From CEOpedia | Management online

Sukuk is a type of Islamic financial certificate, similar to a bond, that complies with Shariah, Islamic religious law. It is a financial instrument that provides an investor with a fixed return through ownership in an asset or pool of assets. Sukuk is often structured to pay a fixed return to its investors, similar to a bond, while still providing an underlying asset that is Shariah compliant.

The structure of Sukuk can be broken down into the following components:

  • Asset: The asset is the underlying asset that is being used to generate the return for the investor. It can be a tangible asset such as real estate, or a financial asset such as a pool of investments.
  • Investment: The investment is the portion of the asset that is being used to generate the return for the investor. It can be a direct investment, such as a portion of the return from the underlying asset, or indirect, such as an income stream from a pool of investments.
  • Management: The management of the asset is the responsibility of the Sukuk issuer, which is typically a financial institution or other entity. The issuer is responsible for managing the asset, ensuring that it is Shariah compliant, and providing the return to the investors.
  • Return: The return is the amount of money that is paid to the investors in exchange for their investment. This can be a fixed amount, a percentage of the underlying asset, or a combination of the two.

Example of Sukuk

A common example of Sukuk is a Real Estate Investment Trust (REIT) Sukuk, which is a publicly-traded security that is backed by a portfolio of real estate assets. The REIT Sukuk issuer is responsible for the management and maintenance of the underlying assets, as well as the distribution of returns to the investors. The underlying assets are usually a combination of commercial and residential properties that are leased to tenants. The returns are typically paid out periodically, such as quarterly or annually, in the form of rent payments or dividends.

Formula of Sukuk

The formula for calculating the return on Sukuk is as follows:

Return on Sukuk = (Investment Amount + Interest Rate) / Asset Value

In this formula, the Investment Amount is the amount of money invested in the Sukuk, the Interest Rate is the rate of return paid to the investor, and the Asset Value is the value of the underlying asset. The return on Sukuk is calculated by dividing the Investment Amount plus the Interest Rate by the Asset Value.

When to use Sukuk

Sukuk can be used when an investor wants to generate a return from an asset or pool of assets in a Shariah compliant manner. It can also be used to finance large projects, such as real estate developments, or to provide access to capital for businesses or governments. In addition, Sukuk can provide a more efficient and cost-effective way to finance projects, as it eliminates the need for traditional debt financing.

Types of Sukuk

Sukuk are divided into two main categories: asset-based and asset-backed.

Asset-based Sukuk are those in which the underlying asset is directly owned by the issuer, such as real estate or a portfolio of investments. The return is usually a fixed amount paid to the investors, or a percentage of the underlying asset.

Asset-backed Sukuk are those in which the underlying asset is indirectly owned by the investor, such as a pool of investments or a lease payment. The return is usually an income stream generated by the underlying asset, or a combination of fixed and variable returns.

Steps of Sukuk

There are four steps in the Sukuk process:

  • Issue: The first step is the issuance of the Sukuk, which is done by the issuer. This includes the setting of the terms of the Sukuk, such as the return, maturity date, amount, and other details.
  • Investment: After the Sukuk is issued, investors can purchase the Sukuk and become owners of the underlying asset.
  • Management: The issuer is responsible for managing the asset and ensuring that it is Shariah compliant.
  • Redemption: The final step is the redemption of the Sukuk, which is done by the issuer. This involves the return of the principal to the investors, as well as the payment of any interest or other return that was promised.

Advantages of Sukuk

The advantages of Sukuk include:

  • Flexibility: Sukuk can be structured to fit the needs of both investors and issuers. The structure of Sukuk can be tailored to provide a fixed return, a percentage return, or a combination of the two.
  • Liquidity: Sukuk can be traded in the secondary market, providing investors with liquidity and allowing them to exit their investments without penalty.
  • Low Risk: The risk of default is much lower with Sukuk than it is with bonds, as the underlying asset is typically a tangible asset such as real estate or a pool of investments.

Limitations of Sukuk

Despite the potential benefits of Sukuk, there are some limitations that should be taken into consideration when investing in it. These include:

  • High Transaction Costs: The cost of issuing and trading Sukuk can be significantly higher than traditional bonds or stocks due to the additional complexity of its structure.
  • Limited Liquidity: Due to the complexity of its structure, it can be difficult to find buyers or sellers of Sukuk in a timely manner, leading to lower liquidity than traditional bonds or stocks.
  • Regulatory Uncertainty: The legal and regulatory environment surrounding Sukuk is still in its infancy, which can lead to uncertainty and potential risks.

Other approaches related to Sukuk

In addition to the traditional structure of Sukuk, there are several other approaches related to the instrument. These include:

  • Securitisation: Securitisation is the process of pooling multiple assets and issuing a security, such as a bond or Sukuk, against the pool. This allows the issuer to diversify their risk and potentially increase returns.
  • Sharia-compliant funds: Sharia-compliant funds are funds that are managed in accordance with Shariah, Islamic religious law. These funds invest in assets that are deemed compliant with Shariah, such as stocks, bonds, and real estate.
  • Islamic banking: Islamic banking is the practice of banking with the principles of Shariah, Islamic religious law, in mind. This includes the prohibition of interest and the promotion of ethical and socially responsible investments.

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