Modern vs. Islamic Bond @ Sukuk Market

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

INTRODUCTION

A bond is a "security" which gives the holder a financial claim on the issuer. This claim protects the holder in circumstances in which the issuer is unable to pay the amount due. Bonds bear certain similarities to savings accounts. When an investor deposits money in a savings account, in effect, that investor is lending the bank money. The bank pays the investor interest on the deposit. Similarly, the investor who buys bonds lends the issuer money in return for interest payments. When the bonds mature (come due), the investor will receive the principle amount of the bonds back, as he would have if he had withdrawn the amount from the savings account. The major difference between savings accounts and bonds is that investors can sell their bonds before they mature to other investors. Savings accounts cannot be sold to other investors.

The legal documentation for a bond is required to specify the terms for both interest and principal payments. Interest can be paid monthly, semi-annually or annually. This makes a difference to the compounding of the interest and will affect the trading of a bond. Most bonds are pay interest semi-annually in North America. "Eurobonds", which trade in Europe, pay interest annually. Mortgage-Backed Securities (MBS) and Asset-Backed Securities (ABS) are pay interest monthly, reflecting the payment terms of the underlying mortgages and loans. The currency of payments is important. Some bonds have the coupon paid in one currency and the principal in another. Bonds which pay part of their principal before maturity are said to "amortize" their principal, this is the case with many mortgage bonds.

Bond market comprises of primary market and secondary market. The primary bond market is where the bonds are initially issued, while the secondary market where the bonds are resold to other investors. Islamic bonds are also having primary and secondary markets. The main difference, however, is the way the bonds are issued and traded afterwards. In the process of Islamic bond issuance bay’ al-‘Inah is used to securitize the instrument in the primary market, while in the secondary market, bay’ al-Dain is used in order to legalize reselling of the bonds. Such process is mostly used in the Malaysian market, while most of the Middle-Eastern countries do not accept it. The proposed alternative is Islamic bonds based on Muqaradah.

CONVENTIONAL BOND MARKET

Primary market : A financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds. The investment bank underwrites securities and then sells them to the public.

Secondary Market : A financial market in which securities, that have been previously issued, can be resold. It could be an organized market, such as KLSE, or over-the counter (OTC) market in which dealers at different locations stand ready to buy or sell securities over the counter to whoever accepts their price.

Bonds generally can be traded anywhere in the world as long as a buyer and a dealer can strike a deal. There is no central place or exchange for bond trading, as there is for publicly traded stocks. The bond market is known as an “over-the-counter” market, rather than an exchange market. There are some exceptions to this however. For example, some corporate bonds in the United States are listed on the exchange. Also, bond futures and some type of bond options are traded on exchanges. But the majority of the bonds do not trade on exchanges.

MARKET PARTICIPANTS

Dealers : While investors can trade marketable funds among themselves whenever they want, trading is usually done with bond dealers, more specifically, the bond trading desks of major investment dealers. The dealers occupy center stage in the vast network of telephone and computer links that connect the interested players. Bond dealers usually make the market for bonds. What this means is that the dealer has traders whose responsibility is to know all about a group of bonds and to be prepared to quote a price to buy and sell them.

The role of the dealers is to provide liquidity for bond investors, thereby allowing investors to buy and sell bonds more easily and with a limited concession on the price. Dealers also buy amongst themselves, either directly or anonymously via bond brokers. The aim of trading is to take a spread between the price the bonds are bought at and the price they are sold at. This is the main way that bond dealers make (or lose) money. Dealers often have bond traders located in the major financial centers and are able to trade bonds 24 hours a day (although not usually on weekends).

Brokers : Brokers are agents who match buyers with sellers of securities.

Investors : Bond investors include financial institutions, pension funds, mutual funds and governments from around the world. These bond investors, along with the dealers, comprise the "institutional market", where large blocks of bonds are traded. A trade of $1-million-worth of bonds would be considered a small ticket. There is no size limit, and trades involving $500 million or $1 billion at a time can take place. There similarly is no size restriction in the "retail market," which essentially involves individual investors buying and selling bonds with the bond trading desks of investment dealers. However, the size of trades is usually under $1 million.

TYPES OF BONDS

Convertible bonds : A convertible bond is a bond that gives the holder the right to convert or exchange the par amount of the bond for common shares of the issuer at some fixed ratio during a particular period. As bonds, they have some characteristics of fixed income securities. Their conversion feature also gives them features of equity securities.

Extendible/Retractable bonds : Extendible and retractable bonds have more than one maturity date. An extendible bond gives its holder the right to extend the initial maturity to a longer maturity date. A retractable bond gives its holder the right to advance the return of principal to an earlier date than the original maturity. Investors use extendible/retractable bonds to modify the term of their portfolio to take advantage of movements in interest rates. The characteristics of these bonds are a combination of their underlying terms. When interest rates are rising, extendible/retractable bonds act like bonds with their shorter terms When interest rates fall, they act like bonds with their longer terms.

Foreign Currency bonds : A "foreign currency" bond is a bond that is issued by an issuer in a currency other than its national currency. Issuers make bond issues in foreign currencies to make them more attractive to buyers and to take advantage of international interest rate differentials. Foreign currency bonds can "swapped" or converted in the swap market into the home currency of the issuer. Bonds issued by foreign issuers in the United States market in U.S. dollars are known as "Yankee" bonds. Bonds issued in British pounds in the British bond market are known as "Bulldogs". Yen denominated bonds by foreign issuers are known as "Samurai" bonds.

Government bonds : Governments have the power to print money to pay their debts, as they control the money supply and currency of their countries. This is why most investors consider the national governments of most modern industrial countries to be almost "risk-free" from a default point of view.

Corporate Bonds : A corporate bond is a loan made by a corporation in return for a specified amount of interest and the repayment of the face value of the bond at a specified maturity date. The creditworthiness of corporate bonds is tied to the business prospects and financial capacity of the issuer. The business prospects of companies are dependent on the economy and the competitive situation of industries. Industries with stable revenues and earnings are called "non-cyclicals", where as those whose revenues and earnings rise and fall with the economy and commodity prices are called "cyclicals". Companies that have financial risk because of high levels of debt and variable revenues and earnings are called "below investment grade" or "junk" bonds because of their speculative nature. Higher quality bonds are considered "investment grade".

High Yield or Junk bonds : A high yield, or "junk", bond is a bond issued by a company that is considered to be a higher credit risk. The credit rating of a high yield bond is considered "speculative" grade or below "investment grade". This means that the chance of default with high yield bonds is higher than for other bonds. Their higher credit risk means that "junk" bond yields are higher than bonds of better credit quality. Studies have demonstrated that portfolios of high yield bonds have higher returns than other bond portfolios, suggesting that the higher yields more than compensate for their additional default risk

Inflation linked bonds : An inflation-linked bond is a bond that provides protection against inflation. Most inflation-linked bonds, the Canadian "Real Return Bond "(RRB), the British "Inflation-linked Gilt" (ILG) and the new U.S. Treasury "inflation-protected security" (IPS) are principal indexed. This means their principal is increased by the change in inflation over a period. In most countries, the Consumer Price Index (CPI) or its equivalent is used as an inflation proxy. As the principal amount increases with inflation, the interest rate is applied to this increased amount. This causes the interest payment to increase over time. At maturity, the principal is repaid at the inflated amount. In this fashion, an investor has complete inflation protection, as long as the investor's inflation rate equals the CPI.

Zero coupon bonds : Zero coupon or strip bonds are fixed income securities that are created from the cash flows that make up a normal bond. Conceptually, a zero coupon security is just like a Treasury Bill or "T-Bill". The investor pays something up front in exchange for a promise to receive $100 on the maturity date.

VALUING BONDS

The price of bond like any other financial instrument is equal to the present value of the expected cash flows of that instrument. The cash flows, in turn, depend of a bond depends on the size of its coupon payments, the length of time remaining until the bond matures and the current level of interest rates.

Present Value : Present value of a bond is the present value of its cash flows (coupons and principal) discounted at a suitable interest rate(s). One convention used to simplify the calculation procedure is to assume a single rate for all cash flows. This is the known as the yield-to-maturity.

Yield to maturity (YTM): Yield to maturity is that yield which equates the present value of all the cash flows from a bond to the price of a bond. It is an iterative (trial and error) calculation that accounts for the reinvestment of the coupons as well as any capital gain or loss on the price of the bond (which will be redeemed by the issuer at par, $100). Conversely, given the YTM, a price can be calculated. A rise in the YTM will cause the price calculated to decrease, while a fall in the YTM will cause the price to rise. Although it does simplify the calculations, this convention assumes that all the coupons from a bond can be reinvested at the same rate (which is unlikely). The actual return generated by a bond held until maturity depends on the future reinvestment rates at which the coupon payments received are invested.

Duration : Duration is a measure of the average (cash-weighted) term-to-maturity of a bond. The value of a bond will vary depending on the amount of the cash flows (coupon size), the timing of the cash flows (term to maturity), and the interest rate used for discounting.

Coupon Interest rate : An interest rate is the cost of borrowing or the price paid for the rental of funds. Consequently, a coupon rate is the interest rate that the issuer of the bond promises to pay the bond holder. If, for example, the coupon rate is 5 percent, the issuer of the bonds promises to pay $50 in interest on each bond per year (5% x $1000). Many bonds pay interest semiannually, the bond holder would receive $25 per bond every six months. There are different coupon interest rates on different types of bonds depending on their riskiness.

Market Interest Rate : Bond’s price moves in the opposite direction of the change in market interest rates. As interest rates rise (fall), the price of a bond will fall (rise). For an investor who plans to hold a bond to maturity, the change in the bonds price prior to maturity is not of concern; however, for an investor who may have to sell the bond before the maturity date, an increase in interest rates after the bond was purchased will mean the realization of a capital loss.

ISLAMIC BOND MARKET

Considering the fact that bond issuance and trading are important means of investment in the modern economic system, Muslim jurists and economists are trying to find the Islamic alternative. However, to meet the various demands of investors Islamic bonds and certificates should be diversified. We have so far the mudarabah or muqaradah bonds, the musharakah bonds, the Ijarah bonds, the istisna‘ bonds, the salam bonds and the murabahah bonds. However, it should be noted that although some of these instruments have been generally accepted as being in compliance with Islamic principles so that they can be traded in the secondary market, the negotiability of certain others is still a point of debate and controversy due to their legal acceptability or compliance with shari‘ah. Therefore, some of these bonds can be traded in the secondary market while the trade of others is limited to the primary market because they can be exchanged only at face value.

In Malaysia for instance, almost all of the domestic Islamic debt papers issued so far have been based on the principles of murabahah,bay‘ bi al-thaman al-ajil, bay’ al-’inah and bay’ al-dayn, despite the controversy surrounding the issuance of tradable bonds in the secondary market based on the above two contracts. At the same time, there is a perceptible increase in the willingness amongst Malaysian issuers of bonds to explore other Islamic principles of financing, namely the profit-oriented based musharakah as well as the asset-backed mode of ijarah. Hopefully, the future issuance of Islamic bonds will focus on the widely accepted bonds such as musharakah bonds, mudarabah bonds and ijarah bonds.

However, the problem with Malaysian Islamic bonds has been the application of bay’ al-’inah and bay’ al-dayn, which is not well accepted by the Middle-eastern investors. The contract of bay’ al-’inah and bay’ al-dayn is seen as something similar to riba based financing. This will certainly pose a great challenge to the Malaysian companies seeking Islamic funds in the Middle-east via bond issues.

THREE MAIN STEPS INVOLVED IN THE BOND ISSUANCE

1) Securitization

2) Bond Issuance

3) Trading of dept certificates

The Creation of a Bay’ al-’ Inah Underlying Asset

Asset securitization is the essence of Islamic bond issues, as a bond must assume the role of al-mal or property to qualify as an object of sale. An object of sale in the Islamic law of contract must be a property of value. When a bond certificate is supported by an asset as evidenced via the securitization process, it is transformed into an object of value and therefore qualifies to become an object of trade whereby it can be purchased and sold in both the primary and secondary market. Investors then will have to the right to sell (haqq mali) these bonds. In the bay` al-‘inah asset securitization, the financier purchases an asset from the issuer and sells it back to the same party at a credit price. This buy-back agreement will ensure that the issuer will receive the money in cash while financier will be paid a prefixed or contracted amount in a future date. Debt payments will be made by installment through bond issues. The difference between cash and mark-up price will represent the profit due to the financier.

(1) Sell an asset for deferred price 15 mil

(3) Cash payment 14 mil

(2) Sell the asset 14 mil

(4) Pays the creditor 15 mil

(1) Sell an asset in cash 14mil

(2) Cash payment 14 mil

(3) Debtor buys back the asset 15 mil

The underlying asset is therefore crucial in determining the Islamicity of these bonds. In the Malaysian experience these assets include factories, equipment, stock and inventory and even intangible asset such as a list including building and properties.

Issuance of Islamic Debt Certificate ( Shahdah al-Dayn)

This usually takes place in the primary market where in settling its debt, the issuing company will sell debt certificates or bonds to investors. As mention above, debt certificates issues are valid only when it is supported by an asset. In other words, the bonds must be securitized. Here the underlying security is the BBA or al-murabahah asset. The underlying asset need not be BBA or al-murabahah alone. If the 1 st stage involves a contract of Ijarah, then the debt certificate is called Sukuk al-Ijarah. If an Istisna’ contract is used, we can called it Sukuk al-istisna’. Islamic bonds new issues can be categorized into two, namely bonds issues with coupons and those with none. The former is known as the Islamic coupon bond while the latter Islamic zero coupon bond.

Trading of Debt Certificate – Discounted Bay’ al-Day n.

For liquidity purposes, bond trading in the secondary market is crucial. However, almost all Islamic bonds today were bought for long-term investments. The lack of secondary market however should not imply that trading issues is no longer significant. This calls the need to explain the Islamic view of bond trading in the secondary market. As mentioned earlier when a debt certificate is securitized, it now becomes property (al-mal) which is also an article of trade. As an article of trade, the bonds can be sold by investors to the issuer or the third party if a secondary market for Islamic bonds exists. The trading or sale and purchase of the debt certificates is called bay’ al-dayn. In Malaysia, the contract is bay’ al dayn at a discount is acceptable while Middle-east Ulama’ consider it invalid even though the debt is supported by underlying assets. Any profit created from the sale and purchase of a debt is riba.

"And whatever riba you give so that it may increase in the wealth of the people, it does not increase with Allah." [Ar-Rum 30:39]

Prophet Muhammad (S.A.W) said: “That every loan entailing benefit is usury”

THE NATURE OF BAY` AL-DAYN

The issue of bay’ al-dayn arises when the bonds are traded in the secondary market at a discount. We have to note that buyers in the secondary market are usually speculators, that those who do not intend to keep the bond for long-term investment purposes. Their main objective is to make quick capital gains on the basis of market liquidity and interest rate movement. However, there is no indication that controversies exist in the bay’ al-dayn where bonds are sold or redeemed at par value. We may now discuss Bay’ al Dayn to show its nature according to Islamic view.

According to al-Majallah , Dayn defines as the thing due i.e the amount of money owed by a certain debtor. So also a sum of money not existing is considered a debt, as also a certain sum of money from things which exist or are present, or from a heap of wheat which is present before it is separated from the mass. Al-Dayn can be either monetary, or a commodity, like, food or metal. Based on the aforementioned of al-Dayn, and the literal meaning of Bay’ al-Dayn we can define it as the sale of payable right either to the debtor himself, or to any third party. This type of sale is usually for immediate payment or for deferred payment (al Nasi’ah).

SALE OF AL DAYN TO A THIRD PARTY

According to most of Hanafis, Hanbalis and Shafis jurists, it is not allowed to sell al Dayn to non-debtor or a third party at all. Such opinions are based on the forbidden sale of al Kali Bil al Kali, sale of a Gharar, sale which the seller does not possess.

Selling al Dayn to a Third Party is Allowed with Conditions

As an exception Malikis, Hanafis and some Shafi’s jurists allowed selling al-Dayn to a third party. Since the creditor has the right to sell it to the debtor, as well as he has the right to sell it to a third party provided the following rules must be observed:

a) The Dayn must be Mustaqir (confirmed debt) and the contract must be performed on the spot, not deferred in order to avoid any relationship with the sale of a debt for a debt which is prohibited by Islamic law.

b) The debtor must be a financially capable, must accept and recognize the sale, in order that he will not deny the sale. This condition aims to avoid any dispute between the parties, and the debtor must be easily accessible so that the creditor knows whether he has the capacity to pay his debt or not.

c) The sale should not be based on selling gold with silver or opposite, because, any exchanges between these items necessitates the immediate possession, and if the debt is money, its price in another debt should be equal in terms of amount of quantity.

Furthermore, the selling of al-dayn must avoid the occurrence of Riba between the two debts, and must also avoid any kinds of Gharar which may be raised at the level of inability of the buyer from possessing what he bought, as it is not permitted that the buyer sells before actual receipt of the purchased item.

It is important to note that Muslim scholars have unanimously prohibited the trading of debt (bay` al-dayn) at anything other than face value. Where the price paid for a debt is not the same as the face value of that debt, the transaction would be tantamount to riba al-Nasi’ah and is therefore prohibited. It is noteworthy that trading in bonds is a subject of dispute on two counts:

First, the bonds are normally sold at less then their nominal values. Second, the state or the issuer would use the mode of Bay` al-` inah and Bay` al-Dayn and these both sales transactions are regarded as riba by the majority of Muslim scholars. This is the very reason for the controversy about the legitimacy of Malaysian Islamic bonds which renders it to be unacceptable by individual Islamic jurists and institutions outside Malaysia and the Middle-Eastern countries. Islam does not allow the legal devices to be treated as a justification for transactions which

Islam regards unjust and against Islamic belief. The bonds would have been acceptable from an Islamic point of view if the application of the mode of financing would be based on the legal maxim of al-Ghunmu bil ghurmi meaning that no person is allowed to invest in a way that generates profit without exposing himself to the risk of loss. It would expose both parties to the outcome of their deal, be it a profit or a loss, and thus avoid of usury as matter of Islamic principle.

TYPES OF ISLAMIC BONDS

Ijarah Bonds

Ijarah is a contract according to which a party purchases and leases out equipment required by the client for a rental fee. The duration of the rental and the fee are agreed in advance and ownership of the asset remains with the lessor. Hence, the relationship between the parties differs from that of a debtor-creditor relationship since it is based on buyer-seller of an asset. Ijarah bonds, on the other hand are securities of equal denomination of each issue, representing physical durable assets that are tied to an ijarah contract as defined by shari‘ah.

Istisna‘ Bonds

Istisna‘ is a contract to sell a manufacturable good with an undertaking by the seller to present it manufactured from his own material, according to specified description and at a determined price.The suitability of istisna‘ for financial intermediation is based on the permissibility for the contractor in istisna‘ to enter into a parallel istisna‘ contract with a subcontractor. Thus, a financial institution may undertake the construction of a facility for a deferred price, and sub contract the actual construction to a specialized firm.

Musharakah Bonds

Musharakah bonds based on the musharakah contract are relatively similar to muqaradah bonds. The only major difference is that the intermediary-party will be a partner of the group of subscribers represented by a body of musharakah bondholders in a way similar to a joint stock company while in mudarabah the capital is only from one party. It should be noted that almost all the criteria applied to mudarabah bonds are also applicable to the circulation of musharakah bonds.

Difference between Musharakah Certificate and a Conventional Bond

Musharakah Certificate

Represents direct ownership of the holder in the assets of the project.

If all the assets of the joint project are in liquid form, the certificate will represent a certain proportion of money owned by the project.

Conventional Bond

Has nothing to do with the actual business undertaken with the borrowed money.

The bond stands for a loan repayable to the holder in any case, and mostly with interest.

MUQARADA BONDS AN ALTERNATIVE FOR ISLAMIC DEBT BONDS

The Islamic financial system is a set of rules and regulation that govern the flows of funds from the surplus-spending unit to the deficit-spending unit. These rules and regulations are strictly governed by Shari’ah principles where there is neither a possibility nor a need to apply usurious financial instruments such as the debt related bonds. Hence, the solution for Islamic financial system dilemma lies in the development of financial instruments in which the Shari’ah rulings are not violated. One such instrument is the Muqaradah bond. A Muqarada bond is an Islamic bond in which no interest is earned, but whose market value varies with the anticipated or expected profits. It is the product of Muslim scholars and thinkers who developed and designed the financial instrument where interest or similar forms of returns which Islam has unequivocally prohibited are excluded. The Council of the Islamic Fiqh Academy of Organization of Islamic Countries (OIC) during its fourth conference in Jeddah, Saudi Arabia from 18 to 23 Jamadul Akhir 1406H/6 to 11 February 1988, approved the mode of Muqarada by issuing Fatwa after having reviewed various studies on Muqarada bonds. The meaning of Muqarada bonds and its salient features is given in the following: Muqarada bonds, as the term denotes, are based on the conclusion of lawful “Muqarada” (the mudaraba) with capital on one hand and labor on the other, and the shares of profit are determined beforehand by a definite proportion of the total. It is called a bond because it is terminal in nature that its maturity is determined by the tenure or project completion date.

Growth in MYR Islamic Bond Market

Potential Growth in USD Islamic Bond Market

CONCLUSION

As we have shown, the conventional bond market comprises of primary market and secondary market. The primary bond market is where the bonds are initially issued, while the secondary market where the bonds are resold to other investors. Islamic bonds are also having primary and secondary markets. The main difference, however, is the way the bonds are issued and traded afterwards. In the process of Islamic bond issuance bay’ al-‘Inah is used to securitize the instrument in the primary market, while in the secondary market, bay’ al-Dain is used in order to legalize reselling of the bonds. Such process is mostly used in the Malaysian market, while most of the Middle-Eastern countries do not accept it. The proposed alternative is Islamic bonds based on Muqaradah.