Islamic Sukuk Bonds Vs Conventional Bonds

Published Date: 02 Nov 2017

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CHAPTER 02: LITERATURE REVIEW

The Arabic term sukuk is the plural of sakk, meaning 'legal instrument', 'deed' or 'cheque'. It is the Arabic name for what is known in conventional banking as 'financial certificates', but more commonly refers to the Islamiccounterpart of 'bonds'. In the mediaeval period of Islamic civilisation, sakk (which is cognate with the European root 'cheque', from Arabic sakk, via Persian chakk) stood for any document representing a contract or transference of rights, obligations or monies done in conformity with Islamic law (Wilson ,2005 , pp. 27).

In contemporary Islamic banking, the essence of sukuk lies in the concept of asset monetisation - the so-called 'securitisation' - which is achieved through the process of issuance of sukuk. Its great potential is in transforming an asset's future cash flow into present cash flow. sukuk, which may be issued on existing as well as specific assets that may become available at a future date, are certificates that represent ownership of specific, revenue generating underlying assets. As owners of the underlying assets, sukuk holders are entitled to the revenues generated by the underlying assets, minus any legitimate deductions such as management fees. sukuk are issued by way of securitisation, the process of converting illiquid, non-tradable assets into liquid, tradable securities. Some scholars stipulate that real assets such as buildings or land comprise at least 51 per cent of the portfolio of assets to be securitised. Other scholars take the view that receivables also qualify as assets for the purpose of securitisation (Wilson 2004, pp. 3).

However, some sukuk defaulted outright. On 27 April 2009, Kuwait-based The Investment Dar (TID) missed a US$100 million payment on its sukuk registered in Bahrain. TID, which claimed 50 per cent of British luxury carmaker Aston Martin in its portfolio of investments, had debts at that time amounting to nearly US$3.5 billion. The default was followed by a dispute with Lebanon's Blom Bank. The Dar default was followed on 12 April 2010 by a failure to pay a distribution payment of US$3.3 million, on a US$200 million sukuk by another Kuwait company, the International Investment Group (IIG) (Tariq 2004, pp. 43).

The same company defaulted a second time on 12 July 2010, failing to pay US$152 million due on another sukuk. The Saad Group of Saudi Arabia, which owns a stake in HSBC, and has been at the centre of fraud allegations, defaulted on a US$650 million sukuk. Texas-based East Cameron Gas Company, which issued a US-offering of sukuk worth US$165 million backed by oil and gas assets, was another defaulter. Most prominent among the 'near defaults' were sukuk issued by Nakheel World, a subsidiary of Dubai World, owned by the Dubai government.8 Due to the extraordinarily large sums involved, the Dubai 'near defaults' had the greatest impact on the sukuk market (Siddiqi 2005, pp. 9).

Islamic rulings (a’kam) for the conduct of commercial activities (mu'amalat) include the permissibility of trade (bay'), risk or profit and loss sharing in commercial enterprise, safeguarding of the public interest (masla?ah), fulfilment of contracts ('uqud), giving full measure in business transactions, documenting future obligations, the avoidance of gharar (excessive uncertainty) and ensuring that wealth circulates among all levels of society. Also included are the prohibition (nahy) of usury or riba, gambling (maysir), hoarding (ihtikar), manipulating markets to raise prices, and producing (or trading in) pork or alcohol. Apart from these basic commands and prohibitions, the principle of original permissibility (iba’ah) applies. This means that a practice is permitted unless it is specifically prohibited by a definitive (qa’'i) text. In general, "[t]he realisation of benefit and the prevention of poverty and hardship are among the cardinal objectives of the economic and political agendas of the Islamic government"(Wilson 2004, pp. 3).

Sukuk certificates are issued by one party (the issuer) and subscribed to (purchased by) another party (sukukholders). Sukuk - like conventional bonds - help channel surplus funds into areas where shortages may be experienced. The key difference between conventional bonds and sukuk is that bonds pay interest whilesukuk pay profit. In Islam, earning returns from the lending of money at interest (riba) is forbidden. Earning profit from trading or other business activity, by contrast, is not only permitted but encouraged. Profit can be earned through trading (distribution of goods and services) or by participating directly in the manufacturing of goods or the provision of services, public or private. Sukuk issued to finance the provision of goods and services provide opportunities for large numbers of people to participate in projects such as schools, hospitals, universities, clinics, factories, bridges, roads, ports, airports, highways and other enterprises. While the "focus of most sukuk offerings has historically been on real estate development projects and generally on acquiring real property [...] there is a recent trend towards new sectors such as energy, oil and gas, and renewable energy" (Siddiqi 2005, pp. 9).

Sukuk are sometimes portrayed as "the Islamic and Shariah compliant alternatives to fixed income, conventional bonds and debt securities". This characterisation is only partly true. Sukuk and conventionalbonds resemble one another in so far as both constitute means of raising and allocating funds in the capital markets. Yet they do so in different ways. In the case of sukuk, funds are raised by selling investment certificates to investors that signify proportionate ownership in an underlying asset, and entitle the holders of the certificates to a proportionate share of the profit generated by that asset or pool of assets. In the case ofsukuk issued to finance trade, this profit is fixed in advance. In case of the sukuk issued to finance other activities, the profit varies according to market conditions. In the case of bonds, however, funds are raised in the form of interest bearing loans (Richard 2005, pp. 1).

With bonds, the principal amount of the loan has to be repaid on a specified date in the future, known as the maturity date. During the life of the bond, the issuers are obliged to make periodic payments of equal value (interest), determined in advance, to the bondholders. The issuer of a bondeffectively borrows at interest from the buyers of the security. In the case of sukuk, the incentive for investors to participate in business is a share of the profit. In the case of bonds, it is a fixed amount of interest, to be paid regularly, no matter how well - or poorly - the business being financed may perform. The relationship between the buyers (investors) and sellers (issuers) of sukuk is one of partners. The relationship between the issuers and buyers of bonds is of a less equal nature, such as exists between creditors and debtors, where in most cases the creditors hold the upper hand (McNamara 2005, pp. 4).

Sukuk are issued to finance private or public enterprise, specifically trading and the provision of goods and services. Sukuk issued to finance trade appear to have the character of contracts of exchange ('uqud mu'awa’at) while those issued to finance the production of goods and the provision of services take the form of contracts of participation ('uqud ishtirak). Both types pay profit rather than interest. All sukuk require assets "to be sold, leased, or invested in. This is the essence of sukuk [...] the certificate should represent an ownership interest in the underlying asset."In contracts of exchange (trade) sukuk evidence a commitment by the sellers (issuers) of the sukuk to pay counterparties (which may be financial institutions) the cost of an asset plus a mark-up, from which comes the profit to the financial institution after expenses associated with the transaction have been paid. The payment is made on a deferred basis. Examples of this type are sukuk muraba’ah where payment is made on a deferred basis (McNamara 2005, pp. 4).

Investors can also participate in profit and loss sharing contracts by means of purchasing sukuk issued by partnerships, such as the mu’arabah or musharakah. Sukuk musharakah and mu?arabah are risk (profit and loss) sharing investment participation contracts par excellence. Sukuk issued (and sold) to raise funds for purposes of participating in productive enterprise evidence the obligation on the part of the issuer to pay proportionate profits to the investors (sukuk holders). The amount of the dividends to be paid to investors (sukuk holders) out of total profits earned depends on a pre-agreed ratio of profit sharing, as well as on the efficiency of the assets purchased using the raised funds. It has been noted that sukuk mu’arabah and musharakah are similar to shares in conventional banking. Like ordinary shares, sukuk enable risk sharing (although more so in the case of participatory contracts than in contracts of exchange). While there are some differences, for example those relating to voting rights, the musharakah sukuk, the mu?arabah sukuk, and conventional shares are all profit and loss sharing forms of participation in productive enterprise. Bona fide profit and loss sharing sukuk cannot default any more than ordinary shares can. The possibility of default in sukuk structured as genuine risk sharing securities in other words does not arise (Hassan 2005, p. 4).

There may be losses from time to time, and these have to be shared just as profits have to be shared, but there are no defaults. The fact that investors are exposed to the possibility of losses is in keeping with the profit and loss sharing principle of Islamic finance. The possibility of losses in risk sharing is, however, mitigated by the possibility and, indeed the prospect that profits, in particular over the longer term, will be greater than losses, if any. In other words, the great advantage of sukuk mu?arabah or musharakah to issuers is that they are less risky to issuers precisely because the risk is shared with investors. Sukuk mu’arabah and musharakah in other words resemble equity financing: "equity financing is less risky in term of cash flow commitments. There is no obligation or liability to distribute or service profit when there is no profit made (Gadar, 2004, pp. 7)."

Raising funds for financing activities other than trading can also take place by means of sale and leaseback of assets, known as sukuk ijarah. Like sukuk muraba’ah, the ijarah is a sale contract, with the added features of a leaseback of the underlying assets by the investors to the originators. In sukuk ijarah, originators first sell specific assets to investors. The same assets are then leased back to the originators by the investors. At maturity, the assets are sold back to the originators by the investors (sukuk holders). The initial sale of the assets to the investors enables the issuers to raise a lump sum of capital. The leaseback from the sukukholders by the originator allows the payment of a regular and (in the short run) fixed stream of income (rent) tosukuk holders. The repurchase of the assets by the originators at maturity enables investors to recoup their principal amounts. Sukuk ijarah have been widely used, by both private sector companies as well as by governments to raise funds in the capital markets for a variety of purposes. The London Stock Exchange listed its first sukuk in July 2006. In part due to generous tax incentives, increasing numbers of non-Muslim institutions are raising capital by issuing sukuk. Sovereign issues have declined in part as a result of difficulties experienced by countries such as Iceland, Spain, Greece and, most recently, Ireland. Sukuk are also becoming popular in the United States. In 2009, General Electric became the first major US company to tap the sukuk market, with a US$500 million issue backed by revenues from its aircraftleasing business (Eastern 2005, p. 2).

Global issuance of sukuk has been fuelled by rising revenues from the sales of oil. The main centres of trading of sukuk are Kuala Lumpur, Dubai, and London. Countries that issue both sovereign and corporate sukukinclude the United Arab Emirates, Malaysia, Saudi Arabia, Qatar, the United Kingdom, Germany, Pakistan, the Philippines, and Indonesia. Since 2002, there have been "seven major types of sukuk and issuance in four currencies and by ten countries". Issuance has been growing on average by 20 per cent per year. In 2007, less than a year before the financial and economic crisis of 2008, a record of US$31 billion sukuk were sold globally. In 2008, global issuance fell to US$14.9 billion.22 Global issuance then rose to US$24.7 billion in 2009.23 In 2010, global sales stood at US$17.1 billion (Eastern 2005, p. 2).

Securitisation

Sukuk are products of securitisation, the process of transforming illiquid assets into marketable securities (liquid assets). A distinguishing feature of 'asset-backed' sukuk is that sukuk holders are paid dividends generated by underlying productive assets that also serve as collateral. These assets are either real (property), debts (financial receivables), or a combination of the two. Securitisation takes place as follows. The originator or party seeking to raise funds (the obligor) sells some of its assets to another company established specifically for the purpose of securitisation (Dommisse, 2005, pp. 7).

This company is known as a special purpose vehicle (SPV) or a special purpose mu?arib (SPM). It acts as a trustee on behalf of the sukuk holders and manages the assets and liabilities of the SPM for a specified period of time, independently of the sponsoring (originating) company. The SPM needs to be bankruptcy remote from the sponsoring company (originator) in order to protect sukukholders from risks arising out of originator bankruptcy. When the SPM is bankruptcy remote from the originator, the investments of the sukuk holders/buyers remain safe even if the originator (the company that sold the assets to the SPM) goes bankrupt. The originator cannot 'claw back' any assets it sold to the SPM in order to stave offa potential bankruptcy or to pay for any of its liabilities (Dommisse, 2005, pp. 7).

The mu’arib (SPM) next issues (and sells) sukuk to both local and foreign investors. The buyers of sukukbecome the sukuk holders (investors). The proceeds of the sale of sukuk pay for the assets bought by the mu?arib from the originator. The SPM remits dividends generated by the underlying assets periodically (twice a year) to the sukuk holders, less agreed-upon fees due to the mu’arib. Most sukuk - like bonds but unlike ordinary shares - come with maturity dates. On 'maturity date' the originators 'redeem' the sukuk by repurchasing the underlying assets back from the sukuk holders, at a previously agreed upon price. This price is invariably the same as the price at which the assets were originally sold by the originator to the sukukholders (investors). The repurchase has the effect of returning to the sukuk holders their initial investments (Aquil 2005, pp. 15).

In February 1988, the Fiqh Academy of the Organisation of Islamic Conference (OIC) declared that issuing and selling sukuk to investors, assuming the required conditions are met, is an acceptable and riba-free way of raising funds in the Islamic capital market. However, the following conditions, among others, need to be satisfied: "The Manager issuing Sukuk must certify the transfer of ownership of such assets in its (Sukuk) books, and must not keep them as his own assets." Moreover, sukuk assets must be "owned by the investors, who would have all the rights and obligations of ownership with respect to the underlying real assets".28 It needs to be emphasised that the claim embodied in sukuk is "not simply a claim to a cash flow but an ownership claim". The sukuk would "lose their Shari'ah compliance without a share in ownership of the asset" (Dommisse, 2005, pp. 7).

In practice, however, it became clear that "many companies do not want to 'sell' their quality assets to investors". As a result, most sukuk have been structured to enable originators to "legally retain" ownership of the underlying assets. The control of the SPMs that purportedly act on behalf of the sukukholders independently of the originators, has likewise in most cases remained with the originators. Accordingly, such SPMs can hardly be described as 'bankruptcy remote'. In still other cases, the underlying assets are not even sold to the mu’arib (SPM) supposedly acting on behalf of the sukuk holders, but remain on the balance sheets of the originators. It would appear that "the assets in the structure are commonly for Shari'ah compliance only. As a result of this practice, in case of a bankruptcy of the originator, sukuk holders would merely have the status of creditors rather than owners of the underlying assets. This produces a considerable degree of risk to sukuk holders (Gadar, 2004, pp. 7).

Asset-based and Asset-backed Sukuk

Sukuk where the ownership of the underlying asset is transferred by way of a true sale to the sukuk holders are known as 'asset-backed'. The "holder of an asset-backed sukuk is the owner of the underlying asset which behaves like collateral". When asset-backed sukuk are sold to investors in this way, the assets become bankruptcy remote. This means that the originator cannot 'claw back' any of the assets in case he goes bankrupt. Sukuk holders become the legal owners of the assets. The true sale and bankruptcy remoteness of the assets ensure that the sukuk are truly 'backed' by assets: "if the originator defaults in its obligation, thesukuk-holders can dispose of [sell] the assets to third parties". Thus the investments of the sukuk holders are protected. Consequently, sukuk holders face less risk. Specifically, they face asset risk rather than originator risk. In case the underlying assets fail to pay expected dividends, sukuk holders can recover their initial investment by selling the underlying assets in the secondary market (Hassan 2005, p. 4).

By contrast, with sukuk where the sale of the underlying assets to the sukuk holders is not a true sale, legal ownership of the underlying assets remains with the originators, or with an SPM controlled by the originators. With asset-based sukuk the ownership of the underlying assets is not legally transferred to the sukukholders. The sukuk holders have only 'beneficial ownership' of the assets. Asset-based' sukuk resemble conventional unsecured bonds, similar to bonds that are not collateralized. Owners of asset-based sukukthus face higher risk than owners of asset-backed sukuk. They face originator risk rather than asset risk (Richard 2005, pp. 1).

Most sukuk are 'asset-based', handing investors ownership of the cashflows but not of the assets themselves. Holders of the vast majority of sukuk do not have proprietary rights but instead, beneficial ownership. The legal standing of investors is akin to that of creditors. In insolvency proceedings, "sukuk [holders would] rank as creditors rather than equity holders. Rating agencies assign lower or no ratings to asset-based sukuk. Only 30% of the sukuk issued have been rated. When they do assign a rating to asset-based sukuk, they assign it on the "creditworthiness of the issuer rather than the assets because of doubts over investors' claim to the assets"(McNamara 2005, pp. 4).

The difference between the asset-backed and asset-based sukuk may not be of much consequence so long as the underlying assets perform well for the sukuk holders (pay the promised dividends). The difference between asset-based and asset-backed sukuk, however, becomes crucial in the event of a default or a prospect of default by the originator, when the protection of the investments of the sukuk holders becomes an issue. In the case of asset-backed sukuk, the investments of the sukuk holders are protected because they are the legal owners of the underlying assets. The sukuk holders can sell the underlying assets - should the need arise - in the secondary market to recover their investments. In the case of asset-based sukuk, however, since legal ownership of the underlying assets remains with the originators, sukuk holders are not able to sell the underlying assets because they do not legally own them. Simply put, although the asset exists in asset-based sukuk structures, in default cases it does not provide protection to the sukuk-holders because they cannot sell it to third parties(Gadar, 2004, pp. 7).

Investors in 'asset-based' sukuk thus face the risk of losing their initial investment in toto. Not every sukukinvestor appears to have realised this. A number of investors appear to have been under the impression that their sukuk "were 'asset-backed', giving them a claim on the assets in the event of a default. In 90% of cases, that is incorrect. Although linked to an underlying asset, most sukuk are not secured instruments and should not be treated as such.

While most sukuk have been asset-based, there have been notable exceptions. In the United Arab Emirates both Tamweel and Sorouh PJSC issued bona fide asset-backed sukuk. The ownership of the assets was fully transferred to the sukuk holders, resulting in a legal ownership of the assets by the sukuk holders, rather than merely in 'beneficial' ownership. Such sukuk holders are exposed to asset risk rather than credit risk (Aquil 2005, pp. 15).

Bond-like Characteristics of Islamic Securities

There is no doubt that adverse economic conditions contributed to the defaults and near defaults. However, the fact that sukuk - apart from not paying interest - were structured to have "bond-like characteristics" also played a role.Despite outward compliance with the shari'ah, "much of Islamic finance today is focused on replicating the conventional system an inevitable consequence is that any problems/flaws are also likely to be replicated (emphasis added)." Sukuk ijarah in particular are customarily structured to resemble conventional bonds. The bond-like features of sukuk are commonly justified by saying that the "market tends to [expect sukuk to be within the 'fixed income' types of investment with minimal or controlled risks and capital preservation features". The "market participants [...] expect sukuk to behave like conventional bonds in terms of capital preservation, periodic distribution frequency and rate of return, and [to possess] any other additional investor protection mechanisms like the ability to take collaterals and credit enhancements" (Hassan 2005, p. 4).

Among features that imparted to sukuk the character of conventional bonds was the undertaking (wa'd) by issuers to repurchase the underlying assets from the investors at par value, on a specified maturity date in the future. The repurchase undertaking (wa'd) is at bottom little more than a way to "repay principal to theSukuk investors".By obliging issuers to repurchase the underlying assets on the maturity date of thesukuk, the arrangers of sukuk (banks or other financial institutions), effectively create an "amount owing" by issuers to sukuk holders. This replicates for issuers a risk similar to that facing issuers of conventionalbonds, the risk of default. The risk takes the form of a possibility that by the time the sukuk 'mature', issuers might not have enough money to repurchase the underlying assets from the sukuk holders. This risk is more precisely known as the asset redemption risk. Asset redemption risk arises "due to the fact that the originator has to buy back the leased assets". It occurs when the originator does not have enough capital "to buy [the underlying assets] back from the certificate holder" (Dommisse, 2005, pp. 7).

While the repurchase undertaking (wa'd) is advantageous to the investors in that it "guarantees" them a repayment of their original investment on a specified date in the future, the need to repurchase the underlying assets imposes an obligation on issuers to ensure that they have sufficient sums of money ready to redeem the sukuk by the time they mature. The requirement to repurchase the underlying assets effectively transforms what should be a profit and loss sharing relationship in the first place - a partnership (musharakah or mu.arabah) - into a creditor/ debtor relationship(Siddiqi 2005, pp. 9). Sukuk have other features "in common with conventional fixed income or 'debt' instruments" sukukagreements are characterised by an absence of a provision to share losses. They promise only profits. Moreover, the quantum of these profits is fixed in advance. By right, profits should fluctuate according to the profitability of the underlying assets, as is the case with all risk sharing securities. The payment of fixed returns, without any provision for sharing losses, is a distinguishing characteristic of conventional, interest-bearing bonds(Wilson 2004, pp. 3).

The commitment to pay predetermined dividends without requiring investors to share losses, mitigates much uncertainty for the suppliers of capital. It provides them with a contractual certainty of earning 'profits' - specified in advance and in isolation from the efficiency of the underlying assets. At the same time, it absolves the investors from any responsibility to share any losses. The promise to pay predetermined dividends, generated in an uncertain business environment, amounts to promising contractual certainty (of profits) on the basis of operational uncertainty. Such an agreement appears rather lopsided and can thus hardly be viewed as a genuine risk-sharing partnership(Gadar, 2004, pp. 7).

The twin practices of refunding to investors their capital by 'repurchasing' the underlying assets (redeeming thesukuk) and paying pre-determined dividends to sukuk holders without requiring them to share any losses, "created sukuk instruments that, in substance, attempt to be identical to conventional bonds". While sukukmay have achieved shari.ah compliance in form, it is less certain that they achieved it in substance. "Questions have been raised as to whether mirroring existing products and returns through financial engineering is a sound basis for the industry to develop. Islamic finance differentiates itself from other forms of finance through the sanctity of the shariah principles on which it is based . If this sanctity is compromised, then the point of Islamic finance is lost. For these and other reasons, The AAOIFI Sharia Board recommends and advises Islamic financial institutions to limit their dependence on operations which closely replicate traditional lending and borrowing, and to capitalize on real musharakah transactions based on profit and loss sharing, in a way that better achieves Shariah objectives (Usmani 2002, pp. 75).

The recommended form of business participation in Islam is the partnership, in the form of the mu.arabah or the musharakah. "Mudharabah may be viewed as equity due to its feature of no pre-fixed periodic payments; rather payments are made from profits, similar to dividends. Further, as a general rule, the rab al-mal cannot foreclose or take legal action if there are no profits for distribution. "Unlike interest-based transactions in which the profit is predetermined, fixed and essentially non-speculative, in the profit-sharing transactions envisaged by the Shari.ah, the profit level remains undetermined and generally predicated on speculative risk-taking."

Advantages of Risk Sharing

"Risk-taking [is] integral to the Islamic modes of commerce such as mudarabah and musharakah." Whensukuk are structured as bona fide risk sharing, asset-backed sukuk, the possibility of default does not arise. There may be losses, but there are no defaults. "If Shariah principles are to be adhered to", the originator or obligor need not pay sukuk holders when there are "no profits to be distributed". Risk sharing securities such as common shares (equity), unlike interest bearing debt securities, do not commit issuers to pay profits without regard to the performance of the underlying assets. Much less do they commit issuers to pay only profits whose magnitude, moreover, is specified in advance. Profits by definition depend on the efficiency of the underlying assets generating them. The prospect that sukuk structured as profit and loss sharing instruments may fail to pay dividends in itself should not be cause for alarm, as the possibility of incurring losses is balanced by the prospect of earning profits (Tariq 2004, pp. 43).

With sukuk designed as profit and loss sharing securities, the requirement to share risk automatically mitigates against overinvestment, as business plans with limited prospects of success will attract few investors. Buyers are more likely to exercise care when investing in risk sharing securities, because they know that they agree to share not only profits but also losses: "investors need to conduct a thorough analysis and due diligence of the underlying assets themselves before they take the decision to invest". The experience of pension funds, insurance companies, hedge funds and investment banks, that suffered multi-billion dollar losses in the recent financial crisis despite the fact that they purchased 'AAA' rated securities, has shown that it is risky to rely on the assessments of rating agencies alone (Siddiqi 2005, pp. 9).

The profit and loss sharing character of sukuk reduces the likelihood that issuers (sellers) of sukuk will raise funds in excess of what is needed to finance viable business proposals. This increases the stability of the issuer and, by extension, of the capital market in which risk sharing securities are extensively utilised. The utilisation of risk sharing securities distributes risk more widely throughout the system, and thus reduces overall exposure for everyone. It also provides a strong incentive to all parties to do what they can to ensure that their respective counterparties remain stable, as all share a common fate. In order to raise funds, issuers of profit and loss sharing (PLS) sukuk need to convince investors that potential profits on the sukuk being offered significantly outweigh potential losses. Business proposals with prospects of success should face little difficulty in attracting sufficient liquidity. By contrast, business proposals with poor prospects will attract few investors. The expanded use of PLS sukuk will thus contribute not only to greater stability of the financial system, but also to a more efficient allocation of capital and the reduction of waste (Richard 2005, pp. 1).

The fact that risk sharing sukuk do not come with guarantees does not mean that holders of such securities cannot recover their investments. Depending on timing and market conditions, holders of risk sharing securities can liquidate their holdings in the secondary market. Sukuk would, however, first have to be structured as asset-backed rather than asset-based securities. "Backing by real assets ensures that a Sukuk is tradable." Backing sukuk by assets would bring the added advantage of stimulating trading in the secondary markets, which are known to be sluggish under the current regimen (McNamara 2005, pp. 4).

While structuring securities in shari'ah compliant ways may not guarantee profits, it does guarantee doing business in ethical and shari'ah compliant ways. Since all business carries risks, there can never be a guarantee of profits any more than there can be a guarantee against losses. Bona fide risk sharing instruments do not come with predetermined and 'guaranteed' profits, 'maturity periods', or 'refunds' of shareholders' capital. These are characteristics of conventional, interestbearing bonds, structured to minimise, if not eliminate, most risks facing creditors. Instead of being structured as risk sharing securities, conventional interest-bearing bonds are structured as risk-shifting instruments, which means that they effectively transfer nearly all risk to the borrowers. Among recent manifestations of this trend is the introduction of variable 'profit rate' housing loans, in which home buyers pay variable amounts on their monthly instalments over the lifetime of the loan, depending on the movements of a benchmark, such as the Base Lending Rate (BLR), to which the 'profit rates' on those loans are pegged. (Wilson 2004, pp. 3)

The practice of pegging or benchmarking protects financial institutions from increases in the costs of their own borrowings. These costs may rise due to increases in the rate at which financial institutions borrow from other institutions, such as the interbank rate. The interbank rate in turn is pegged to the Bank Rate, which is the rate at which the central bank may lend funds to financial institutions as the need arises. While passing on the risk of increases in current interest rates to homeowners may be comforting to financial institutions, it produces a considerable degree of uncertainty to the borrowers, as it means that they never know in advance what amount they may be asked to pay in any given month, with little prior notice.

Between January 2006 and December 2007, before the economic and financial crisis of 2008, Dubai companies issued numerous sukuk. In January 2006, PCFC of Dubai issued $3.52 billion convertible musharakah sukuk, guaranteed by Dubai World, to fund DP World's acquisition of P&O, the UK's biggest ports and ferries operator, the third largest in the world. Dubai World also purchased the Turnberry golf course and a 21 per cent interest in the London Stock Exchange. In December 2006, Nakheel World, a subsidiary of Dubai World, issued US$3.5 billion sukuk. This was soon followed by an additional US$750 million of sukuk. In addition, Jebel Ali Free Zone issued US$2 billion, and Dubai World US$1.5 billion worth of sukuk.74 In 2007, Dubai World purchased the luxury liner Queen Elizabeth 2.

In October 2008, as the global financial crisis was gripping the rest of the world, Dubai announced an ambitious US$38 billion development plan, that included the tallest tower in the world. In the run up to the global financial crisis Dubai World and its investment arm, Istithmar purchased a number of 'trophy properties' that included:

CityCenter Casino & Resort, a large Las Vegas development in which Dubai World teamed with MGM Mirage. Dubai World's share of the CityCenter investment was $5.4 billion . Barneys, the luxury retailer, bought in 2007 for $942 million; 450 Lexington Ave in Manhattan, bought for $600 million in 2006; a stake in the Mandarin Oriental, a 248-room hotel in Manhattan in 2007 at $380 million; and a 50% stake in the Fontainebleau Miami, an 876-room resort hotel in Miami for $750 million [and] the iconic art-deco former Adelphi hotel building on the Strand, WC2. By the end of 2009, Dubai World and its companies accumulated debt of over US$100 billion to over 100 lenders.76 Its debts currently exceed its GDP.77 Publicly, Dubai "acknowledges having US$80 billion of liabilities".78 US$50 billion of its liabilities are scheduled to mature by 2013.79 The United Arab Emirates has a population of 4.5 million and is smaller than South Carolina.

The credit squeeze and a 50 per cent drop in oil prices in 2008 from their peak levels ended a six-year boom, fuelled in part by high oil prices. Sales, profits and asset prices all declined. Property prices likewise dropped 50 per cent from their pre-crisis peak in 2008. In Saudi Arabia the stock market lost up to two thirds of its market capitalisation.80 "Cheap money, leverage and expectations of ever-rising property prices generate 'hot money inflows' which ultimately reverse in spectacular fashion when the bubble bursts." According to several reports, funds from doubtful sources helped fuel the boom. In early 2008, "authorities embarked on a series of high-profile corruption investigations at some big real-estate and finance firms".

The sukuk market "has not escaped the throes of the credit crisis [...] with investment banks and finance houses worldwide still reeling from the collapse of the U.S. sub-prime mortgage market and the breakdown of the wholesale money markets amid persistent counterparty risk concerns and deep-seated investor distrust in credit-sensitive assets". Since the crisis started, approximately US$430 billion of planned development projects, the majority of them in Dubai, have been cancelled (Wilson ,2005 , pp. 27).

Poor investment decisions contributed to the problems. "Many of the high profile sukuk defaults have taken place as the result of poor business decisions, not Shariah."87 With the onset of the economic and financial crisis in 2008, the market for luxurious properties weakened. In 2009 oil prices fluctuated between US$35 to US$80 per barrel. Sales and rentals of properties slowed. There was not enough demand for the newly constructed facilities to generate the income necessary to pay offall the commitments on a timely basis.

In the first half of 2009 Nakheel, which issued sukuk guaranteed by Dubai World but not the Government of Dubai, declared a loss of US$3.65 billion. This compared to a profit of US$722 million during the same period a year earlier. Losses were attributed to slower sales and write-downs in the values of properties. On 22 February 2009 the Abu Dhabi-based central bank of the United Arab Emirates bought US$10 billion of sukukfrom Dubai. Two banks backed by the Government of Abu Dhabi bought another US$5 billion of Dubai Worldbonds. In October 2009, one month before the call for a standstill on sukuk issued by Nakheel, Dubai sold an additional US$2.5 billion of sukuk.

When the economic downturn came, sales and rentals of newly constructed waterfront residential and commercial properties did not generate enough revenue to redeem the assets underlying US$4.1 billion worth of sukuk, the largest ever issued, which matured on 14 December 2009. On 25 November 2009, in a 200 word statement, Dubai World announced that it was seeking six additional months to repay $26 billion of maturing liabilities, including the US$4.1 billion Nakheel sukuk due on 14 December 2009. The announcement sent shockwaves through the global financial markets, raising fears of default on sovereign debt, and triggered an extensive capital flight. "Credit-rating agencies quickly downgraded all governmentrelated debt."The subscribers (buyers) of the sukuk issues comprised both foreign and local investors. A refusal to grant a standstill or restructuring would trigger default and formal bankruptcy proceedings. Such proceedings would have been complex due to the fact that a number of the sukuk agreements lacked clarity regarding the rights and obligations of the counterparties.

Few laws exist in Dubai to govern bankruptcy proceedings: "the prospect of losses has forced creditors to think about some of the uncertainties surrounding Islamic default. One issue is enforceability: many sukuk contracts are governed by English law but refer to assets located in the Gulf."95 Investor confidence has been damaged in the wake of "uncertainty about investor protection".Many investors assumed that the debts were "backed by the government of Dubai, and ultimately by Dubai's oil-rich neighbour, Abu Dhabi".On 30 November 2009, however, the Government of Dubai announced that it did not guarantee the debts of Dubai World. This prompted fears that its creditors could lose billions of dollars. "Many creditors had assumed that the structure of Islamic bonds implied there was state backing for this type of financing."98

In a television interview on the same day, the director-general of the Department of Finance, Abdul Rahman al-Saleh, announced that lenders to Dubai World were in for "short-term pain". Creditors need to take part of the responsibility for their decision", he stated. "The government is the owner of the company, but since its foundation it was established that the company is not guaranteed by the government. These announcements "reminded investors that tacit sovereign guarantees may be worthless. Nakheel sukukpromptly fell to 38 cents on the dollar. Following the announcements, fears surfaced that sukuk failed to provide the same legal protection as conventional bonds. The concern is that sukuk creditors may not be protected. Holders (buyers) of sukuk realised that they had a "limited ability to lay their hands on their assets".There was uncertainty as to whether the sukuk holders would be legally able to take possession of assets underlying the securities in a time of distress.

With English and American law one can predict the outcome but there is more uncertainty in Dubai as there has never been a major corporate insolvency. The issues could be heard in an English court if the relevant documentation allows it but enforcement might have to take place in Dubai. There is no precedent for this kind of eventuality. The system has not been tested. Because sukuk were subject to overlapping regulatory jurisdictions (of the shari'ah in Muslim countries and conventional law in non-Muslim countries), it would be difficult to take possession of the underlying assets.It became apparent that UAE law places restrictions on foreigners dealing in sukuk, and while it's true that thesukuk market is governed by English law, and comes under the jurisdiction of the British court system, the enforcement of this requires the consent of the UAE authorities. This means that sukuk holders are at the mercy of sukuk issuers, limiting their legal options . On 14 December 2009, just hours before US$4.1 billion of sukuk was due, Abu Dhabi announced a US$10 billion loan to Dubai.106 In March 2010, Dubai presented another rescue plan of US$9.5 billion. On 20 May 2010 Dubai World announced that it reached agreement with a group of creditors to restructure US$23.5 billion of liabilities.

The 97 creditor banks of Dubai World include four British banks, HSBC, Lloyds, RBS, and Standard Chartered. Others include the Bank of Tokyo-Mitsubishi, Abu Dhabi Commercial Bank and Dubai's Emirates NBD bank. These seven banks hold 60 per cent or US$14.1 billion of Dubai World's debt. Lenders will wait up to eight years to get their US$14.4 billion back but have avoided a 'haircut' on their principal under the terms of the deal, which offers 1 percent cash interest and an extra 1.5-2.5 percent per annum rolled up into a lump sum payment on maturity.

During the recent economic crisis stock and property markets fell in the Gulf countries just as they had declined in the rest of the world. All markets experienced reduced growth, lower asset prices and reduced liquidity. Structuring sukuk to resemble conventional bonds brought into being a new type of risk, the asset redemption risk which is analogous to the risk of default on conventional bonds. The asset redemption risk does not arise in relation to risk sharing instruments, because they do not oblige issuers to refund the initial amounts invested. Investors are free to recover their investments by selling their sukuk in the secondary market. When losses are experienced by issuers of PLS instruments, they declare a 'loss', and the loss has to be absorbed by the sukuk holders. In times of distress there are no defaults, only losses.

The requirements to 'repay' the initial amounts raised (and to pay pre-determined dividends) committed issuers to provide contractual certainty on the basis of an uncertain economic environment. By agreeing to these terms, investors exposed themselves to the asset redemption risk, and thus to the possibility that issuers might not be able to redeem the underlying assets by 'repurchasing' them on their respective due dates.

Conventional bond market

By its clear profitability, reduced risk and correlation characteristics, bonds indexed to inflation can be considered as an alternative investment with an undoubtedly attractive. Thanks to the structure of these bonds, the investor has an investment that reports a real return, allowing preserve along the while its purchasing power. If inflation expectations are an investor higher than the discounted market is preferable investment in bonds indexed to inflation (also known as bonds "indexed or linked" to the inflation), in the opposite case, if inflation expectations are lower investor to the market, the best choice will be to traditional bonds.

In terms of duration, it is twofold interpretation: if consider the duration of a bond is a measure of the time sequence all flows of the bond, it would seem that the duration of indexed bonds is greater than that of conventional bonds because interest payments on these bonds increases with the passage of time and are relatively small compared with the principal of the bond at maturity. The uncertainty about future inflation is a risk that has always been present in traditional bond investors, particularly when levels of inflation were substantially higher than the current ones. Today, low levels of inflation, it is not impossible that we return to the context of higher price levels. Onsite inflation risk is reflected most clearly in the long end of the bond curve the traditional short length, where the inflation forecasts are relatively more accurate.

One of the main reasons why some have shown Treasures reluctant to issue indexed bonds is the fear of increased costs indebtedness, as a result of the segmentation of the whole market sovereign debt. This segmentation would imply a decline in the liquidity of the bonds traditional, which ultimately unclean investors would demand higher returns in terms of liquidity premium. However, the payment savings of interest is one of the main reasons that can lead to the Treasures issuance of debt indexed to inflation. Finally, another important advantage is linked bonds information that can provide monetary policy makers about real rates at any time and inflation expectations market.

For example, we have a conventional bond with a nominal yield 8% and accused of similar maturity bond with a real return of 4%. The difference between the two, of 4%, is made ​​up of inflation expectations and the premium inflation aversion. If after 6 months the profitability of both bonds has fallen to 7.5% and 3.5% respectively, maintaining their difference, therefore, at 4%, the monetary policy makers may see the decline in rates during this period was not due to improved inflation outlook future but a decrease in the actual types. Having a tool that allows observed at any time future inflation expectations can facilitate largely the work of the monetary authorities can gain agility in its decision making.

Conventional bonds issued by the government, are part of the borrowing program, intended to fund, in whole or in part, the lack of income over public spending. Government bonds are usually issued form the largest domestic bond market. Demand for government bonds is determined primarily by institutional investors. Lower the safety and marketability of corporate bonds means that investors required margin of return over the return of relevant government bonds, to encourage them to hold corporate bonds. The size of the margin yield depends on the security and marketability of debt. Relatively low security and marketability will mean higher margins, while more security issues will have a small margin in comparison with the equivalent public bonds.

Some conventional bonds have a reservation for early repayment, or "recall" (redemption provisions, call provisions), which allows the issuer (or its obligation) to buy them back from investors to maturity upon the occurrence of a predetermined date, paying with their nominal value. Bond issuers sell bonds puttable, or reviews (callables), to give leeway, retaining the right to redeem the bonds before maturity after a predetermined date. This right is essential to the issuers of bonds in the face of falling interest rates, as it allows them to withdraw from circulation the existing debt, issue new - for the same amount, but at a lower interest rate.

In the case of "reviews" bond investors returns the nominal amount of the debt in cash, at which time a much less attractive opportunity to reinvest in more expensive instruments with lower returns. This risk is called reinvestment risk. Investors who wish to avoid this risk may acquire irrevocable bond (bullets) with a fixed maturity date, produced at a time, which is not provided for the possibility of early retirement. Profitability of this type of market tends to be lower than that of callable bonds, but the issuer cannot force the bondholders to repay them by the deadline, regardless of changes in the level of interest rates.

There are so-called bonds with an option to "put" (put bond), which, on the contrary, give the investor the right to require the issuer to redeem their paper that upon the occurrence of a specified date prior to maturity. Investors usually use it right when they need cash or when interest rates rise significantly in comparison to the level at which they were at the time of the bond issue. In this case, the bondholders may be re-investing the money in securities with a higher interest rate.

Before you buy a bond, the investor should determine whether the conditions of the sale include a reservation for early repayment, and, if available, to make sure that it will receive income, calculated on the first possible date of early redemption, not only the income on the date of maturity. Bonds sold it subject to early redemption, usually bring a higher annual income to offset the risk associated with the possibility of early retirement.

CHAPTER 03: METHODOLOGY

Research method

This project related to Sukuk and conventional bonds requires us to use both a quantitative and qualitative approach; therefore a mixed method strategy will be used. The most popular research approaches used to make informed scientific decisions include qualitative and quantitative methods. Differences between quantitative and qualitative research lie in their approach to recognition of the problems in research and the literature reviews. The two approaches have different strategies in specifying the purpose, data collection, data analysis, reporting, and evaluating research. In identifying a research problem, Creswell (2006) claimed that it is descriptive and explanatory for quantitative but exploratory for qualitative research. (Carolyn 2008, 175)

Quantitative research uses scientific methods to investigate phenomena and address issues and problems. These methods utilize an objective manner that enhances the reliability of the information and reduces biases. Qualitative research answers questions and discovers fresh information in a natural setting. This approach attempts to understand all aspects of people’s behaviors, attitudes, and experiences. To address the research questions, the qualitative approach depends on four main data collections strategies: participation, observation, interviews, and analysis.

Qualitative research explores a given phenomenon in order to provide further understanding and enhanced knowledge. Qualitative research questions are generally broad and the numbers of subjects in the study can be small. In qualitative methods, the researcher depends on the observations or experiences of the participants. Creswell (2006) stated that numeric data and analysis through statistics formed the basis for quantitative research. Questions were more apt to be specific and involve large numbers of participants. Statistics allowed the researcher to recognize trends and ultimately find ways to explain the relationships of the subjects to the element studied, or vice versa. (Anthony 2005, 142)

Both the qualitative and the quantitative approach proved beneficial to explore and explain important issues within the different disciplines. Both approaches offered important scientific knowledge that answered many questions and addressed multiple issues. Qualitative and quantitative approaches could be complementary to one another. Using both methods could produce stronger evidence to use within multiple fields, particularly within. (Carolyn 2008, 176)

Data Collection Method

The data collection method employed in order to study Sukuk and conventional bonds we will use both survey questionnaire and secondary data collection. For the purpose of this research, the questionnaire survey will be employed to gather the records from the participants. The sample participants will be 4 members from the pool of service users and managers. With the consent of the participants their data will be gathered and the researcher’s own moral principles would be clarified to everyone involved in this and cooperation will be ensured. The potential conflict will be resolved in the initial stages of the study. (Vicki 2008, 78-80) The technique in which the qualitative and quantitative techniques are used collectively for data collection purpose is called mixed research. Mixed research method is the third most important. The results of the mixed methodology are more reliable because it is more descriptive in nature.

The methodology supporters generally stick to the philosophy of pragmatism and the compatibility thesis. The concept of compatibility thesis is that the quantitative and the qualitative methods both are related and compatible to each other. Their combination can be used to analyze the data in one research. On the other hand, the pragmatism philosophy suggests that the techniques used for the data analysis should be such that provide the proper and practical result and approaches are also applicable in the real world. Nowadays, the mixed method supporters use the fundamental principles of mixed research and this principle suggests that the researcher must use such approaches, which collectively have more strength and less weaknesses. This way the results would be more validated and accurate.

Mixed research method will be used to for data collection of Sukuk and conventional bonds. In mixed research method, the researcher has to gather both primary and secondary information for study in order to obtain a more extensive analysis of the research problem. Primary research is conducted through interview questionnaire and the data collected from it is utilised for the analysis of the study. Secondary research is conducted through many sources such as both online and public libraries. These databases enable access to many libraries that contain surplus of information and current knowledge. Internet is also a major source for gathering information. Data about almost all fields of study is available and can be accessed easily. The secondary data can also be collected by reviewing past publications including newspaper and online articles. (Creswell 2006, 25-60)

Search Strategies And Keywords

EBSCO, JSTOR and other related electronic databases & academic journals will be used to gather the academic literature and data. Deming (1990) has defined secondary data as a type of data, which other researchers have compiled for completely different research objectives or research problem. He has made a statement that a few questions of research could be answered only through using secondary data; however, there are some risks involved, as well, because other researchers had compiled that data for a peculiar purpose and; therefore, there are chances that this data could be biased in nature. In this research, the researcher has used sources for collecting data that are dependable for collection of secondary information. The researcher has collected data for the review of literature and answering the research questions from different libraries.

Project Timeline

We estimate that the study would require 17 weeks to complete. The detailed estimate is shown below:

Week 1-4: Extensive Literature Survey (secondary research) to concretize the problem as well as the opportunity.

Week 5-10: Design of the e-survey for experts in the field of customer care and to reach out to these experts in the countries of interest.

Week 11-14: Analysis and interpretation of the data to formulate results. This will lead into the final discussion and conclusions.

Week 15-16: Writing of the dissertation Report

Week 17: Revisions based on the feedback.

We intend to seek guidance on all of these steps every week, showing the progress made to our Supervisor.

Confidentiality

Confidentiality is a vital part which needs alert consideration within the research process. The researcher carefully considered confidentiality in the study for both qualitative and the quantitative phase. The qualitative sample included a purposeful selection of samples based on their knowledge of the essential trend. The collection will guarantee the privacy and confidentiality of the participants. Only the researcher will approach potential participants. (Tashakkori 2008, 42)

Validity

Validity assesses if the interpretation and meaning of an experience is thorough or if a specific quantity is a correct expression of intent. The validity of data needs to be carefully checked. Classifying the data can help the researcher reach important conclusions and uncover the results that led to such conclusions.

Researchers may check for validity in several ways. These include comparing findings of one instrument with findings from other instruments and conducting joint observations or collaborative marking of the same tests. Checking validity could also include returning draft reports to respondents for accuracy checks, considering opposing explanations for the issue or question, and conducting multiple observations of the same event. The researcher can also enhance respondent validity by asking the participants to check their interpretations of the information provided or observed.

Another option to insure validity when seeking data is to use a pre-designed measurement such as an existing instrument previously tested and found valid. Ensuring validity can be difficult and should be taken seriously and carefully and to show the impact of the collected data on the business. Utilizing such methods add certainty that the data collected is valid and useful for planning and decision making processes.

Ethical Issues

The participants of the interviews and surveys will be provided a description of the objectives, scope and anticipated results of the research. The kind of data required will be clearly stated along with the policy of confidentiality.