Sukuk issuance withdraws liquidity from banks, markets: Experts

The issuance of sukuk leads to the withdrawal of liquidity from banks and markets, especially if they offer investors higher returns than deposits and direct investment with acceptable risks, said experts, during a webinar hosted by Argaam. 

Ahmed Al-Nasser, a consultant in Islamic finance, said that, when the inflation rate rises as a result of increased liquidity, sovereign financial institutions begin to raise the interest rate. This is aimed at withdrawing liquidity from consumers in the markets to reduce demand.

For his part, Ahmed Al-Gafari, CEO of Dinar Investments Co., said that achieving high economic growth rates is reflected in the rise in interest rates as well. He added that the absence of an increase in interest rates means that there is huge liquidity in the markets, as central banks work to balance interest rate levels and growth targets for their economies. He also stressed that the rates of sukuk and bonds are affected by interest changes.

The Need to Issue Sukuk

Al-Gafari explained that the financing need of companies and entities puts them before a number of options. This namely includes obtaining loans from banks and financing firms, increasing their capital by issuing new shares and selling them to shareholders, financing the company’s operations from retained earnings, or issuing sukuk and bonds.

He considered that sukuk are distinguished as being long-term and achieving the purpose in financing capital projects. This is in addition to their flexibility in terms of repayment schedules, as well as the possibility of issuing new sukuk after the expiry of existing ones.

Meanwhile, Al-Nasser said that sukuk and bond issuances tap several goals, as they are a type of financing, whether for expansion or working capital. He indicated that they are also issued to achieve creditworthiness and increase the confidence of international investors in the facility, as the sukuk issuer is looking for lower interest rates in other currencies and markets to reduce the cost of financing.

Difference Between Sukuk, Bonds and Stocks

Al-Nasser stressed that there is a fundamental difference between sukuk and bonds. The bond is a security that proves the indebtedness of its holder to the issuer, meaning that the bondholder has a debt on the company or the entity issuing the bond, which is a debt due at a specific value. The bond is not correlated with the company's assets. It is guaranteed by some of the assets, but as a kind of guarantee, not ownership.

He pointed out that the risks related to bonds mainly stem from the creditworthiness of the issuer. The latter must have financial solvency and strong cash flows to be reflected in the strength of the bond and the low risk of investing in it.

As for the sukuk, it is a certificate of ownership in the assets of the issuer, and the risks for the sukuk holders come from the issuer and from the assets of the sukuk. The shareholder is considered an owner in the company by a percentage equal to their owned shares, while the sukuk holder is not deemed a company owner, but rather owns a share in its assets. Therefore, the sukuk holder does not enjoy the same rights as shareholders.

Al-Gafari indicated the most well-known type of sukuk, or Murabaha, is the closest in terms of structure, form and legal commitment to bonds, given that there are no assets representing the sukuk, but rather commodities sold on a deferred basis to the issuer, which is a debt that must be fulfilled. He added that Murabaha sukuk are recognized in the Kingdom and they are strongly admissible, with no legal risks.

Sukuk Risks

Al-Gafari said that bond and sukuk issuances differ in the degree of their risks. Sovereign issuances by governments have low risks, given that the government has a sovereign currency and will be committed to paying the holders of the sukuk or the bond. However, there are also government-related issuances with high risks, such as the bond issuances of South American countries.

The difference in the degree of risk also applies to corporate sukuk issuances, whose risks are classified according to the size of the company, its cash flow, growth and other indicators. In general, the price volatility in sukuk is less than in stocks and other investment assets, as the addition of sukuk with good credit quality to the investment portfolio reduces the risk of portfolio volatility, he added.

Meanwhile, Al-Nasser explained that it is not possible to place all sukuk issuances in one credit rating. If the credit ratings are high for the issuer, the risks decrease, and on the contrary, low ratings are followed by high risk. Therefore, the rates of return on sukuk vary based on the sukuk issuer’s credit rating. The return increases when credit risks on the issuer are high and vice versa.

It is also not permissible to classify sukuk according to the creditworthiness of the issuer, as in bonds. However, it is necessary to consider the structuring of the sukuk and on any type of jurisprudence contract it has been structured when classifying sukuk, as the risks of sukuk and the degree of their liquidity differ from one contract to another, he further stated.

Financial technology (fintech) companies will face a challenge in the liquidity of the sukuk that they issue to companies, as they are based on the Murabaha contract. The Islamic law bans the trading of Murabaha sukuk, because they are debt sukuk, reflecting liquidity risks as sukuk holders cannot liquidate them when needed, he indicated.

Al-Nasser also highlighted the importance of fintech businesses working to diversify the investment structures that would shape such sukuk in the future, even if there is a secondary market for sukuk through which trading and long-term sukuk are issued.

Sukuk Redemption

Al-Gafari pointed out that the most prominent reason for the issuer to redeem the sukuk is the cost factor, in which interest rates have decreased and the issuer can redeem the sukuk completely, and re-issue new sukuk at a low return.

The sukuk are also redeemed by companies or issuers to rearrange the financial position of the establishment. This could either be in preparation for the public offering, the existence of a new acquisition deal or for strategic reasons. It has nothing to do with costs, he added.

How do Sukuk Guarantee a Stable Return for Investors?

This is achieved according to the structuring of the sukuk. If it is a Murabaha sukuk, then there is no legal problem with the return being fixed and known to the sukuk holders. This is because the Murabaha sukuk is indebted to the issuer, with a known profit and term, thus no legal objection, Al-Nasser said.

As for Ijara sukuk, the return is mostly fixed and known, and it may be variable and known because the rent is considered a debt owed by the lessee as per the lease contract that takes place between the sukuk holders and the issuer. The change in the return is determined according to a specific indicator, which is usually the interest rate indicator according to the currency in which the sukuk was issued, Al-Nasser added.

He further highlighted the existence of hybrid sukuk, which is a mixture of Murabaha and Mudaraba or Mudaraba sukuk - Musharaka, in which profit is expected and not a commitment on the issuer. A specific structure is usually created to achieve a kind of stability for the return, such as the presence of reserves to be set aside. This is because if profit surges during some period, part of it is set aside in the profit reserve account, and if the opposite happens, the profit difference is compensated from this account.

"Also, Istisna’ or Salam sukuk are considered to have fixed returns as they are considered to be debt, but neither issuers nor investors often favor debt-based sukuk, due to their lack of liquidity and circulation. Therefore, we find that issuance of them is few, and in order to reduce the risks to sukuk holders and increase the attractiveness of sukuk to investors, hybrid sukuk are issued at rates of 49% Murabaha, compared to 51% Mudaraba," he continued.