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Thursday, 7 February 2008

The Risks Entailed in Islamic Bonds

By Lahem al Nasser

Riyadh, Asharq Al-Awsat- Islamic bonds (sukuk) can be distinguished from traditional debt bonds by various risks that every issuer and investor must take into serious consideration, and they should not be viewed in the same manner reserved for traditional debt bonds. Additionally, the assets on which sukuk are based and the contractual structure that makes up Islamic bonds may be perceived as a bridge to transfer funds from investors to the issuers of these sukuk.

In fact, not differentiating between these two types of bonds results in an inability to assess the risk factors involved in each, and thus the risks are not dealt with using the appropriate means. When these differences are taken into account, the risks that the Islamic bonds are subjected to by virtue of their structure [whether asset, equity or debt based] are revealed; the risks inherent in Murabaha bonds, Musharaka bonds and Istisna bonds are different from one another, in the same manner in which there are discrepancies between simple bond structures and the complex ones that are based on multiple contracts.

Moreover, risks vary in accordance with the different assets on which Islamic bonds are based, some of which are constant while others are variable, in addition to benefits and services.

The risks may be outlined as follows:

Firstly; violating the provisions of Islamic Shariah. Since sukuk are financial instruments built upon Islamic Shariah laws, any case of flouting these rules throughout the term of the bond's validity results in damage in varying degrees. Some cases invalidate the bond in question while others may nullify some of its conditions. For example, when the sukuk are Murabaha or Ijarah, the debt rates must not exceed 33 percent of the bond's composition throughout its validity so that it may circulate.

Should the bond's rate exceed the stipulated 33 percent, it then becomes unfit for circulation and thereby its liquidity is weakened, or the holder's ownership of the Ijarah bond becomes in name only, which makes the contract ineffectual. Whatever has been built on an invalid basis results in voiding the bond.

It is common knowledge, for example, that many Islamic institutions are transferring the ownership of customer assets on the basis of mortgages rather than sales. If these institutions were to convert these assets into Ijarah or Musharaka sukuk, or other types of Islamic bonds, they would be invalid since the institution will have sold bonds that it does not own and this type of sales transaction is prohibited by Islamic Shariah.


Violations of Islamic Shariah are numerous and cannot be listed in this article since each different bond structure has its own set of Shariah regulations. Such violations present various types of risks; these bonds must be examined to determine the possibility of their potential invalidation, in addition to devising ways to limit this occurrence and finding ways to remedy it.

Secondly; operational risks: the structures of sukuk that are valid for circulation must be based on assets; moreover, the returns on these bonds are generated from these assets. The operational risks entailed involved in such assets must be studied carefully, since for example, we know that the returns on Ijara sukuk are based on the revenues of the bond in question, therefore if the lessee's benefits are disrupted [if a given project is terminated or at a standstill] then they are not required to pay the rent, and thereby there are no returns on such bonds.

Thus it becomes clear that Ijara sukuk that are based on property are less susceptible to the risk of losing their revenue as opposed to disruptions that take place in Islamic bonds that are based on vehicles, ships, factories and aircrafts etc., since these may raise potential risks such as environmental damages or other types of risks that are specifically attributed to each separately.

Third, legal risks: Since much of the systems and legislation adhered to in most states has been established by man, it means that many of its articles do not follow the provisions of Shariah law. This results in a conflict between such systems and Shariah law, in addition to neglecting to implement Shariah law in the governance of states.

From here, we can see the importance of knowing and taking into account the risks entailed in sukuk as opposed to conventional debt bonds. This difference must be carefully examined in a precise scientific manner so that they may be resolved in a Shariah-compliant way.

* Lahim Nassar is an Islamic banking adviser.


MAJOR TYPES OF SUKUK AT A GLANCE

MURABAHA: a financer, such as a bank, buys a commodity and sells it to the purchaser at a higher price.

MUDARABA: the bank provides funding to entrepreneurs, who share the profits of any venture. The entrepreneurs do not put up any capital.

MUSHARAKA: the bank provides funding to entrepreneurs, who also contribute capital. Profits from the venture are shared.

IJARAH: Arabic for leasing. An agreement in which banks lease an asset to a client for a specific time at a specific price. At the end of the leasing period, the client may or may not own the asset.

ISTISNA: The purchaser asks the seller to create a product, which is then sold to the purchaser at a given price. Istisna allows parties to contract the sale of a something that does not exist at the time of the agreement.


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