Islamic Model of Bond @ Sukuk Market

By:
Prof. Dr. Mohd. Ma’sum Billah
masum@applied-islamicfinance.com
masum2001@yahoo.com
+6019-3699542

INTRODUCTION

The religious scholars, or ‘ulama’, of Islam have played an indispensable role in the contemporary movement of Islamic finance and investment. For one, they interpret and analyze the sources of Islamic law and constitute a link with the vast body of work on commerce in the Islamic legal tradition. This is crucial in deriving the principles of Islamic finance and investment. As a group, they also arrive at collective positions on contemporary financial issues.

BONDS

Corporations and government entities issue bonds to raise funds for operations or for cap­ital projects. The buyer of the bond has a claim on the issuer, who owes the buyer a speci­fied amount in the future as well as (usually) interest payments in the interim.

Bonds:

Contractual liabilities that obligate the issuer to pay a specified amount (the par, face, or maturity value) at a given date in the future (the maturity date), generally with peri­odic interest payments in the interim at a fixed rate (the coupon rate).

bearer bonds are payable to whomever holds the securities; registered bonds are payable only to the owner specified in the issuer’s records. Even though bonds have a definite term or life, investors often do not hold these instruments until they mature. Thus, the valuation of bonds prior to maturity is an important concept to understand.

Capital market instruments are classified in five categories:

• Government notes and bonds

• Municipal bonds.

• corporate bonds.

• corporate stock.

• Mortgages.

In the capital markets, a bond is a security that gives its owner the right to receive an amount of money stated on the face of the bond certificate (the face value) at a specified time in the future (the redemption date) and often also to receive specified payments of interest (coupons) at specified dates (coupon dates) throughout the life of the bond. The amount of the coupon when expressed as a percentage of the face value of the bond is termed the coupon rate.

The yield or redemption yield or internal rate of return of a bond is the rate of interest that, when used in the discounting process, sets the sum of all the present values of cash-flows incurred in the process of owning that bond (including the purchase price) to zero. As the yield of a bond falls, the price rises (and vice versa). This is a result of the fact that present values increase as discount rates fall and vice versa. Whilst the redemption yield of a bond can change, the coupon rate cannot. Redemption yield should not be confused with running yield, the latter being a figure that is calculated by dividing the coupon rate into the percentage market price of a bond.

Some bonds do not pay coupons during their life. Such bonds are called zero-coupon bonds. The return to the bond holder is then simply the difference between the purchase price and the redemption value over the bond's life. The price of such a bond expressed as a percentage of the redemption value produces the zero-coupon discount factor for the bond's redemption date. A zero-coupon yield curve can therefore be constructed by examining the yields on zero-coupon bonds for different redemption dates.

Some bonds are convertible into other bonds on a specified date or between a specified range of dates. For instance, some government bonds can be converted into other government bonds on conversion dates and are therefore termed conversion stock. Some corporate bonds allow convertibility into the equity of that corporation on specified conversion dates.

Bonds may be 'callable' or 'term'. Callable bonds can be redeemed at 100% of face value, otherwise known as par on the call date or dates, by the issuer and at the issuer preference. Term bonds may only be redeemed on a single redemption date.

When a bond is purchased, the total price paid is called the dirty price. The dirty price equals the bond's clean price plus accrued interest, this latter amount being the interest due (but so far unpaid) to the bond holder since the last coupon payment date. Accrued interest is calculated using the coupon rate and the appropriate bond market day and year count convention. The market price quoted for a bond is always the clean price.

Bearer bonds are owned by the bearer of the bond certificate. Registered bonds are owned by the individual or entity listed in the register of the bond issuer (or the issuer's trustee). Loosing a bearer bond is a serious matter because often no other evidence of ownership exists.

Some bond issuers agree to establish sinking funds, these being funds into which the issuer makes regular payments throughout the life of a bond so as to provide greater assurance to bond holders that repayment will be possible according to the schedule agreed in the bond terms. Sometimes, issuers will enter into covenants that prevent the issuer from incurring further debts, or debts of a more senior nature, that may reduce the issuer's ability to make repayments on previously issued bonds.

ISLAMIC INVESTMENT

Islamic Investment can be defined as investment in financial services and investment products that adhere to principles established by the Shari'ah (Islamic law as revealed in the Qur'an and Sunnah). These principles require that:

One of the implications of Islamic investment principles is in the selection of the type of financial instrument among those available in global financial markets today. Interest based securities (e.g. bonds, bank deposits etc.) are not acceptable as Shari'ah-compliant investments, since these securities provide returns that are predetermined, and unrelated to the underlying performance of the asset that is generating the returns. By the same logic, equity securities (shares) are considered permissible by a consensus of contemporary scholars (e.g. the Islamic Fiqh Academy), because the profits an investor makes on equity securities are tied to returns of the underlying company and hence are risk related.

SHARIAH RULINGS ON BOARD

Since its establishment in 1991, the Institute of Islamic Banking and Insurance has been expanding its services to meet the growing needs of Islamic financial institutions, economists, jurists and researchers. The latest important addition to the Institute's wide range of services has been the Shariah Advisory Unit. This Unit offers a consultancy service to financial institutions which desire to operate in accordance with the Islamic principles or set up independent Islamic financial units

A Shari'ah Board is a committee of 'ulama', established to ensure that the financial institution's practices and products it offers are in compliance with the Shari'ah.

The religious scholars, or 'ulama', of Islam have played an indispensable role in the contemporary movement of Islamic finance and investment. For one, they interpret and analyze the sources of Islamic law and constitute a link with the vast body of work on commerce in the Islamic legal tradition. This is crucial in deriving the principles of Islamic finance and investment. As a group, they also arrive at collective positions on contemporary financial issues in representative bodies such as the OIC Islamic Fiqh Academy.

Perhaps most importantly for Islamic financial institutions, selected Shari'ah advisors or Shari'ah boards are in continuous dialogue with economists and bankers to develop new financial products in compliance with Shari'ah principles. This is necessary to ensure that Islamic finance stays abreast of the latest developments in financial markets and that Muslim investors have access to proper Shari'ah advice on how to approach these markets. Recognizing this necessity, all credible Islamic financial institutions today have a Shari'ah advisor or Shari'ah board.

Islamic scholars have reached a general consensus on many issues related to Islamic investment by considering the established sources of Islamic law in the following order:

Note that a scholar's ijtihad only comes after the analysis of the other sources, and remains within the parameters established by them.

The Islamic Financial System

While elimination of "Riba" or interest in all its forms is an important feature of the Islamic financial system. Islamic banking is much more. In essence, it aims to eliminate exploitation and to establish a just society by the application of the Shariah or Islamic law to the operations of banks and other financial institutions. To ensure compliance to the Shariah, Islamic banks use the services of religious boards comprised of Shariah scholars.

The Religious Board

The religious boards have both supervisory and consultative functions. Since the Shariah scholars on the religious boards carry great responsibility, it is important that only high calibre scholars are appointed to such boards.

The day-to-day application of Shariah by religious boards is two-fold. First, the religious board reviews the operations of the financial institution to ensure that they comply with the Shariah. This is, to a large extent, an investigatory role. In the increasingly complex and sophisticated world of modern finance, the religious board endeavours to answer the question whether or not proposals for new transactions or products conform to the Shariah, and offers constructive and creative recommendations.

An Islamic financial institution is required to establish operating procedures to ensure that no form of investment or business activity is undertaken that has not been approved in advance by the religious board.

Also, the management is required to periodically report and certify to the religious board that the actual investments and business activities undertaken by the institution conform to forms previously approved by the religious board.

Riba AI-Nasi’ah: Usury of Credit

The term nasi’ah in Arabic means to postpone. Muslim jurists’ define riba aI-nasi’ah in loan as bringing to the lender a fixed increment after an interval of time, or extension of time over the fixed period and increase of credit over the principal (fadl al-hulul ala al-ajal wa fadlal- ‘a yin ala al-dayn)

In other words, riba aI-nasi’ah relates to the repayment period which is instrumental in earning for the lender a fixed increment rather than delays in repayment. This form of riba was common in pre-Islamic jahiliyyah and early Islam. It was also called riba al-jali or clear riba, and riba almubashir or direct riba. This form of riba was widespread in all credit transactions where a loan was advanced to a person on the payment of monthly interest over and above the principal. If a debtor could not repay principal with the accumulated surplus— interest at the time it fell due, he was given on extension of time in which to pay the loan but at the same time, the sum due was double. Hence, riba al­nasi’ah signified the additional amount, which was paid by the debtor to his creditor over and above his creditors’ principal. In this sense, it has been forbidden by the Qur’an (Surah al-Baqarah verses 276-278 this form of riba by way of credit with a fixed period was prohibited without distinguishing between consumption and product loans.

In the strict legal terminology of the Shari’ah, riba is therefore defined as surplus, profit or increase in loans and sale—that is in all economic sectors, in agriculture, trade, commerce and credit for which no equivalent return, compensation or counter value (‘iwad) is given to other parties (debtor, buyer or laborer) who receive a lesser value in these transactions because one man’s gain is another man’s loss. Hence, riba al-nasi’ah is unlawful because the greater benefit is reaped by the rich, who becomes richer whilst the poor and weak suffer a situation which creates different socio-economic classes in society. Bonds are generally divided into those issued by governmental agencies for infrastructure (utilities), and those issued by private corporations for use in their operations. The first becomes an obligation of the relevant taxpayers, the bond being backed by the utilities it funds. In theory, if the bond issuer of a public telephone company defaults, then you and the other bond holders may foreclose on enough telephone poles to recover the amount due.

Because these types of public bonds are deemed more secure, the rate of interest return (coupon) required to successfully market them is lower. They are usually readily marketable anytime before the date of maturity and the interest is paid routinely as it accumulates, generally twice a year until the maturity date.

The corporate bond is more risky, being secured by the assets of the corporation, and having a claim on corporate assets superior to that of holders of shares. A corporate bondholder, once the insurer defaults on any regular interest payment, may force the corporation to suspend operation and go into foreclosure in the hands of a court-appointed administrator. Since this is a time-consuming affair, the potential for default is carefully watched, and once weakness is detected, the marketability of the bond (and its value) decreases proportionately.

Because some bondholders have a high tax liability, a bond that pays no interest until the maturity date is attractive. At maturity the bond is retired with full interest charges included. These bonds increase in value with time as the interest due accumulates in a compound manner. Because the bonds can be exchanged for new bonds at maturity, the payment of taxes on the accumulated interest can be indefinitely deferred. These bonds, known as "zero coupons" bonds, are popular because of this deferred interest feature. For the issuer they are popular for another reason. The funds are immediately available, interest-free for the term till maturity and none of the money need be returned in the interim. In addition, there is no accounting for the entire term of the bond.

The promotion of "Islamic" banking and the sale of "Islamic" bonds have now taken the odor of a gigantic scam, one endorsed by Malaysia's central bank. A great future is envisaged for this type of activity. Muslims everywhere are enticed to donate money to this scheme.

ISSUES

As expected with this type of deal, most of the interest came from Islamic financial institutions, but commercial institutions also took 30% of the paper, according to a Deutsche official. The banker added that all the bonds were sold to Malaysian accounts.

Even though Islamic debt financing is by no means a new concept, there is often a degree of ignorance about what it is and how it prices against straightforward corporate deals with the same rating. This is because, unlike corporate bonds, Islamic bonds carry a zero coupon, because interest payments are banned under Islamic law. Investors are enticed instead by receiving a share of the profits from the deal.

Deutsche Bank has placed a M$2.01 billion ($530 million) Islamic bond issue for Sistem Lingkaran Lebuhraya Kajang (Silk), a Malaysian toll road operator. In addition to Deutsche's role as lead manager and sole book runner, Alliance Bank Malaysia and Bank Islam Malaysia served as co-leads.

Aside from being a significantly sized issue for the Islamic debt market, the Silk deal is also the biggest single-A rated bond deal ever to be launched in Malaysia.

Bank Negara Malaysia has issued another savings bond, the Bon Simpanan Malaysia Siri 03 (BSM03) that may be subscribed by senior citizens and charity organizations. A total of RM1 billion of BSM03 was offered for sale during the period 2 January 2002 to 31 January 2002, of which RM500 million was issued based on Islamic principles. The bonds will have a maturity period of 2 years and a rate of return of 5% per annum. Only senior citizens 55 and above who are not employed on a full time basis, and charitable organizations registered with the Registrar of Societies are eligible to purchase the bonds.

The BSM03 is issued by Bank Negara Malaysia to mitigate the impact of the current low interest rates environment on incomes of senior citizens and charity organizations, primarily dependent on income from deposits placed with banking institutions. The BSM03 will provide alternative investment instruments for these groups and in the process, improve the returns on their investment, thereby sustaining their spending ability.

CONCLUSION

Enter the Islamic bond. Many of the Islamic bond issuers have opted for the zero coupon feature. This has the advantage that the money need never be repaid. A ten year Islamic bond is sold today, and nothing further is heard from the issuer for ten years. For example, he has the money, and you have the bond. Ten years is a long time. One can get very nervous in ten years, fretting about the safety of the money.

Suppose ten years passes, and the full amount of the bond comes due. If one is very lucky, the principal is paid, with all interest due. No matter what it is called, if it is fixed in the terms, the sum in excess over the principal is interest (riba). Suppose, as the maturity date approaches, the issuer finds the money is not available ... that no sinking fund has been established to retire the bond when it matures.