Sharia law, which is the Islamic legal system based on the Quran, Hadith (traditions of the Prophet Muhammad), and other Islamic texts, forms the foundation of Islamic finance, and all financial transactions and investments must align with its principles; it is the basis for the entire legal framework of the United Arab Emirates (UAE). One of the main principles of Sharia is the prohibition of riba, or interest. Conventional bonds are typically based on interest-bearing loans, which are prohibited in Islam. As solution to financing without offending Sharia Law and Islamic values is the Sukuk.
Sukuk are structured in a way that avoids interest payments and instead allows investors to share in the profits from real, tangible assets, therefore not offending any law or oral conventions in the UAE. Sukuk, often referred to as Islamic bonds, represent a unique investment structure that complies with Sharia law,Sukuk, often referred to as Islamic bonds, are securities that represent ownership in an underlying asset or a pool of assets. Instead of paying interest (as with traditional bonds), Sukuk holders are entitled to receive a share of the profit generated from the underlying asset, in accordance with the principles of Islamic finance; both the issuer and the investor share in the risk and reward of the underlying asset. Please mind that Sharia law prohibits transactions where one party bears no risk while the other assumes all the risk.
Examples of Sukuk structures may be based in assets leasing with an option to purchase, a profit-sharing partnership, a cost-up financing (short-term finance)m or a joint venture.
In the Lease / Purchase Option Sukuk, known as the Ijarah Sukuk, the issuer leases an asset (real estate, equipment, etc.) to the investor, and the Sukuk holders receive a share of the lease income as profit. At the end of the lease term, the asset may be transferred to the issuer or purchased by the investor.
A Sukuk based on a profit-sharing partnership, known as Mudarabah Sukuk, takes place where one party provides the capital and the other provides expertise and management. In Mudarabah Sukuk, the investor provides the funds, and the issuer (the managing party) invests the funds in a business venture. The profits are shared based on a pre-agreed ratio, and any losses are borne by the investor.
The Murabaha Sukuk is to a cost-plus financing arrangement, where the issuer purchases an asset and sells it to the investor at a marked-up price. The profit made from the sale is shared with the Sukuk holders. Murabaha Sukuk are typically used in short-term financing needs due to the re-sale window typically envisioned.
Finally, a joint venture in which all parties contribute capital to an investment and share in the profits and losses based on the amount of capital contributed can be structured as a Musharakah Sukuk. In Musharakah Sukuk, the investors and the issuer both participate in the underlying project, and profits are shared according to the agreement.
The investor should bear in mind that Sukuk markets can be less liquid than conventional bond markets, especially in regions where the Islamic finance industry is still developing and may limit an investor’s ability to exit or trade Sukuk positions easily.