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Background
This essay seeks to compare and contrast Islamic Sukuk with Bank issued Bonds, especially in terms of their respective risks, volatility and yield factors. The fact that Shariah does not believe in trading in money, and prohibits interest transactions are one of the distinctive features of Islamic bonds vis-à-vis other kinds of bonds. So what essentially happens in a Sukuk investment is that the investor returns the sukuk instrument to the issuing bank and in turn receives a commitment for rent disbursements to him on underlying assets, and also a pledge to honor the sukuk upon its maturity.
Besides, another factor is that through investments in such bonds, the investor gains certain amount of ownership in the assets of the company in the extent of his investments, which unfortunately is not possible in the case of bank Bonds, especially the World Bank bond which would be our subject matter of study.
What are Mudaraba sukuks
That being said, it is now necessary to consider the bonds issued by Saudi Hollandi Bank (SHB). It is observed that the sukuk offered by them are Mudaraba Bonds. Some of the characteristics of these kinds of bonds are that they are a contract between owners of capital and managers. Typically, in a Mudaraba contract, the financiers, viz. the venture capitalists assign the help of a manger to take care of the funds against a share of profits. There may be essentially one or more owners of capital and the appointed managers. The risk of capital under Mudaraba is entirely borne by the owners of capital, while the manager would receive share of profits or compensation only if he produces desired quantum of profits as per agreement.
The details of this Saudi Hollandi bank Mudaraba Sukuk are as follows:
- The minimum value of sukuk is SR500,000
- It is in denomination of SR100,000
- The mandatory minimum agency fee of SR 100,000 has to be paid
- The shareholders of the Mudaraba sukuk would be getting “90 per cent.of the Net profit” and balance 10% would go to the issuer” (Legal Advisers to Joint Bookrunners & Joint Lead Managers 28).
- The proceeds would be used in the Islamic Business Portfolio and the Capital, as utilized in this Portfolio, will make up the assets of the Mudaraba
- The sales and delivery of these Mudaraba Sukuk would be made only to natural citizens of the Kingdom of Saudi Arabia (KSA) or to persons having a permanent base in this country.
- There is no coupon attachment and thus the question of any payments except the Periodic Distribution Amounts. (PDA). Around the last day in June and December each year, commencing June 2010, the PDP would be regularly paid off. The Periodic distribution period amounts would be according to this formulae :
P x (S +M) x D /360, where:
- P= Face value of the Mudaraba sukuk
- S = Six months SIBOR for periodic period
- M = Margin or step up margin, as need be
- D = Actual number of days.
- The Expiry period would be on December 31, 2019
- Investors could call back investments at the end of fifth year- 2014
- The sukuk are sold through private placements.
Details of 3.5% green bonds issued by World Bank
It is now proposed to take up a comparative study of Mudaraba sukuk issued by 3.5% Green Bonds issued by the World Bank.
The details of this WB Bond issue are:
- “Issuer: International Bank for Reconstruction and Development (IBRD)
- Rating: Aaa/AAA
- Amount: SEK 2.325 billion
- Settlement date: November 12, 2008
- Maturity date: November 12, 2014
- Issue price: 100,157
- Redemption: 100%
- Coupon: 3.5%
Denomination: SEK 10,000.00 and integral multiples thereof” (World Bank and SEB Partner with Scandinavian Institutional Investors to Finance “Green” Projects).
The annual interest which an investor of 10 units would get would be:
- 3.5 x 100,000 / 100 = 3500.
- The yield would be = 3500/ 100157 x 100 = 3.49%
At maturity, the Present value of this bond investment would be $ 18,649.94 after applying PV Table.
This is besides the half yearly interest payments of $1750 interest.
Thus at final maturity of the bond, the holder would get his full principal back, too as per terms of the Bond Agreement. The comparisons between these kinds of bonds and that of sukuk are that both are bond that are issued by banks, they have delivery and maturity periods and, as per agreement both need to be paid off on expiry. While sukuk does not have coupon rate, the World Bank Bond has a coupon rate of 3.5%. Besides, both sukuk and bonds are subject to market and business risks arising out of competition. It is quite possible that new companies with more attractive schemes may come into the market, which in effect may hamper the business prospects of both the World Bank bonds and also the Mudaraba Sukuk Bonds.
Risks in the business
Another aspect would be that of the quality and professionalism of the management of both the bond issuers. Under the present scenario, the need for aggressive business promotion and having qualified and experienced personnel who could oversee the critical aspects of bonds and its many ramifications are intrinsic and could impact upon the quantum and scope of business. There is no guarantee that qualified and experienced personnel would be in this business for long term basis and this risk needs to be kept in mind.
One of the major challenges posed is that sukuk bonds are very much dependent upon its admissibility under the Sharia laws. The interpretation of Sharia laws are very critical in the matter of allowing Sukuk. These laws are interpreted by Sharia experts who may be on the advisory panel of banks who indulge in such bond business. The issue that now arises is that Sharia laws are susceptible to various interpretations by various Sharia experts, and thus there is no consistency in such interpretations. However, the matter of interpretation (or misinterpretations) could also be possible in other kinds of bond issues, and this, by itself is not a major cause for concern. Besides, it is also seen that the major issues that apply in the case of sukuk are also found in global bond issues, especially in the current recessionary economic scenario.
Perhaps one of the major aspects of sukuk business is the concern for liquidity, since it is not actively traded when compared to other global bonds. In the case of the latter, it is held in well diversified portfolios and perhaps widely spread, which may cause for a greater degree of liquidity and trading activity, which may not be in the case of sukuk being perhaps restricted to local or even Islamic countries like Malaysia, KSA (Kingdom of Saudi Arabia) or UAE (United Arab Emirates).
Besides both types of bonds could have market, credit and international business risks, that are innate in both kinds of bonds. Perhaps, Mudaraba sukuk with more restrictive ownerships would have a lower degree of market risk that global bonds. There are factors that could not only impact upon the Kingdom of Saudi Arabia but which could cast its influence on even the World Bank bonds. For one thing the market value of both the sukuk bond and World Bank bond could fluctuate, due to extraneous factors. Again, the sale ability of these bonds may be conditional on many factors. Sukuk bonds are not actively traded and may thus have lower liquidity as compared to World Bank bonds. Besides, in the event of liquidation of the issuer, there is no guarantee that the underlying assets could be sold and provided to the holder. This again would depend upon the verdicts of Sharia committees as how they feel business needs to be wound up. Although these Bonds are unsecured in nature, they would be needed to be paid back, before payment of unsecured creditors but only after payment of Preferential creditors.
In the event of dissolution, only the claim for payment of the principal due could be made in the case of Mudaraba sukuk, and the claim of share in underlying assets may not be entertained by the company, or its Shariah Committee.
Volatility of business
Coming to volatility of the business, it may be evidenced that while both Mudaraba sukuk and World Bank issued Green Bonds are subject to market risks arising out of fluctuations in market prices. This is dependent upon the level of trading indulged in, it is possible that the world bank bonds could be subject to more volatility since it more activity traded, the volume of business is more than 2 Billion whereas this Mudaraba sukuk is $ 206.7 million in equivalent US dollars terms. Moreover, the sukuk being privately places would have lower volatility than public bonds.
Returns in the business
Coming to returns on the business, it is believed that this private placement Bonds would be on floating rate basis (FR) and would have returns at SIBOR + 1.9 % per annum payable half yearly. The World Bank bonds, on the other hand, offers interest rates@ 3.5% payable half yearly.
Contrast between Bonds and Sukuk
Perhaps the essential aspect that needs to be considered in Mudaraba sukuk is that the venture capitalist entrusts his capital with a manager, who is presumed to manage the business profitably and in the best interests of the owner. In the event there are profits, these are shared between the capitalists and the manager, the risks are entirely borne by the venture capitalists, but in the event there is no positive contribution from the manager, he cannot make any claims. Therefore, the management of the sukuk in the best interests of the owners of sukuk is intrinsic factors for the continued sustenance of the business. Another interesting aspect with regard to SHB sukuk is that in the event of dissolution or liquidation of the scheme, there is no guarantee that the share of underlying assets would be passed on to the sukuk holders. The decision of the Sharia Committee of the bank has the final say in the distribution of the Periodic Distribution Amounts (PDA) and in the event they feel that the installments payment made are more than their actual dues, the excess shall be deducted from the final distribution and repayment of final dues.
However, in the case of World Bank bonds, the Redemption would be 100% with no questions asked. Besides, interests would be paid promptly as on due. However, since the issue price is more than face value (issue is at a premium), the effective yield would be lower than if issued at par or at a discount.
Besides the years involved are less – 6 years against 10 years of the World Bank Bond and an earlier maturity period – November 12, 2014 (World Bank bond) as against expiry date of December 31, 2019. ( sukuk). Thus it would be preferably to go in for an investment which has an earlier redemption and call back period as against one for which the investor would have to wait till 2014 (call) or 2019 (final maturity)
From the following table it is proposed to discuss about each type of investment bond. Finally, the reader would be in a position to reach a decision on his own, as to which would be a better investment and should be invested in.
SR 7.25 M (SIBOR + 1.9%) Mudaraba sukuk compared to 3.5% World Bank bond issue.
Conclusions
From the above it is clear that the World Bank Bond issue, would be definitely better than the Mudaraba sukuk issue, not only in terms of returns and final disbursement, but also in terms of being a more secure and valued investments. Being a publicly traded instrument it is possible that there is higher liquidity value for World Bank bonds and there is assured returns and capital return after the expiry of the bond period. In the case of sukuk, this would depend upon the financial strengths of the banking company to pay off such a large amount of $ 206 Million upon due date, but this is less when compared to world bank bond redemption of around $ 2 Billions. When compared on equal terms, , and without any kind of discrimination, it is believed that World Bank issued Green Bonds would be a better option for the investors, in terms of rate of return, safety of capital and its final redemption.
Works Cited
Legal Advisers to Joint Bookrunners & Joint Lead Managers. Prospectus, Saudi Hollandi Bank. (Provided by the customer).
World Bank and SEB Partner with Scandinavian Institutional Investors to Finance “Green” Projects. World Bank Treasury. 2009. Web.
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