1

Islamic Sukuk
Concept & Applications

Muhammad Faisal Shaikh

Head,Corporate & Product
Development
BankIslami Pakistan Ltd

Ramadan 13, 1428

September 26, 2007
Islamic Sukuk-Introduction

Bonds are important part of overall
financial system.


Well developed bond markets ensures
stable financial system as it minimize
over-reliance on financing from the
banking sector.


The development of the bond market
allows for access to funding with the
appropriate maturities, thus avoiding the
funding mismatches. It also allows for the
diversification of risks by issuers and
investors.
Islamic Sukuk-Introduction

Dealing in Bonds is not permissible
according to Shariah because of two
aspects.


Firstly, they represent a portion of Debt
payable by the issuer. Earning any kind
of profit falls under the category of RIBA
as defined in the Hadith

“Every loan that draws any premium is Riba”.

Hadith is reported by Hazrat Harith ibn Abi Usamah in his Musnad. (See Supreme Court Judgment December 23, 1999)
Islamic Sukuk-Introduction

Second aspect pertain to the trading of
Bonds.


Shariah prohibits trading of debts (Bai
Dayn) as it involves Gharar.
Islamic Sukuk-Introduction

Sukuks( ) are developed as
alternative of Bonds.


A Sukuk represents proportionate actual
or beneficial ownership in an Asset or a
Pool of identified assets.


For a defined period the Risk and Return
associated with such Assets belong to
Sukuk holders which makes their return
permissible for the holder.
Islamic Sukuk-Introduction

Trade of such Sukuks is permissible,
because it will be equivalent to the sale/
purchase of holder’s proportionate share
in the assets.


However, trading of Murabahah and
Salam Sukuks is not permissible.
Islamic Sukuk-Difference with
Bonds

Sukuks Conventional Bond


Represents the direct 
The bond stands for a
pro rata ownership of loan repayable to the
the holder in the holder in any case,
assets of the pool. and mostly with
interest.

Sukuk holder
generally earn return
from income
generated through
the asset
Islamic Sukuk-International
Overview

Today, the global Sukuk market,
denominated in international currencies,
is estimated to be $18 billion. If domestic
sukuk issuance is included, it has now
exceeded $50 billion. Source:
Dr Zeti
Akhtar Aziz,
Governor,

Although the size of the market may seem Bank Negara
modest by global standards, the sukuk Malaysia,
Sukuk
market has been registering an average Summit
growth of 40% per annum. 2007,
London
Khaleej
Times (June
22, 2007)
Islamic Sukuk-International
Overview

High levels of surplus savings and
reserves in Asia and Gulf region has
further boosted demand for Sukuks. Asia
has a savings rate which is higher than
any other region in the world and is Source:
expected to remain between 30 and 40 Dr Zeti
Akhtar Aziz,
per cent of GDP for many years to come. Governor,
Bank Negara
Malaysia,
Sukuk

The Middle East and in Asia, two of the Summit
fastest growing regions in the global 2007,
London
economy are expected to spend $500 Khaleej
billion and $1 trillion respectively on Times (June
22, 2007)
infrastructure over the next five years —
Islamic capital market, in particular the
sukuk market, will serve as an important
Islamic Sukuk- Local
Overview

In Pakistan, the first Islamic Sukuk was
issued in 2002 when Sitara Chemicals
Industries issued its MTFC.


However, the market really started in FY
2005 and since then Sukuks worth at
least Rs. 30 billion has been issued or are
in the process of issuance.


Market is growing at a very healthy rate
as large corporates and conglomerates
such as WAPDA, Engro Chemicals, PEL,
EDEN Developers, Maple Leaf Cement, etc
are using Sukuk to fund their
Islamic Sukuk-Types

The issuance of Sukuk requires an
exchange of a Shariah compliant
underlying asset for a financial
consideration through the application of
various Islamic commercial contracts such
as the Mudarabah, Musharakah, Ijarah,
Istisna, Salam and Murabahah.


The equity-based nature of Mudarabah
and Musharakah Sukuk exposes investors
to the risks connected with the
performance of the project for which the
financing is raised.
Islamic Sukuk-Types

In contrast, issuance of Sukuk on
principles of Ijarah and Murabahah yields
deterministic receivable and hence result
in predictable and somewhat fixed returns
for the prospective investors.
Sukuk Al
Ijarah
Islamic Sukuk-Sukuk Al
Ijarah

Ijarah is an Islamic alternate of
conventional leasing.


Issuing certificates of ownership of assets,
leased to a particular customer is known
as Sukuk Al Ijarah or simply Ijarah Sukuk.


Ijarah Sukuk concept is one of the most
popular concepts among issuers of global
Islamic Sukuk.


A simple process is explained next.
Islamic Sukuk-Sukuk Al
Ijarah

If a Company requires, for example, Rs.
500 million for the purchase of land, real
asset, equipment etc it can issue Ijarah
sukuk equaling that amount in small
denominations, say Rs. 500,000 each.


After collection of funds from the investors
the company either purchases the asset
on behalf of the Sukuk investors or
transfers the ownership of the already
acquired asset to sukuk holders usually by
establishing a Special Purpose Vehicle
(SPV), which owns the underlying assets.
Islamic Sukuk-Sukuk Al
Ijarah

The investor or sukuk holders owns the
asset held by SPV as Trustee in the form
of Sukuk. The asset is then leased to the
firm and the lease proceeds from the
asset is distributed to the sukuk holders
as return/dividend.


The returns on the sukuk certificates could
be either fixed or floating. As the
expected returns (pre-determined rental
payments) are fixed and can be treated as
predictable like the coupon payments of a
conventional bond.
Islamic Sukuk-Sukuk Al
Ijarah

Ijarah sukuk can be issued through a
financial intermediary, a bank or a
brokerage house or directly by the users
of the lease asset. A third party can also
guarantee rental payments.


Since the yield is predetermined and the
underlying assets are not liquid but
tangible and secured, thus the Ijarah
certificate can be freely traded in the
secondary markets at par, premium or
discount.
Sukuk Al
Ijarah
Structure
 ABC
Ltd.
(Corporate)

ABC Ltd. wishes to purchase a new asset and plan to

raise finance through issuance of Islamic Sukuk.
Supplier

Supplier of the
Asset is identified
and negotiations is
finalized by ABC
ABC Ltd.
Ltd.
Supplier
Issuer
SPV
(LLC
100%
owned
ABC Ltd.)
ABC
Ltd.

SPV is created by ABC Ltd. as a limited

liability Company.
Supplier
Issuer
Payment
made to SPV Suku
Supplier (LLC ks
Title is 100%
transferred Investors
to SPV owned
ABC Ltd.)
ABC
Ltd.
Procee
ds

SPV issues certificates and receives

proceeds which are used to purchase asset
from the supplier
SPV holds Asset as
Trustee and leases
the plant to ABC
Ltd. as per rules of SPV holds
Ijarah Plant/
Asset as
Trustee
Issuer
SPV Investor

ABC
SPV
Ltd.
leases
Plant to
ABC Ltd.
on Ijarah
ABC Ltd. Issuer Investors
(Lessee) SPV
Periodic Lease Semi-annual coupon
Rentals distribution
amounts

ABC Ltd. (Lessee) pays periodic rentals to

SPV for tenors & amounts matching the
coupon & tenor of the Sukuks
 Exercises the purchase
undertaking. Asset
transferred to ABC
Ltd.
ABC Ltd. Issuer Investors
(Lessee) SPV
Pays the Redeems the
exercise price Trust
at dissolution Certificates at
dissolution
•
ABC Ltd (Lessee) give the SPV an irrevocable purchase
undertaking to purchase the Asset at maturity.
Exercise Price = Initial Purchase Price of Asset + service
•

costs.
•
Asset is transferred back on maturity, upon payment of
Islamic Sukuk-Sukuk Al
Ijarah
Important
Conditions

Ijarah Sukuk represents the holder's
proportionate ownership in the leased
asset.


The holder will assume the rights and
obligations of the owner/lessor to the
extent of his ownership.


As owner the holder will have the right to
enjoy a part of the rent according to his
proportion of ownership in the asset.
Islamic Sukuk-Sukuk Al
Ijarah
Important
Conditions

In the case of total destruction of the
asset, holder will suffer the loss to the
extent of his ownership.


SPV rules in Pakistan does not allow SPV
to hold actual tangible assets, therefore,
the asset is shown on the books of the
client itself instead of SPV.
Islamic Sukuk-Sukuk Al
Ijarah

Essential Condition

“It’s essential that the Ijarah

Sukuks are designed to
represent real ownership of
the leased assets, and not
only a right to receive rent.”
Islamic Sukuk-Sukuk Al
Ijarah
Innovation in
Pakistan

In Pakistan essentialy the same structure
has been used to develop Sukuks based
on Diminishing Musharakah.
Islamic Sukuk-Sukuk Al
Ijarah
Innovation in
Pakistan

There are two basic differences in
Diminishing Musharakah Sukuks:


Underlying Assets is jointly owned by
investors and issuer according to
specified percentage.

Ownership is also transferred
periodically to the issuer.


Ijarah is essential part of a Diminshing
Musharakah transaction under Shirkatul
Islamic Sukuk-Sukuk Al
Ijarah
Documentation
Documents executed in a Sukuk Issue
based on Diminishing Musharakah (under
Shirkat-ul-Milk arrangement) are:

1. Investment Agency Agreement

2. Asset Purchase Agreement
3. Musharakah Agreement
4. Service Agency Agreement
5. Payment Agreement
6. Undertaking to Purchase Sukuk Units
7. Undertaking to Sell Sukuk Units
8. Trust Deed
9. Letter of Hypothecation/Other Security
Documents
Islamic Sukuk-Sukuk Al
Ijarah
1. Investment Agency
Agreement

Through this Agreement, all

Participating Islamic Financial
Institutions ('Investors') appoint a
Bank/FI as 'Investment Agent' to
carry out all actions (including
entering into all Sukuk related
Transaction documents) for and on
behalf of all Investors in respect of
Sukuk Issue.
Islamic Sukuk-Sukuk Al
Ijarah
2. Asset Purchase Agreement

Investment Agent (acting for and on

behalf of Investors) buys undivided
beneficial ownership in specified fixed
assets ('Musharakah Assets') in
partnership with Issuer at a pre-
agreed price (equivalent to the Sukuk
Issue Amount) via the Asset Purchase
Agreement.

Legal title of the assets remains with

the Issuer and only the beneficial title
will remain with the Investors.
Islamic Sukuk-Sukuk Al
Ijarah
2. Asset Purchase Agreement

Musharakah Assets can be:

(i) Already existing, and owned by the

Issuer. This would become a Sale and
Lease Back (SLB) case. SLB cases are
done only after approval of Shariah
Adviser and are undertaken mainly to
settle existing conventional banking loans
of Issuer.

(ii) New, and would be purchased from

third party. E.g. fixed assets purchased
for expansion projects.
Islamic Sukuk-Sukuk Al
Ijarah
3. Musharakah Agreement

Investment Agent (acting for and on

behalf of Investors) and Issuer will
enter into a Musharakah Agreement
to jointly own Musharaka Assets.

Each Investor’s entitlement to the

Musharakah Assets will be undivided
and shall for the purpose of more
particular determination constitute of
‘Sukuk Units’. Share of each Co-Owner
will be specified in the Musharakah
Agreement.
Islamic Sukuk-Sukuk Al
Ijarah
4. Service Agency Agreement

Issuer is appointed 'Service Agent' via

signing of Service Agency Agreement
between Investment Agent (acting for
and on behalf of Investors) and Issuer.

Service Agent will be responsible for:

(i) Ensuring all major maintenance of

the Musharakah Assets;
Islamic Sukuk-Sukuk Al
Ijarah
4. Service Agency Agreement

(ii) Paying ownership related expenses

and taxes; and

(iii) Arranging Takaful/Insurance of the

Musharakah Assets.

Such ownership related expenses/taxes

incurred by Service Agent on behalf of
Musharakah Co-Owners will be
reimbursable from Investment Agent.
Islamic Sukuk-Sukuk Al
Ijarah
5. Payment Agreement

Investment Agent (acting for and on

behalf of Investors) will allow Issuer to
use Investors' share of the Musharakah
Assets against periodical KIBOR-
benchmarked Rental Payments in terms
of the Payment Agreement.

From Shariah perspective, this is

basically an Ijarah Agreement. The
tenor of the Payment Agreement will be
matched with the Musharakah tenor.
Islamic Sukuk-Sukuk Al
Ijarah
6. Undertaking to Purchase
Sukuk Units

Undertaking to Purchase Sukuk

Units is a promise undertaken by
Issuer in favor of the Investment
Agent for:

(i) the periodical purchase of Sukuk

Units (representing Investors'
undivided beneficial ownership in
the Musharakah Assets); and

(ii) the purchase of all outstanding

Investors' Sukuk Units in case of an
Islamic Sukuk-Sukuk Al
Ijarah
7. Undertaking to Sell Sukuk Units

Undertaking to Sell Sukuk Units is a

promise undertaken by the Investment
Agent in favor of Issuer granting a call
option to Issuer to purchase all or part
of the Sukuk Units.

In SLB cases, purchase/sale of Sukuk

Units will only start after at least one
year from the Musharakah
Commencement Date/Asset Purchase
Date.
Islamic Sukuk-Sukuk Al
Ijarah
8. Trust Deed

Trust Deed will be executed

between Trustee (appointed by
Investors for the Sukuk Issue) and
Issuer detailing the responsibilities of
the Trustee during the tenor of the
Sukuk Issue.
Islamic Sukuk-Sukuk Al
Ijarah
9. Letter of Hypothecation/Other
Security Documents

Letter of Hypothecation and Other

related Security Documents will be
executed by Issuer in favor of Trustee
for security purposes.
Sukuk Al
Salam
Islamic Sukuk-Sukuk Al
Salam

Salam is an Islamic mode of finance.
Under a Salam transaction the seller
makes an advance payment for goods
which are to be delivered later provided
the goods are defined and the date of
delivery is fixed


Government of Bahrain first issued Salam
Sukuks as an alternate to short term
government treasury bill.
Islamic Sukuk-Sukuk Al
Salam

Under the transaction Government took
an advance payment from the investors
for a future delivery of Aluminum ingots. A
paper was issued as an acknowledgment
of receipt which is known as Salam Sukuk.


Upon delivery of Aluminum ingots to the
investors at the time of completion of
Salam contract, Government sold ingots
to third parties as agent of the investors.


The difference between Sale and Purchase
price was the profit of the investors.
Islamic Sukuk-Sukuk Al
Salam

On the same lines Government of Pakistan
can also issue Salam Sukuks to cater to
the short term liquidity management
issues of Islamic Banks.


A proposed structure is discussed next.
Islamic Sukuk-Sukuk Al
Salam

On behalf of Govt. of Pakistan, Zarai
Taraqiati Bank Limited (ZTBL) may sell the
commodity to the buyers on Salam basis
which in this case would be Islamic Banks.


In this transaction, various banks may
participate in the Sukuk and one Bank
would act as trustee nominated to
represent other banks wishing to
participate in the Al Salam contract.
Islamic Sukuk-Sukuk Al
Salam

As consideration for advance payment,
ZTBL will undertake to supply a specified
amount of a commodity say wheat at a
future date. ZTBL would arrange the
commodity by providing Shariah
compliant funding to farmer e.g. It may
purchase wheat on the basis of Salam
from the farmers.


Simultaneously a third party such as
PASSCO may provide an undertaking to
the Trustee to purchase wheat at an
specified higher price thus ensuring profit
of the investor banks.
Islamic Sukuk-Sukuk Al
Salam

Upon delivery Trustee would appoint
PASSCO its agent to take delivery from
ZTBL.

After taking delivery its premises PASSCO
will inform the Trustee which would sell
the wheat to PASSCO.

Payment received from PASSCO would be
distributed among the investor banks
along with the profit.

Banks may also provide funding on the
basis of Murabahah to PASSCO for the
purchase of same wheat.
Islamic Sukuk-Sukuk Al
Salam
Important
Conditions

Salam Sukuk represent investors shares in
the Advance Price paid to the seller.


Since its a dayn, it cannot be traded in the
secondary market.
Islamic Sukuk-Sukuk Al
Murabahah

Sukuks can also be issued against a
Murabahah transaction. Under the
transaction investors would provide
funding to purchase some assets for the
issuer. Acknowledgment of their
investment would be regarded as
Murabahah Sukuk.


The asset would be purchased from its
supplier and would be immediately sold to
the issuer against deferred price.


Profit earned from the transaction would
be distributed among the investor
Islamic Sukuk-Sukuk Al
Murabahah
Important
Conditions

Murabahah Sukuk represent investors
shares in receivable from the purchaser


Since its dayn, it cannot be traded in the
secondary market.
 Sukuk Al
Musharakah
Islamic Sukuk-Sukuk Al
Musharakah
 Musharakah is a mode of financing
against which Sukuks can be issued.

 If a comapany required financing for any

of its project through Musharakah it can
issue Sukuks against which investors
would provide funding as per the rules of
Musharakah.
Islamic Sukuk-Sukuk Al
Musharakah
 Every Sukuk would represent holder's
proportionate ownership in the assets of
the Musharakah.

 Once the majority of the cash amount is

converted into fixed assets, these
Musharakah Sukuk can be treated as
negotiable instruments in the secondary
market.

.
Islamic Sukuk-Sukuk Al
Musharakah
Important
Conditions
 Profit earned by the Musharakah is
shared according to an agreed ratio
between the Issuer and Investors at
an agreed ratio.

 Loss is shared on pro rata basis.

 Profit & Loss is shared between the

investors as per investment ratio
only.
Islamic Sukuk-Sukuk Al
Musharakah
Important
Conditions
 To ensure tradability of the Sukuks
following condition should be
adhered to:

 All the assets of the Musharakah

should not be in liquid form.

 At least 20% of the value of

Portfolio should be invested in
non-liquid assets.
Islamic Sukuk-Sukuk Al
Musharakah
 Musharakah Sukuks can be used for number
of purposes including:
 Construction of Projects and factories
 Expansion Projects
 Working Capital Finance

 Sitara's Musharakah's TFC advised and

arranged by Meezan Bank Ltd. is an excellent
example of a Musharakah Sukuks.
 Musharakah Term Finance
Certificates
by
Sitara Chemicals Industries Ltd
Islamic Sukuk-Sukuk Al
Musharakah
Sitara Chemical Industries Limited

 Incorporated In Year 1981, Listed on All Stock

Exchanges in Pakistan.

 Commencement Of Commercial Production in

1984.

 The Company’s Core Business is

Manufacturing of Caustic Soda - Largest
Producer Of Caustic Soda In Pakistan.
Islamic Sukuk-Sukuk Al
Musharakah
 Issuer Sitara Chemical Ind.
 Total Issue Size Rs. 360 Million
 Private Placement Rs. 255 Million
 Public Issue Rs. 105 Million
 Tenor 5 years (Aggregate)
 Profit Payment Six monthly

Based on profit and loss sharing on the

Operating profits of the Chemicals Division
 Issue Value of Rs 360 Mn

PSR for 1st Rs 100 Mn For each Subsequent

Operating Profit Rs 100 Mn of
Level -1 Operating Profit

MTFC Company MTFC Company

Holders Holders

100% O/S 43% 56.8% 7.2% 92.8%

67% O/S 28.9% 71.1% 4.8% 95.2%

33% O/S 14.3% 85.7% 2.4% 97.6%

Islamic Sukuk-Sukuk Al
Musharakah
Profit & Loss
Sharing
 Profit was linked to the Operating Profit of the Chemical
Division.

 Level 1 Profit: On First Rs. 100 Million Operating Profit @

12% p.a. of the Outstanding Principal.

 If Operating Profit is less than Rs. 100 Million then:

Actual profit entitlement rate = (Actual Operating profit/

Rs.100 million)* 12%
Islamic Sukuk-Sukuk Al
Musharakah
Profit & Loss
Sharing
Level II Profit:
 2% p.a. of the outstanding principal on each

subsequent Rs. 100 million operating

profit(over and above first Rs. 100 Million).
 If operating profit falls between the two

brackets of Rs. 100 million then:

Profit entitlement rate=(Actual operating
profit/Rs. 100 Million) * 2%
Islamic Sukuk-Sukuk Al
Musharakah
Profit & Loss Sharing- Takaful
Reserves

 The Company formed and maintains Takaful

Reserve during the tenor of the TFCs to mitigate
the risk of loss for the TFC holders.

 TFC holders also contributed 25% (1/4th ) of their

level II Profit to Takaful reserve annually during
the tenor of the TFCs.
Islamic Sukuk-Sukuk Al
Musharakah
Profit & Loss Sharing- Takaful
Reserves

 The Company transfered Rs 50mm in the

reserve.

 In case of no losses during TFCs tenor the

amount contributed by the company and
TFC holders will be paid on final settlement.
Islamic Sukuk-Other types

 Sukuks are also issued under other Islamic mode

of finance and currently much focus is given
Sukuk Al Intefah which is transfer of usufruct
instead of ownership of the asset.

 Other types include Sukuk Al Muzar'a

(sharecropping), Sukuk Al Musaqa (irrigation),
Sukuk Al Mugharasa (agricultural) etc.

.
Islamic Sukuk-Other types

 Sukuks are also issued under hybird

structures where number of Islamic
modes of finance are used to issue a
single Sukuk.

 Under these structures each of Islamic

mode is applied at different intervals to
cater to different requirements of the
issuer.
.
Islamic Sukuk-
Standardization
 AAOIFI has also issue Shariah standards
for Sukuks and its expected that
issuance of these standards would help
reducing differences in fatwas issued for
Sukuks.
Islamic Sukuk-Criticism
 Some Sukuks are criticized for their close
resembelence with conventional bonds.

 Many times these closeness is created to adhere to

the tax and other regulatary laws of the country.

 For example, in Pakistan SPVs cannot hold actual

assets. For this reason assets cannot be carved out
from the balance sheet of the issuer which creates
complexities in identification of the assets and only a
hypothecation charge ensures bank's benefical
ownership in the Musharakah assets.
.
Islamic Sukuk-Criticism
 Similarly, concept of the Diminishing Musharakah
financing is not there in the stamp duty laws of
Pakistan, which compels banks to sell share in
assets without any legal registration.

 It should be noted that concept of Diminishing

Musharakah is recognized in British stamp duty
laws since April 2003.

 Nevertheless, not all of this criticism is incorrect,

and therefore it should be ensured that
unesseccary usage of artificial structures should
be avoided as much as possible.
Islamic Sukuk-Criticism
 The problems could be resolved by
Shariah rating systems

 This will help investors in making

informed decisions regarding the
authenticity of the Shariah structure of
the Sukuk.
Islamic Sukuk-Benefits

 Sukuk can be used very effectively as a

halal alternate to conventional bonds for
provding funding for matching maturities
and without relying too much on
commerical banking sector.

 Another aspect of Sukuks which make

them more effective than bonds is there
ability to mobilize and motivate investors
to work for the overall benefit of the issuer.
.
Islamic Sukuk-Benefits
Sukuks for Government
Projects
 Sukuks based on Ijarah can be used very effectively
to finance Government projects.

 If general public is involved in the construction of

these project through issuance of Sukuks, it can
give them sense of ownership.

 Effective usage of such Sukus would increase the

ratio of success and ratio of sustainbility of the
projects by many folds.
.
Islamic Sukuk-Benefits
Sukuks by Private Sector
 Corporate Sector can also benefit from unique
characteristic of Sukuks.

 Musharakah Sukuks can be used to associate

general customer with the company.

 Sense of ownership and share in the profit of

the company can be used as a marketing tool
for the products of the company especially in
FMCG sector.

.
Islamic Sukuk-Benefits
Sukuks by Private Sector
 “The more company earns the more return
investor would get” concept can
revolutionalize sales.

 Even Sukuks Al Ijarah would help the

companies to position themselves as an
caring member of the society by involving
community in the business of the company.

.
Islamic Sukuk-Conclusion

 Sukuks can be used very effectively to obtain

Shariah Compliant funding which surely bring
Allah's blessing and barakah for the business.

 Issuers can also benefit from the huge increase in

liquidity in the Islamic world, and can tap on these
new sources of funds. Raising funding from the
Islamic bond market in the current environment
has been 10 to 20 basis points lower than
mainstream bonds.

.
Islamic Sukuk-Conclusion

...And whosoever fears Allah and

keeps his duty to Him, He will make
his matter easy for him... (Surah Al
Talaq Ayat 04)