public good and not related to activities or products that are against Islam.
What are Sukuk and Bonds?
Sukuk and Bonds are financial instruments issued by Governments or Corporates to raise money from investors for a period of time.
Commonly, over this period, Sukuk and bonds distribute periodic coupon payments (either at a fixed or floating rate). At the end of this period, known as maturity, issuers pay back the money raised from investors, known as principal.
The difference between Fixed and Floating rate:
Fixed rate coupon is characterized by its fixed coupon payment which does not change over time.
Floating rate coupon has a variable rate which changes periodically.
Sukuk and Bonds vs. Stocks:
When a company issues stock, it is selling partial ownership in exchange for cash. However, when an entity issues Sukuk or Bonds, it is borrowing cash with an agreement/promise to repay the borrowed amount at maturity.
Stocks are issued by companies only, whereas Sukuk and Bonds are issued by both companies and governmental entities.
Sukuk and Bond prices are considered less volatile compared to equities, while the return on equities could potentially be higher than that of Sukuk and bonds.
Sukuk and Bonds commonly promise fixed returns as well as the repayment of the principal, while stocks does not commonly promise fixed returns, rather, it depends on the company’s performance.
Sukuk and Bond holders have the priority of repayment in the event of company liquidation or bankruptcy.
The main differences between Sukuk and Bonds:
Sukuk are Sharia-compliant financial certificates through which investors gain partial ownership on an issuer’s assets until maturity. While Bonds are financial certificates through which investors lend money to the issuer, indicating an obligation for repayment at maturity.
Bondholders receive regular interest payments, while Sukuk holders receive a share of the profit generated by the underlying asset.
What are Sukuk and Bonds used for?
By issuers:
Raising capital to fund operations or development plans.
By investors:
An investment opportunity to receive periodic coupon payments and potential price uplift.
A diversification strategy for investors as their portfolios include Sukuk and Bonds along with other securities.
Q2 Explain the concept of harmonization. Discuss the practical steps towards the harmonization for sukuk
Answer.
ThedifferencesbetweenSECAPsandSUMPshighlightedinthepreviousparagraphshouldnotleadthereadertotheconclusionthattheirharmonizationisnotviable.Harmonizing,furthermore,doesnotmeanunificationofactivitiesorthemereinclusionofsectionsofoneplanintotheother.
Harmonizationmeansworkingonthoseareaswhicharecomplementaryinordertohavetheplansworkingtogetherfortheachievementofanoverallstrategicobjective.Harmonizationhelpsdifferentdepartmentsinlocalauthoritiessharethesamevision,worktogetherandoptimizetheuseofresources.
Note:MakingananalogybetweenagearingsystemandtheharmonizeddevelopmentandimplementationofSECAPandSUMP,wecouldcomeupwithtwoconsiderations:
thelackofactivityinoneoftwoplansorintheirharmonizationforcedlystopstheothertwo;
oncestarted,thewheelrepresentingtheharmonizationprocess,showinganinertiaandadiameterfarmoresignificantthantheothertwo,easilydragsthesmallerwheelsrepresentingtheSECAPandtheSUMP.
Theareasofpotentialcooperationtofocusonduringtheharmonizationprocessarethefollowing:
Strategicvision:bothSUMPsandSECAPs(inparticularconsideringthenewelementsaddedbySECAPs)aimatimprovingcitizens’qualityoflifeandminimizingimpactsontheenvironment.
Baseline:allplansrelyonathoroughdefinitionofthebaselineagainstwhichtheprogressinachievingtheplans’objectivesistobemeasured.Definingcommondatabasesleadstomorecoherenceandamoreefficientuseofresources.
Participationofstakeholders:thesuccessfuldevelopmentofbothuponaSECAPandaSUMPdependsupontheactiveinvolvementofstakeholders.Acoordinatedmanagementofthestakeholders’involvementprocesshelpsinthedefinitionofasinglevisionandabetteruseofresources.
Commonactions:allactionsrelatedtolowcarbonmobilityactionscontributetotheachievementofthegoalsofbothplans,bytargetingimprovedmobilityandenergyefficiencyorrenewableenergy.Thereforeforthedevelopmentofcoordinatedactionsiscrucial.
Monitoringandcontrolling:CheckingprogresstowardsthegoalsiscommontoSECAPsandSUMPS,as well as the identification of new challenges, so both plans should be monitored and controlled in a harmonizedway.
Localauthoritiesinitiatingtheirharmonizationprocessmayhavedifferentstartingscenarios:
TheymayalreadyhavebothaSECAPandaSUMP,needingharmonization;
TheymayalreadyhaveeitheraSECAPoraSUMP,needingtodeveloptheotherinsuchawaythatitisharmonizedwiththeexistingplan;
Theymayhavetodevelopbothplans.
In terms of management, four operational principles should guide the harmonization process:
Shared vision: all departments taking part in the process (mobility, environment, energy, land use planning etc.)
should share the same vision and strategic objective.
Cooperation: all departments taking part in the process (mobility, environment, energy, land use planning etc.) should work jointly and actively cooperate.
Leadership: a single, qualified and capable project manager should lead the process.
Project management techniques: the harmonization process is a complex task, requiring coordination of different activities, multidisciplinary teams and compliance with several, and sometimes contradicting, regulations and guidelines. Defining a work plan, attributing tasks and setting milestones are therefore necessary steps.
Q3 Explain currency risk. How could currency nisk be avoided to maximize returns on investment in sukuk market? Discuss with examples
Answer.
Currency Risk?
Currency risk, commonly referred to as exchange-rate risk, arises from the change in price of one currency in relation to another. Investors or companies that have assets or business operations across national borders are exposed to currency risk that may create unpredictable profits and losses. Many institutional investors, such as hedge funds and mutual funds, and multinational corporations use forex, futures, options contracts, or other derivatives to hedge the risk.
Currency Risk Explained
Managing currency risk began to capture attention in the 1990s in response to the 1994 Latin American crisis when many countries in that region held foreign debt that exceeded their earning power and ability to repay. The 1997 Asian currency crisis, which started with the financial collapse of the Thai baht, kept the focus on exchange-rate risk in the years that followed.
Keys.
Currency risk is the possibility of losing money due to unfavorable moves in exchange rates.
Firms and individuals that operate in overseas markets are exposed to currency risk.
Institutional investors, such as hedge funds and mutual funds, as well as major multinational corporations, hedge currency risk in the forex market, and with derivatives like futures and options.
Currency risk can be reduced by hedging, which offsets currency fluctuations. If a U.S. investor holds stocks in Canada, for example, the realized return is affected by both the change in stock prices and the change in the value of the Canadian dollar against the U.S. dollar. If a 15% return on Canadian stocks is realized and the Canadian dollar depreciates 15% against the U.S. dollar, the investor breaks even, minus associated trading costs.
Examples of Currency Risk
To reduce currency risk, U.S. investors can consider investing in countries that have strong rising currencies and interest rates. Investors need to review a country’s inflation, however, as high debt typically precedes inflation. This may result in a loss of economic confidence, which can cause a country’s currency to fall. Rising currencies are associated with a low debt-to-gross domestic product (GDP) ratio.
The Swiss franc is an example of a currency that is likely to remain well-supported due to the country’s stable political system and low debt-to-GDP ratio. The New Zealand dollar is likely to remain robust due to stable exports from its agriculture and dairy industry that may contribute to the possibility of interest rate rises. Foreign stocks sometimes outperform during periods of U.S. dollar weakness, which typically occurs when interest rates in the United States are lower than other countries.
Investing in bonds may expose investors to currency risk as they have smaller profits to offset losses caused by currency fluctuations. Currency fluctuations in a foreign bond index are often double a bond’s return. Investing in U.S. dollar-denominated bonds produces more consistent returns as currency risk is avoided. Meanwhile, investing globally is a prudent strategy for mitigating currency risk, as having a portfolio that is diversified by geographic regions provides a hedge for fluctuating currencies. Investors may consider investing in countries that have their currency pegged to the U.S. dollar, such as China. This is not without risk, however, as central banks may adjust the pegging relationship, which would be likely to affect investment returns.
Special Considerations
Many exchange traded funds (ETFs) and mutual funds are designed to reduce currency risk by being hedged, typically using forex, options, or futures. In fact, the rise in the U.S. dollar has seen a plethora of currency-hedged funds introduced for both developed and emerging markets such as Germany, Japan, and China. The downside of currency-hedged funds is that they can reduce gains and are more expensive than funds that aren’t currency-hedged.
BlackRock’s iShares, for example, has its own line of currency-hedged ETFs as an alternative to its less-expensive flagship international funds. In early 2016, investors began reducing their exposure to currency-hedged ETFs in response to a weakening U.S. dollar, a trend that’s since continued and has led to the closures of a number of such funds.
Return on Investment
Historical return on investment is the annual return of an asset over several years. Research analysts and professional investors use historical returns, along with industry and economic data, to estimate future rates of return. You can use actual results and estimated returns to evaluate various assets, such as stocks and bonds, as well as different securities within each asset category. This evaluation process helps you pick the right mix of securities to maximize returns during your investment time horizon.
What Is Investment Risk
Risk is the likelihood that actual returns will be less than historical and expected returns. Risk factors include market volatility, inflation and deteriorating business fundamentals. Financial market downturns affect asset prices, even if the fundamentals remain sound. Inflation leads to a loss of buying power for your investments and higher expenses and lower profits for companies.
Business fundamentals could suffer from increased competitive pressures, higher interest expenses, quality problems and management inability to execute on strategic and operational plans. Weak fundamentals could lead to declining profits, losses and eventually a default on debt obligations.
Risk vs. Return
You cannot eliminate risk, but you can manage it by holding a diversified portfolio of stocks, bonds and other assets. The portfolio composition should be consistent with your financial objectives and tolerance for risk. Investment returns tend to be higher for riskier assets. For example, savings accounts, certificates of deposit and Treasury bonds have lower rates of return because they are safe investments, while long-term returns are higher for growth stocks and other riskier assets.
Considerations for Investment Decisions
Life events will require adjustments to your financial plan, including the asset mix in your investment portfolio. For example, the stock component of your portfolio may be high when you start your first job because you can afford to take more risks and want to grow your investments as quickly as possible. Your portfolio may change to a balanced mix of stocks and bonds when you start a family and switch to mostly bonds and dividend-paying stocks as you get closer to retirement.
Market movements may also require periodic portfolio adjustments. For example, you may take some profits in stocks following a sharp stock market rally or invest in quality stocks at bargain prices after a sharp market correction.
Q4 What are the various techniques used by Standard & Poor’s for rating sukuk securities? Discuss with examples.
Answer.
SUKUK RATING METHODOLOGY
What Is Sukuk
Sukuk (plural of sakk) had been extensively used by Muslim in the Middle Ages, an
papers representing financial obligations originating from trade and other commercial activities. However, sukuk as applied in the capital markets pertains to the process of securitization According to AAOIFI, sukuk are certificates of equal value that represent an undivided interest in the ownership of an underlying asser, usufruct and services or assets of particular projects or special investment activity Sukuk certificates are unique in the way that the investor becomes an asset holder.
Therefore, he should bear the risk of its underlying assets. Sukuk certificate holders e carry the burden of these unique risks. However, sukuk nature is different with conventional bond. A bond is a contractual debt obligation whereby the issuer is contractually obliged to pay to bondholders, on certain specified dates, interest and principal. On the other hand, sukuk entails that holders claim an undivided beneficial ownership in the underlying assets. Consequently, sukuk holders are entitled to share in the revenues generated by the sukuk assets as well as being entitled to share in the proceeds of the realization of the sukuk assets. The different nature of bond and sukuk in term of their respective credit risk exposure causes the need for different rating assessment. Indeed, the rating agencies such as Fitch Ratings, Moody’s, S&P. MARC, RAM, etc, have come out with their own methodology to rate sukuk
Unlike a bond that is confined to the loan upon interest, sukuk can be structured. from various applications of Islamic financial contracts, Nonetheless, sukuk has some similarities to conventional bonds because they are structured with physical assets that generate revenue. The underlying revenue from these assets represents the source of income for payment of profits on the sukuk. According to AAOIFI, sukuk are issued on various transaction contracts. These sukuk are Ijara, Murahaha, Salam, Istisna, Mudaraba and Masharaka, Muzara’a (sharecropping), Muqasa (irigation) and Mugharasa (agricultural partnership). However, the last three types are rarely used in the market.
Sukuk Rating Methodology Based on Recourse of the Underlying Asset
An important consideration in structuring sukuk is its Sharia applicability to be traded in the exchanges. Unlike conventional bonds, sukuk should be endorsed by Sharia advisor as Sharia compliance marketable securities, Related to Sukuk ratings, rating agencies, however, only give an opinion on the credit aspect linked with the instruments. Since the rating agencies argued that Sharia compliant nature of Sukuk is neutral from a credit perspective, the rating assigned to Sukuk does not imply any confirmation on sharia compliance (Fitch, 2011; S&P, 2007; Moody’s 2006; RAM. 2011: and MARC, 2012). Most of Sukuk rated by rating agencies are structured with the approval of Sharia board. The board evaluates the structure of the transaction and pronounces on its compliance with Sharia Consistent with its position on addressing only the credit aspects of the transaction, rating agencies neither review the role or composition of Sharia board, nor opine on the validity of the board’s recommendations
and decisions Besides underlying contracts, Sukuk can also be differentiated into two modes due to recourse over underlying asset. The two modes are Asset-based and Asset-backed Sukuk These two modes semantically have similar descriptions but mask significant differences in terms of credit risk
Asset-backed sukuk rating methodology
Asset backed Sukuk represents a true sale of assets because the underlying asset has been validly transferred to the Special Purpose Vehicle (SPV). In the even of default, therefore, the underlying assets will remain completely separate from the originator. The Sukuk holders or the investors have recourse to the underlying asset of the Sukuk. In addition, the risk occurs during insolvency proceedings should be remote from the originator to the SPV Meaning, the investors have the full claim over the underlying asset, without any risk of the sale subsequently being inverted by the local or Sharia courts.
Fach (2011) S&P (2007). Moody’s (2006), RAM (2011), and MARC (2012) argued that rating assessment of asset backed Sukuk will be depending on the performance of the underlying asset in generating cash to meet timely obligations Standard and Poor’s (2007) categorized asset backed Sukuk as no-credit enhancement Sukuk because the rating. would depend mainly on the nature of the underlying asset
Asset-based sukuk rating methodology
Asset based sukuk, however, is structured in such that investors only have a beneficial ownership in the underlying asset instead of legal ownership over the underlying asset. In this structure, assets are generally sold by the originator to SPV (Special Purpose Vehicle) in the form of trust. The trustee issues certificates showing the investor’s ownership interest, while the proceeds are used to purchase the assets. The investor receives a distribution income representing a share of the return generated by the underlying assets or from any sources comes from the originator.
In an asset-based Sukuk, it is clearly showed that the credit risk of Sukuk reflects on the credit risk of the originator rather than the underlying assets. This is because the investors do not have any recourse to the underlying assets in the event of default since the investor is not a legal owner of the underlying asset. Theoretically, in the event of bankruptcy, investors should have a claim or right to the corporate assets. However, in asset-based Sukuk, the investor have an unsecured claim, because Sukuk claim will be ranked at the same level as other unsecured creditors. Sukuk investors, in the case of senior unsecured obligations, have no priority over the Sukuk assets as compared to other creditors and will be rated equivalent to them. Otherwise, in the case of subordinated Sukuk, ratings are notched down. In this case, rating agencies apply fundamental rating methodologies to rate this Sukuk (Fitch, 2011; S&P, 2007, Moody’s, 2006; RAM, 2011, and MARC, 2012)
This implies that the agency adopts the common conventional rating method that applied corporate credit rating (CCR) in the case of corporate sukuk and Islamic financial institution rating method for financial institution’s sukuk issuer.
Q5 What are the various securitization principles for sukuk securities in the capital market? Discuss with examples
Answer.
Securitization is the procedure where an issuer designs a marketable financial instrument by merging or pooling various financial assets into one group. The issuer then sells this group of repackaged assets to investors. Securitization offers opportunities for investors and frees up capital for originators, both of which promote liquidity in the marketplace.
In theory, any financial asset can be securitized—that is, turned into a tradeable, fungible item of monetary value. In essence, this is what all securities are.
However, securitization most often occurs with loans and other assets that generate receivables such as different types of consumer or commercial debt. It can involve the pooling of contractual debts such as auto loans and credit card debt obligations.
Securitization is the process used to create asset-backed securities (ABS). It takes the illiquid assets of a financing company (the leases, loans, mortgages and credit card debts of its customers), pools them and transforms them into highly liquid securities that are sold to investors.
The process benefits both the financing companies and the investors.
For the financing companies, new capital is raised at more affordable rates than they could get through their commercial banks. Better yet, they do that by freeing up cash from assets sitting on their balance sheets. They also grow their loan books by lending the capital back out to new borrowers.
Investors not only benefit from the income that flows from the assets that “back” the securities, but also from the liquidity of the securities themselves—the ability to sell them to another buyer at any time.
More about securitization
Securities are categorized according to the type of assets used to back them. Examples include:
Securities backed by long-term loans with high interest rates
Securities backed by short-term loans with low interest rates
Securities backed by accounts receivable (money a business is owed by its customers)
Securities backed by royalty payments from contracts
This grouping helps investors select the asset-backed securities that best fits their investment profile.
One specific sub-category of asset-backed securities is backed by real estate. These are called mortgage-backed securities (MBS).
Securitization Works
In securitization, the company holding the assets—known as the originator—gathers the data on the assets it would like to remove from its associated balance sheets. For example, if it were a bank, it might be doing this with a variety of mortgages and personal loans it doesn’t want to service anymore. This gathered group of assets is now considered a reference portfolio. The originator then sells the portfolio to an issuer who will create tradable securities. Created securities represent a stake in the assets in the portfolio. Investors will buy the created securities for a specified rate of return.
Often the reference portfolio—the new, securitized financial instrument—is divided into different sections, called tranches. The tranches consist of the individual assets grouped by various factors, such as the type of loans, their maturity date, their interest rates, and the amount of remaining principal. As a result, each tranche carries different degrees of risk and offer different yields. Higher levels of risk correlate to higher interest rates the less-qualified borrowers of the underlying loans are charged, and the higher the risk, the higher the potential rate of return.
Benefits of Securitization
The process of securitization creates liquidity by letting retail investors purchase shares in instruments that would normally be unavailable to them. For example, with an MBS an investor can buy portions of mortgages and receive regular returns as interest and principal payments. Without the securitization of mortgages, small investors may not be able to afford to buy into a large pool of mortgages.
Unlike some other investment vehicles, many loan-based securities are backed by tangible goods. Should a debtor cease the loan repayments on, say, his car or his house, it can be seized and liquidated to compensate those holding an interest in the debt.
Also, as the originator moves debt into the securitized portfolio it reduces the amount of liability held on their balance sheet. With reduced liability, they are then able to underwrite additional loans.
Pros
Turns illiquid assets into liquid ones
Frees up capital for the originator
Provides income for investors
Lets small investor play
Cons
Investor assumes creditor role
Risk of default on underlying loans
Lack of transparency regarding assets
Early repayment damages investor’s returns