Sukuk should be treated as equity

Most Islamic bonds (sukuk) should be treated as equity instruments, a top scholar of a body that sets Islamic financial standards across the Middle East said, marking a shift for Muslims seeking fixed-income returns.

Sheikh Muhammad Taqi Usmani, chairman of the board of scholars at AAOIFI – the Accounting and Auditing Organisation for Islamic Financial Institutions – said two key types of Islamic bonds should not promise guaranteed returns.

"That is the basic objective… from an ideal Shariah point of view you can have either equity or quasi-equity sukuk," Usmani said.

Islam bans lending on interest as usury. Instead, returns derived from underlying physical assets are paid to bondholders. These physical assets may be financed through profit-sharing ventures, such as musharaka and mudaraba deals.

Some 60 per cent of Islamic bonds were structured this way in 2007, ratings agency Standard and Poor's said in a March report.

Islamic banking is witnessing a phenomenal growth in recent years. "Maybe you can have fixed-income in ijara, but not musharaka or mudaraba," Usmani said.

Most Gulf Islamic bonds have been sold with a repurchase undertaking – a promise that the borrower will pay back their face value at maturity, or in the event of a default, mirroring the structure of a conventional bond.

This promise contravenes the obligation to share risk in the case of mudaraba and musharaka sukuk, Usmani said. The bonds should be bought at market value at maturity, turning them into an equity instrument.

Islamic bonds or sukuks based on an ijara, or leasing structure, do allow a repurchase guarantee, as bond returns are derived from rental payments, and not from a joint business venture.

Usmani roiled Islamic bond markets in November when he told Reuters that about 85 per cent of Islamic bonds did not comply with Islamic law because of repurchase agreements.

AAOIFI scholars have since met in February this year to review sukuk guidelines and again confirmed the prohibition on repurchase agreements, although previously issued sukuk were deemed valid.

Commodity murabaha is another mainstay of Islamic banking that has also drawn the ire of top Islamic scholars around the world. By far the most common Islamic financial transaction, the contract involves a bank buying a commodity for a client, who later pays the bank back the commodity cost plus a bank charge.

The contract is often used by clients to secure a loan by selling the commodity again, effectively buying money from the bank for the cost of the profit rate. (Reuters)

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