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)[1]. 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). Once the bond matures, the interest payments stop, and the issuer is required to repay the face amount of the principal to the investor. Because the interest payments are made generally at set periods of time and are fairly predictable, bonds are often called fixed-income securities.

Bonds are considered debt investments. On the other hand, a stock purchase is considered an equity investment because the investor (also known as the stockholder) acquires a beneficial interest and equitable ownership in the corporation. The issuers of stock or equity are typically companies; issuers of debt can be either companies or governments. While bonds generally don’t provide an opportunity to share in the profits of the corporation, the stockholder is entitled to receive a portion of the profits and may also be given voting rights. Bondholders earn interest while stockholders typically receive dividends. Both may experience capital gains or capital losses if the price at which they sell their holdings is, respectively, higher or lower than the price at which they bought them. Coupon rates are most often fixed – the rate of interest stays constant throughout the life of the bond. However, some bonds have variable or floating coupon rates (interest payments change from period to period based on a predetermined schedule or formula). Some bonds pay no interest at all until maturity. Because bondholders are creditors rather than part owners, if a corporation goes bankrupt, bondholders have a higher claim on assets than stockholders.

The bond contract gives bondholders the right to take legal action if the issuer fails to make the promised payments or fails to satisfy other terms specified in the contract. If the bond issuer fails to make the promised payments, which is referred to as default, the debtholders typically have legal recourse to recover the promised payments. In the event that the company is liquidated, assets are distributed following a priority of claims, or seniority ranking. This priority of claims can affect the amount that an investor receives upon liquidation.

When a borrower issues secured debt securities, it pledges certain specific assets as collateral to the bondholders. Collateral is generally a tangible asset, such as property, plant, or equipment, that the borrower pledges to the bondholders to secure the loan. In the event of default, the bondholders are legally entitled to take possession of the pledged assets. In essence, the collateral reduces the risk that bondholders will lose money in the event of default because the pledged assets can be sold to recover some or all of the bondholders’ claim (missed coupon payments and par value). Thus, senior bonds are a class of debt whose rights with respect to payment of interest and repayment of principal rank ahead of (are senior to) other classes of debt and over all classes of equity by the same issuer. Senior debt is typically backed by a charge over various assets of the debtor.

Unsecured debt securities are not backed by collateral. Consequently, bondholders will typically demand a higher coupon rate on unsecured debt securities than on secured debt securities. A bond contract may also specify that an unsecured  bond has a lower priority in the event of default than other unsecured bonds. A lower priority unsecured bond is called subordinated debt. Subordinated debtholders receive payment only after higher-priority debt claims are paid in full. Subordinated debt may also be ranked according to priority, from senior to junior.

Shariah Perspective

In explaining the Shariah status of bonds, the paper states that bonds are a debt obligation for which the issuer pays a pre-determined rate of interest to the bond holder. There is no investment in any underlying asset; rather, the issuer has a personal right and a liability on his legal personality. A repayment of debt with interest is due to the bond holder. The payment for the bond is effectively a loan (Qard) from a Shariah perspective.

In Islam, 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. Thus, any profit or additional return in lieu of the loan is impermissible and non-Shariah compliant. Both the Qur’an and the Sunnah have prohibited the lender from charging the borrower any additional amount.

Shariah Alternative

Sukuk are sometimes referred to as ’Islamic bonds’ but a more favourable translation is, ’Islamic Investment Certificates’. Under Sukuk structure, the Sukuk holders (investors) enjoy beneficial interest and rights to cash flow from the performance of the “Sukuk assets’. The risk and return associated with underlying assets and there cash flows are passed to Sukuk holders. These assets may be tangible or intangible, existing or described with deferred delivery, usufruct or services. Under Sukuk structure the investors – Sukuk holders – each hold an undivided beneficial ownership in the underlying assets.

The proposed alternatives to senior and subordinated bonds are senior and subordinated Sukuk. Sukuk in essence was designed to provide an Islamic alternative to a bond instrument. Sukuk can be classified in varying ways; Sukuk can be categorised in respect to the contract used in Sukuk, the type of issuer, or in terms of priority upon liquidation or bankruptcy. Senior (unsubordinated) Sukuk and subordinated Sukuk are categorisations in respect to the liquidity management and priority rights to the cash flows from the Sukuk. A senior Sukuk is a type of Sukuk structure in which Sukuk holders get paid in full before other claim holders. This is because the “senior” Sukuk holders have a high-ranking claim over the underlying assets in the event of default or redemption. Seniority means the Sukuk holder’s claims rank superior vis-à-vis others against the issuer, and the Sukuk holders of the same rank (tranche) have similar rights and rank pari passu among themselves.

[1] IIAC (2008), Bonds: An introduction to bond basic, Available from: http://iiac.ca/wp-content/themes/IIAC/resources/146/original/BondsEN.pdf