Topic 12ISLAMIC INVESTMENT

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ECON 3430 - Islamic Banking and Finance

2. CAPITAL MARKETS

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Capital market involves long-term investment; maturity of greater than a year

Issued by large corporations and governments

2 major instruments: Debt-based vs Equity-based instruments

1. Role of investors: capital provider vs owner2. Payment: fixed payment vs profits3. Default: priority claimant vs residual claimant

Shariah principles on equity investment

1. Prohibition of riba (no guaranteed fixed return), gharar

(excessive uncertainty) and maysir (gambling/game of chance)

2. Primary business activity must be halal

3. Majority of assets must be illiquid

4. Non-permissible income must be below a specified benchmark

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The market offers a deep pool of Shariah approved equity securities

with accompanying benchmark indices, Islamic bonds and Islamic

unit trusts

Other conventional products such as warrants, call warrants,

crude palm oil, future contracts and asset back securities are also

deemed to be Shariah approved.

The growing popularity of such securities has led to the

introduction of the KLSI (Shariah index) in 1999

Shari'ah Compliant Stocks in Bursa Malaysia (As of November 2011)

Screening Methodology forShari'ah-Compliant Stocks

Currently there is no international Shari'ah standard for stock screening

Different funds or fund managers utilise different standards based on their respective Shari'ah councils

In Malaysia: list issued by Shariah Advisory Council of Securities Commission, Dow Jones-RHB Islamic Malaysia Index and FTSE Bursa Malaysia, namely FBM Hijrah Shariah Index and FBM EMAS Shariah Index

At global level: there are Dow Jones Islamic Market Indexes, FTSE Global Islamic Index Series, S&P Islamic Index Series, MSCI Islamic Index Series

Screening Methodology for Shari'ah-

Compliant Stocks

Various types of screening criteria depending on SAC decisions 1) Securities Commission of Malaysia: central level; screening based on core

activities and benchmark of tolerance for mixed activities

2) Pakistan uses Meezan Bank Islamic Fund criteria: screening based on permissibility of underlying businesses and balance sheet composition benchmarks

3) Dow Jones Islamic Index and FTSE: screening based on primary business activities and acceptable financial ratios

(and more)

Shari'ah stock screening

Rules to ensure that ordinary shares are Shari'ah compliant

In general, the stock screening process are divided into two

stages:

1. Evaluation in terms of company activities, products and industry

2. Computation of a set of financial ratios & compare them against

specified benchmarks

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8Shariah benchmark for listed shares

1a. Primary Activities Criteria

1. Conventional finance (riba)

2. Gambling/gaming (maysir)

3. Prohibited goods & services

Pork, alcohol, prostitution

4. Conventional insurance (gharar)

5. Entertainment deemed non-permissible

6. Tobacco manufacturing or sale

7. Stock-broking or share trading in non-Shariah approved securities

9Shariah benchmark for listed shares

1b. Mixed Company Criteria [applied to revenue & profit before tax ]

5% Benchmark

Clearly prohibited activities conventional banking, gambling, liquor, pork

10% Benchmark

umum balwa (prohibited element affecting most people & difficult to avoid)

e.g. interest income from fixed deposits in conventional banks, tobacco-related activities

25% Benchmark

maslahah to the public

e.g. hotel and resort operations, stock-broking

2. Financial filters is also used to refine the selection

Use of selected financial ratios and compare them against their respective

benchmarks to weed out non-Shariah compliant stocks

In general these ratios can be categorized as liquid assets, interest income and

leverage

Ratio benchmark ranges from:

Liquid asset: 17% to 49%

Interest income: 5% to 15%

Leverage: 30% to 33%

Data are taken from:

Balance Sheet

Income Statement

Macroeconomic date (in the case of DJI)

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Securities Commission of Malaysia applies additional criteria to companies which are involved in multiple industries, i.e., companies whose business activities comprise both Shari'ah permissible and non-permissible elements.

Analysis is done at the holding company, subsidiary company and associate company levels. Criteria include:

1. Core activities of the company are activities not against the Shari'ah principles as mentioned earlier

2. Haram element is small compared to core activities, i.e., compared against benchmark

3. Public image/perception of company is good4. Core activities of the company are important and of public interest (maslahah) to the

Muslim ummah and the country5. Proportion of haram element is small and in matters such as umum balwa (common

plight), uruf (customs) and rights of non-Muslim community which are accepted by Islam

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It maybe possible that a company is in industries which are Shariah

compliant but the revenue from the subsidiary whose activities are not

Shariah compliant may lead the company to be considered as non-Shariah

compliant

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Consequences of non-standardization

1. Slow development due to lack of confidence in shariah-compliancy of products

2. Lack of generally accepted operational standards : criteria for determining shariah-compliancy of the stocks need to be improved and unified across jurisdictions

3. Weak regulatory environment

4. Fund managers cannot benefit from economies of scale: Islamic capital markets are segmented across countries and regions, thus reducing the effective available size and riskreturn spanning possibilities to investors

Islamic Investment: Sukuk

Definition of Sukuk

Literally means written document: A document or certificate whichrepresents the value of an asset

investment Sukuk are certificates of equal value representingundivided shares in ownership of tangible assets, usufruct andservices or in the ownership of the assets of particular projects orspecial investment activity[] (AAOIFI Standard 17)

Technically defined, sukuk are financial securities of equal denominations representing undivided ownership interests in a portfolio of eligible existing and/or future assets, usufruct, services, and business activities (Ali, 2008, p. 4)

It is an ownership claim to an asset or a pool of assets, but not a financial claim to a cash flow or receivables as in conventional bond

Sukuk holders receive returns from the underlying assets

SUKUK-DEFINITION

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AAOFI defines 14 types of Sukuk, the main ones are:i. Ijara Sukuk (leasing)

ii. Certificates of ownership of usufructs (e.g. Sukuk Manfaat Al-Ijara)

iii. Salam Sukuk (deferred commodity delivery)

iv. Istisnaa Sukuk (manufacturing or project finance)

v. Mudarabah Sukuk (partnership/finance trusteeship)

vi. Murabaha Sukuk (purchase order)

vii. Musharaka certificates (Joint Venture)

Salient Features of Sukuk

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Asset-backed, stable income, tradeable, shariah-compliant trust certificates

Not simply a claim to cash flow but an ownership claim

Return derives from yield generated by clients lease of the asset

Shariah legitimacy of sukuk lies in the fact that they do not take advantage of interest rate movements Sukuk are directly linked to real sector activities: will not create short-term

speculative movement of funds and potential financial crises

Investing in sukuk involve funding of trade or production of tangible assets

SUKUK-BONDS COMPARED

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SUKUK BONDS

Represent ownership stakes in existing and/or well defined assets

Represent pure debt obligations due from issuer

Underlying contract for sukuk issuance is a permissible contract such as a lease or any of the other categories defined by AAOIFI

Core relationship is a loan of money, which implies a contract whose subject is purely earning money on money

Underlying assets monetised in a sukukissuance must be Islamically permissible in both their nature and use

Bonds can be used to finance almost any purpose which is legal in its jurisdiction

Asset-related expenses may attach to sukuk holders

Bond holders are not concerned with asset-related expenses

Sukuk prices depend on market value of underlying asset, apart from obligors creditworthiness

Price depends solely on issuer creditworthiness

Sale of sukuk represents a sale of a share of an asset

Sale of bond is basically the sale of a debt

050,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

500,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Sukuk Conventional

Types/RM Billion 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Sukuk 38.46 54.71 71.06 88.37 88.37 120.12 146.44 199.45 211.37 248.47 294.19

Conventional Bond 224.91 245.94 236.01 276.28 284.20 297.83 306.10 358.04 374.59 395.36 469.18

263.37 300.64 307.07 364.65 372.57 417.95 452.54 557.48 585.96 643.83 763.37

Malaysia: Amount of sukuk and conventional corporate bonds outstanding, 2000 to 2010

Issue-Secondary Marketing (Bay Ad-dayn)

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Tradability of bonds in secondary market is a key feature of bonds-To provide liquidity options to the investor

-Without a liquid secondary market, bonds are not attractive to investors

With this debt-based bond, object of trade is debt (dayn)-The debt is the right to future cash payments or the financial claims

-Controversy on permissibility of bay-ad-dayn

Securitization

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issuerlender

owes

BHD

10K

IOU paper

Break up payments into periodic payments

Can sell to C,D,E (LIQUIDITY POTENTIAL)

IOU- financial liquidity

-securitizing the debt

(A) (B)

Issue-Secondary Marketing (Bay Ad-dayn)

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Tradability of bonds in secondary market is a key feature of bonds-To provide liquidity options to the investor

-Without a liquid secondary market, bonds are not attractive to investors

If the sukuk is asset-based (debt), object of trade is debt (dayn)-Controversies regarding the permissibility of bay ad-dayn

Sukuk

Asset Based (Debt)

Murabahah, salam

Asset Backed (Equity)

Mudharaba, musharakah

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Classification of Sukuk

Key difference is the concept of true sale

Asset-based sukuk allows inclusion of the actual asset which may NOT be legally recognized to be owned outright by the sukuk holders

Asset-backed sukuk: grants sukuk holder a share of the asset or business venture, and a share of

risk commensurate with the true sale ownership of the asset

There is a true sale between the originator and the special purpose vehicle (SPV) that issues the sukuk and sukuk holders do not have recourse to the originator

Assets are owned by the SPV, returns are derived from assets, and asset prices may vary over time

The majority of sukuk issues, however, are not asset backed24

Asset-based versus Asset-backed Sukuk

Issue-Secondary Marketing (Bay Ad-dayn)

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Fiqh views in relation to trading of debt (bay al-dayn)

1. Bay al-dayn at par value Unanimously agreed as permissible

Represents the contract of hiwalah (transfer of debt)

2. Bay al-dayn at discount to issuer Unanimously agreed as permissible

Principle of dha wa taajjal (incentive to expedite payment of debt) between

original buyer and seller

Issue-Secondary Marketing (Bay Ad-dayn)

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3. Bay al-dayn at discount to third party (securitization) Disagreement among fiqh scholars

Middle Eastern view unlawful tantamount to riba

Malaysian view lawful extend application of dha wa taajjal to third party

Most common case of secondary trade

Types of Sukuk

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Different sukuk structures:Ijarah sukuk

Ijarah Sukuk

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According to AAOIFI, this specific sukuk are certificates that carry equal value and are issued by either owner of a leased asset or an asset to be leased by promise, or by his agent, the aim is to sell the asset and to recover its value from subscription, in which case the owners become owners of the asset

In essence, lessor chooses to sell leased asset to a number of individuals, then the ijarah certificate should be issued to represent the individuals proportionate ownership in the assets

Holder of this certificate will assume rights and obligations of owner or lessor to the extent of the number of certificates he holds

Company SPV

(Issuer/Lessor)Sukuk

Primary

subscribers/

Investors

Secondary market

Figure 1: Ijarah Sukuk Structure 1 Sale and Leaseback

Trading of Sukuk

2.

1.

3.

1. Company sells leased assets to SPV for an amount required in the financing exercise2. SPV does not hold any cash, thus issue sukuk to raise the required funds. The sukuk- represents investors proportionate ownership of the leased asset4. The company will pay the rentals periodically with a payment of maturity or to incorporate the principal with rentals periodically, hence leasing to own

Company

(Mudarib)

SPV(Rab-al-mal representing

Investors)

Investors

Figure 2: Mudaraba Sukuk

1. Company and Investors enter into a Mudaraba Agreement

2. SPV (managed by Trustee) issues Sukuk evidencing proportionate participation in underlaying Mudaraba venture

3. Investors make proportionate payments to account of Mudaraba capital

1. SPV issues sukuk to investors while using the gathered proceeds to make payment to account for mudharaba agreement.

2. Any profits arising from the mudharaba project should be divided according to predetermined ratio or the originator simply take the mudharib fee.

3. Losses will be borne by investors.

Company

SPV

(representing Investors)

Investors

Figure 3: Musharaka Sukuk

1. Company and Investors enter into a Musharaka Agreement.

2. SPV (managed by Trustees) issues Sukuk evidencing proportionate participation in underlaying Musharaka venture

3. Financier makes proportionate payments to Musharaka

Like Ijarah,and MudhrabahSukuk, Musharaka Sukukrepresents participation certificate where the investor becomes a proportionate owner in the business activity.

1. Company invites investor to a partnership in a specific project.

2. Share profits and Losses

Primary Subscriber

SyarikatNeed fund/ cash

SPV / Sukuk Issuer

2. Fund

1. Asset sale

4. Sukuk BBA

5. Proceed

3. Sell back

Secondary Market

6. Sell BBA Sukuk ( Bai ad-Dayn)

Figure 4. ABBA Sukuk

ABBA Sukuk

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1. SPV sells the asset to the investors with the price of RM300 million in cash after having beneficial ownership over the asset.

2. Such fund of RM 300 million is given to the company for a particular project to which this Sukuk is issued.

3. The investors sell back the asset with RM 300 million and expected return in deferred within the period of 5 years BBA Murabahah

4. SPV issues sukuk BBA on behalf of investors in receiving payment made in part by the SPV and the company.

5. Payment will be made in deferred, thus investors will receive their capital and profit expected within those 5 years.

6. Along that 5 years period, the investors are free to keep and accept the payment in deferment on behalf of SPV or sell it in the secondary market to get the immediate cash. If it is sold, it will use debt selling concept (bai ad-dayn)

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Issuer

Assets Financier

(1) Identifyassets to beacquired by the financier

(2) Financier purchased the asset under the BBA principleat a cost of RM100 mil

(3) Sells assets ata price higher than (2)

say at RM124 mil

ABBA bonds

(4) Issue ABBA bonds as evidenced of indebtedness

Al-Bai Bithaman Ajil Bond (ABBA)

Eg. PLUS RM5.1 billion Sukuk in 2002

3rd Party

Company

SPV Sukuk Investors

Figure 4: Istisnaa Sukuk

1.

3. 2.

1. Istisnaa purchase agreement between 3rd party and SPV. 3rd party is responsible for delivering the goods.2. SPV issues Sukuk to investors. These sukuk are not negotiable and cannot be traded until the asssets are manufactured or constructed.3. Proceeds of Sukuk to purchase the Istinaa assets.4. SPV enters another istisnaa agreement with company where the SPV is responsible of delivering the specified asset to the company at a profit (parallel istisnaa).5. The company does not pay lump sum. Pays profit portion on periodic basis and pays principal at maturity.