My Say: Sukuk: When debt gets cloaked as equity

This article first appeared in Forum, The Edge Malaysia Weekly, on November 8, 2021 - November 14, 2021.
My Say: Sukuk: When debt gets cloaked as equity
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Islamic finance can offer the world a way out of its current problems with debt. The risk-sharing and partnership contracts of Islamic finance — mudarabah and musyarakah — offer viable alternatives to debt financing.

Conventional finance stands on two main pillars, debt and equity. While Islamic finance has no issue with the underlying philosophy of equity financing, which is risk sharing, debt — where the business risk is transferred to the borrower and the returns are predetermined as fixed interest and independent of business returns — is deemed unfair and so prohibited.

Yet, looking at what is being practised, it is hard to tell that Islamic finance shuns debt. Islamic banking has long been criticised for its reliance on debt-based contracts for financing, but the same seems to be true in the capital market space.

Sukuk are shariah-compliant capital market instruments that are really investment certificates. Depending on the underlying shariah contract, a sukuk can be structured to be debt-like or equity-like. Sukuk structured on contracts, like murabahah and ijarah, mimic bonds. A fixed-rate ijarah sukuk with a predetermined repurchase price can have the exact cash flows of a coupon bond. However, a sukuk structured on risk-sharing contracts, like mudarabah or musyarakah, would mimic equity, with the difference being that these are terminal whereas equity is perpetual.

Despite the availability of alternatives, the vast majority of sukuk outstanding belong to the debt category. Market acceptance, ease of structuring, ease with pricing, ease in rating and so on are the reasons often cited for this. What is truly saddening is that, even though the issuance of risk-sharing sukuk is minimal, they are often embedded with features that either erode or preclude the risk sharing and effectively make them debt-like instruments.

A recent study at INCEIF of all corporate sukuk issued in Malaysia over a 15-year period, found that of the nearly 900 issuances, a mere 86 sukuk were available under the partnership/risk-sharing structure. While all these sukuk were shariah-compliant in form, whether they were risk sharing in substance was the objective of the study. Unfortunately, despite their mudarabah/musyarakah label, not a single sukuk was found to be truly risk sharing. All had clauses that eroded the risk-sharing feature but introduced features that had the binding constraints of debt. For example, through the use of requirements for fixed capital repayment, including of face value, specification of the advance profit payments, the use of reserve accounts to smoothen payouts and the provision of collateral, the risk-sharing instrument was made to behave debt-like. Some 97% required the issuer to repurchase the sukuk at its face value at maturity, exactly as a bond would.

The most blatant was the use of a feature known as tanazul, by which sukuk investors agree to waive returns higher than a predetermined threshold and in return the issuer promises to make up for any profit shortfall below the threshold. This effectively turns the supposedly risk-sharing sukuk into nothing more than a fixed-rate bond. An overwhelming 93% of the sukuk in the sample had this tanazul feature. Such reconfiguration flies in the face of the shariah rationale for the prohibition of debt, that returns should be dependent and not detached from the earnings of the underlying business.

So, why does this happen? It is hard to explain why a sukuk has to be structured on an equity-based contract only to then be subjected to constraints that make it debt-like. Seen from the viewpoint of stakeholders, there is little justification. One may argue that, for sukuk investors, the resulting cash flow certainty reduces risk and thereby their required returns. This in turn results in lower cost of funds to sukuk issuers. But the same results can be achieved and in a more efficient and cheaper way by simply issuing a murabahah or ijarah sukuk. Any knowledgeable market participant should be able to see through the inconsistency of the structure. Keep in mind that while debt is indeed cheaper, it comes with costs. The issuer’s financial leverage increases, its cash flows become more volatile and it becomes that much more vulnerable to external shocks. As companies become more indebted, there is a resulting cost to society from potential systemic risks.

All of these begs the question, why do regulators allow this and what exactly is being achieved when a debt instrument is allowed to be cloaked as equity? Perhaps regulators want to see variety in outstanding sukuk structures, but this is variety in labelling not in substance. Regulatory acquiescence of this practice hinders the innovation and offering of true risk-sharing instruments. For example, a genuine mudarabah-based sukuk would have risk-return profiles that offer the flexibility of equity but with limited and time-specific dilution in earnings and ownership. Such a unique risk-return profile would contribute meaningfully to asset portfolios as the sukuk’s returns would have very low correlation with debt instruments and little, if any, sensitivity to interest rates.

For a world drowning in debt, risk-sharing finance is the way to go. A G30 report on reviving economies post-Covid-19, recommends that policymakers avoid debt and instead use equity or quasi-equity-like instruments to help businesses and industries out of their current quagmire. A mudarabah-based, risk-sharing sukuk would precisely fit such needs. Islamic finance has the instruments to help the world out of its debt problems, what is needed is good thinking and foresight, especially on the part of policymakers, to nudge issuers in the direction of using these in lieu of debt.

Dr Obiyathulla Ismath Bacha is professor of finance at the International Centre for Education in Islamic Finance (INCEIF)

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