As 2015 settles in, the search for funds among private firms, government agencies and the Treasury is expected to gain traction, with fundraisers targeting all potential avenues, including Sukuk and diaspora bonds.

Last year, Kenya’s National Treasury indicated it would issue its debut Sukuk in the next financial year, as the instrument emerges as a potential gamechanger in Africa’s financial sector.

Sukuk is the Islamic equivalent of bonds, and it is structured in such a way as to generate returns to investors without infringing on Islamic law (which prohibits riba or interest).

Shariah-compliant financial structures and products are growing rapidly and becoming an integral part of the mainstream global economy and changing the financial landscape. This rapid growth is driven by the interest in Islamic finance by conventional financial institutions and its integration with the conventional financial architecture.

The sustained increase in commodity prices and huge levels of foreign direct investment has compelled many countries and multinationals to venture beyond their borders in pursuit of investment opportunities, leading to the emergence of innovative Shariah-compliant products and structures.

These Islamic financial solutions are often demand-driven, largely by investors who have strong preferences for products that are compatible with their faith.

Considering the growing share of global GDP of the predominantly Muslim countries and the huge youth demographic composition of these countries, we are bound to see more demand for Shariah-compliant products and solutions in the coming years.

One key area that has witnessed accelerated development in Islamic finance is the global Sukuk market, which has reached a value of $270 billion.

Sukuk offers a wide range of benefits to the economy in terms of liquidity management, fundraising, balance sheet management and securitisation.

A mix of Sukuk actively traded in the secondary market helps to manage liquidity for the Islamic financial institutions. For instance, a bank with excess liquidity may opt to invest in Sukuk that affords it a return. It can also be traded in the event of need.

Debt and equity

Sukuk can also serve as a tool for fundraising to fulfil corporate objectives when the need for funds arises. In the event of a need to have an optimum balance between debt and equity on the corporate balance sheet, Sukuk offers a solution: To unlock funds tied up in assets through monetisation for the purpose of reinvestment.

In the conventional financial markets, firms or borrowers engage banks to access loans or tap into the capital markets.

The conventional banking market is viewed as the indirect financing market since the borrowers or the firms deal with banks that play an intermediation role by channelling the surplus funds mobilised to the parties in need. The capital market is seen as direct financing because the firms directly engage with investors without going through the market.

In the conventional structure, the bonds serve as evidence of a loan from an investor to the issuer and the repayments reflect both the loan capital as the principal and the interest. Sukuk is an equivalent of a bond: A “document or certificate that represents the value of an asset.”

The other instrument often used in the conventional debt market is asset-backed securities (ABS), which involve owners of income-generating assets selling them through a securitisation transaction or monetisation of the originators’ assets. The repayments to the investors are realised from the cash flows generated by the asset under the ABS structure.

While the Shariah-compliant structures do not allow the sale of conventional debt, the ABS market has a significant proportion of assets with underlying receivables that may include mortgages, credit card receivables and other loans.

The structuring of Sukuk is based on the relationship in the primary market. If the investors’ interest is to enjoy returns, then the primary relationship cannot be a loan transaction. The underlying asset should not include receivables that are traded at a discount or premium.

In the secondary market trading of Sukuk, there is a need to appreciate the underlying asset they represent and the fact that the Shariah standards do not allow the secondary trading of Sukuk that are represented by debts as the underlying assets.

We also have the asset-based and asset-backed Sukuk, whose differences are reflected in the role of the asset in the structure and recourse available to the holders in the event of default.

In the asset-backed Sukuk, the underlying assets serve as the sole recourse for the investors. In the asset-based Sukuk, the holders may not necessarily obtain the asset in case of default, unless the assets are charged as security. Their recourse will be to the obligor because, in case of default, the asset will be sold back to the obligor at par.

Sukuk offers opportunities for diversification into multiple asset classes for investors. Since it operates on the basis of underlying assets, it limits the opportunities for over-exposure of accessing financing beyond the value of the underlying assets, thus reducing the prospects of over-indebtedness and its harsh consequences for the stability of the financial market.

Beneficial ownership

It also affords the investors the opportunity of direct participation in the projects and enjoying the beneficial ownership in the underlying assets, with the right to receive a share of the rental income or profits from the same asset while bearing the associated risk of such ownership.

Given the huge financing requirements for infrastructural development to support economic development and the competing needs for government budgets, Sukuk markets have the potential to be a good source of funding for long-term projects. There is a need for governments to put in place the appropriate legal, governance and regulatory framework to facilitate the issuance of Sukuk.

An issue of concern is the prohibitive costs that may stem from taxation associated with the sale of the underlying asset or returns due to the Sukuk holders that may either be taken as a return from a debt instrument or taxed as in the case of dividend in an equity case.

The proactive management of the tax regime serves to foster the growth of the Sukuk market that helps to complement existing initiatives that seek to channel the world’s growing pool of Shariah-compliant capital to promote development in line with the tenets of Islamic finance, which focuses on social justice and welfare in all economic activities.

The writer is the head of Islamic Banking at KCB Group.