INSIGHTS

Bonds Vs Sukuk: A Longer Term Look with Perpetuity

Assets have value and include real assets and financial assets. Real assets are physical assets such as land, buildings and gold. Financial assets are claims representing the right to some return or to ownership of physical assets. Tradeable financial assets are also known as securities. A security is a fungible, negotiable financial instrument that holds some type of monetary value.

A bond is a type of asset; They are common and popular low risk securities. However, bonds can be structured in a number of ways to interest different customers with particular risk-return requirements. This paper considers the Shariah compliance of perpetual bonds and looks at a proposed alternative in the form of perpetual sukuk. At the heart of things, a bond is a type of investment that represents a loan between a borrower and a lender. Think of it as similar to getting a personal loan from a bank – except in this case you are the lender (known as the investor or creditor) and the borrower is generally a government or corporation (known as the issuer). With bonds, the issuer promises to make regular interest payments to the investor at a specified rate (the coupon rate) on the amount it has borrowed (the face amount) until a specified date (the maturity date).

The paper then shares findings on the nature of perpetual bonds. Perpetual bonds are fixed income securities without any maturity dates tied to it. Perpetual bonds are ranked higher than normal equities and classified to be junior to bonds with a defined maturity. Perpetual bonds are also commonly known as “Perps” or “Consol”. The interest on the principal amount is paid out in perpetuity. In essence, the notion of perpetual bond is quite similar to a dividend-paying share in the sense where as long as investors are in possession of the bond, they will be getting a recurring interest pay-out for as long as the bond is with them

Perpetual bonds differ from ordinary bonds in that perpetuals have no maturity date, usually have a callable feature, the coupon is not guaranteed and resembles equity in some aspects.

The paper identifies several benefits of perpetual bonds including holders being able to receive fixed interest repayments on a fixed schedule for an indefinite amount of time, step-up features, higher yield rates and secondary trading services. Some of the disadvantages includes holders not having any control over when the bond will be redeemed, issuers not being obliged to redeem perpetual bonds and investors bearing with the credit rating of the issuer for a very long period of time

The paper unravels the Shariah non-compliance issues in perpetual bonds and highlights how a loan (Qard) is considered a gratuitous contract, and it is commendable for a lender to provide a loan to a borrower who is in need of money. Both the Qur’an and Sunnah promise reward to a lender who provides a loan to a person in need. The fact that the Shariah prohibits the lender to derive any conditional benefit from the loan further emphasises its gratuitous nature. It also implies that the loan contract should not be used for profiteering purposes.

The paper highlights perpetual Sukuk as a Shariah compliant alternative. The AAOIFI Shariah Standard No.21 proposes an alternative to bonds by stating:

“The Shari’ah substitute for bonds is investment Sukuk.” The overall risk profile and economic return for a Sukuk investor has some similarities albeit differences to a conventional bond where the bondholder is a debtor of the issuer

Perpetual sukuk are debt securities with no fixed maturity date. They are regarded as hybrid securities because they are a debt security with equity-like features due to the absence of maturity, hence such Sukuk are treated as equity rather than debt. Perpetual Sukuk are viewed as part of capital due to the absence of a redemption date.

In the last decade, a number of Islamic banks have issued perpetual Sukuk to strengthen their Tier-1 capital requirements to comply with the Basel III regulations. Abu Dhabi Islamic Bank recently issued a $750 million perpetual Sukuk which was based on Sukuk al-Mudharabah. Corporate institutions have also issued perpetual sukuk to raise capital. Malaysia Airline System Berhad issued a perpetual junior sukuk whilst Malaysia Airports Holdings Berhad issued a perpetual subordinated Sukuk both based on Sukuk al-Musharakah.

Some of the features of perpetual sukuk highlighted in the paper are as follows: Perpetual sukuk are contractually subordinate to the claims of external creditors, perpetual sukuk generally carry the right or option of the issuer to redeem the perpetual sukuk, perpetual sukuk provide protection to senior and other creditors.

Perpetual sukuk issued by Islamic banks are used to strengthen Tier 1 (T1) capital. To qualify as T1 capital, perpetual sukuk need to meet Basel III requirements as well as any additional regulatory requirements by the central bank of their respective jurisdiction. Some of the Basel III requirements are that AT1 instruments must not have step-up features or other incentives to redeem, including a call option. Distributions/payments shall be at the full discretion of the financial institution at all times. Write-off or conversion mechanisms for achieving principal loss absorption

The paper ends with highlighting the benefits of perpetual sukuk and highlights their unique balance sheet management tool which is potentially cost effective. These Sukuk denote a non-dilutive way of shoring up capital. They represent a longer-term mode of funding compared to straight or plain vanilla Sukuk. Perpetual sukuk enhance the issuer’s credit profile due to increased financial flexibility and efficient capital management.

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