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An overview of sukuk
Ensuring your Muslim pensions scheme members can invest in more than just stocks
Akbar Muminov
Investment Analyst
Working in investment consulting I never expected my pension to be something I struggle with. Yet, like millions of Muslims across the UK, I find my options limited by my Defined Contribution (DC) Scheme, which lacks a range of financial products compliant with Islamic law (shariah).
Currently, most DC schemes in the UK only provide solely a shariah-compliant passive equity fund – leaving Muslims nearing retirement in a particularly vulnerable position as they are unable to move their pensions into less risky assets.
In a 2022 study conducted by Islamic Finance Guru, which surveyed 600 working professional Muslims, 30% were found to not have a pension, citing a lack of options as one of the key reasons for this. Considering that Muslims make up 4+ million people in the UK, this raises serious concerns that a considerable portion of the population lacks a pension.
The core challenge lies in the prohibition of paying or earning interest under Islamic law, which is intended to prevent exploitative lending practices. While this helps protect individuals from falling into debt cycles, it also inadvertently limits Muslim’s access to lower risk asset classes such as fixed income.
However, the financial wizards of the 21st century have created a viable alternative: Sukuk, a shariah-compliant, bond-like instrument. With a near 25-year track record, Sukuk has become a key asset class for many Muslim investors seeking a more balanced portfolio. Trustees of DC schemes may wish to consider Sukuk as a means of offering members a broader range of investment strategies that align with their members’ needs.
Unlike conventional bonds that guarantee the lender a certain pay out every period, Sukuk investors take on a share of the risk associated with owning the asset.
Understanding Sukuk
Sukuk differs from a traditional bond as it represents ownership in a tangible asset or project such as a property, infrastructure, or business.
The investor is entitled to a share of the profits generated by the asset, whether that is through a certain portion of the issuer’s net income or fixed rental income paid by the issuer.
A simplified example: Joe (issuer) and the pawn shop (investor)
The easiest way to think of Sukuk might be through the lens of a pawn shop example.
Joe, a handyman who needs funds, goes to the local pawn shop and offers to give them his tools in return for £1000. However, as he still needs to work, Joe requests to continue using his tools until he can pay the pawn shop back in 1 year. The Pawn shop, which represents the Sukuk investor, gives Joe two ways to pay for the use of his tools:
- Joe can pay a fixed £20 rental amount for each month he uses the tools, which aligns with an Ijara Sukuk, the most common type of Sukuk.
- OR Joe can pay 5% of his monthly net income, which is currently £20 but may vary over time. This reflects a Mudaraba Sukuk, the second most common type of Sukuk.
At the end of the year, when Joe has sufficient funds, he then repurchases his tools for £1000. The below chart provides a good representation of the real process in the context of our example.
In contrast, under a traditional fixed income system, the pawn shop would take the role of a bank and lend Joe £1000. Joe would then be required to make fixed monthly interest payments, i.e. £20, regardless of his income and repay the £1000 at the end of the year.
This example with Joe comes to show the key difference between Sukuk and traditional fixed income: their contrasting approaches to risk sharing.
Unlike conventional bonds that guarantee the lender a certain pay out every period, Sukuk investors take on a share of the risk associated with owning the asset. If Joe experiences a decline in customer orders for a couple months, or he sees profits fall due to higher taxes, the pawn shop’s return would be affected. This risk sharing mechanism means that both the investor and the asset provider are aligned in their interests, reflecting the foundational values of Islamic finance.
Companies across the world have been exploring this new form of funding. General Electric (GE) made headlines in 2009 for being the first major US corporation to issue $500mn of Sukuk. Investors’ money was used to purchase aircrafts which GE then leased.
Sukuk Funds
Though investors looking to invest in Sukuk face a limited number of pooled funds, options are growing fast. Currently available products include:
- Sovereign Sukuk Funds: Focus on government-backed issuances.
- Corporate Sukuk Funds: Offer higher yields but with more credit risk, similar to corporate bonds.
- Global Sukuk Funds: Include all forms of Sukuk from across the world.
- Green Sukuk Funds: Focus on environmentally sustainable projects, similar to green bonds.
Global Sukuk funds are the most common among the limited number of UK DC pension schemes which currently offer Sukuk. These funds best represent the Sukuk market as a whole and have a range of unique characteristics both similar and distinct to traditional bonds:
Geography
Global Sukuk and global bonds differ greatly in their geographic allocation. While there have been cases of non-Muslim countries like the UK issuing Sukuk, global Sukuk funds are mainly concentrated in the Middle East and Southeast Asia, areas where Islam is the dominant religion. These regions rely heavily on natural resources (meaning they are subject to fluctuating oil prices) and they are susceptible to localised risks, such as geopolitical instability, both of which could negatively impact the value of their Sukuk.
In 2016, for example, Malaysia’s sovereign Sukuk price declined as falling oil prices affected the country’s revenues. Over time, a growing number of frontier markets such as Turkey, Pakistan and Nigeria have started issuing Sukuk to finance their projects. Despite this, geographic exposure differs substantially from a global corporate bond fund, which allocates predominantly to debt from companies or governments in the US and other developed countries.
Global Sukuk Fund
Source: BIS Data Portal
Global Bond Fund
Source: BIS Data Portal
Industry exposure
Guided by Islamic law, the Sukuk industry avoids exposure to sectors like alcohol and gambling.
Instead, being asset focused, Sukuk is widely used by governments and corporations to fund large infrastructure projects such as roads, airports, and public utilities. Particularly in the Middle East, large energy companies like Saudi Aramco have used Sukuk as a means of funding renewable energy project. The large scale of these projects (and government backing) means default risk tends to be low, and the cashflows reasonably predictable over the long term.
For investors interested in the energy transition, Sukuk funds - especially green Sukuk funds - offer a unique opportunity to support a growing trend in emerging markets.
Liquidity challenges
One of the key differences between Sukuk and conventional bonds is the lack of liquidity in the Sukuk market. With fewer participants, transaction costs (spreads) are often large, and investors looking to sell (or buy) large amounts of Sukuk are often forced to do so at a discount (or premium). This issue is only exacerbated by Sukuk’s regional concentration as events can further lead to a sudden shift in the number of buyers or sellers of Sukuk. This is to say, Sukuk fund investors may experience delays or difficulties in redeeming their units and should be ready to pay a wider bid-ask spread than corporate credit as a result of the market’s lack of participants.
Diversification benefits
Despite these challenges, Sukuk offers Muslim investors essential diversification benefits, especially for those only holding shariah compliant equities.
Over the past 5 years, Sukuk indices have shown a weak positive correlation with global equities, primarily due to their asset backed, contractual nature. This diversification is particularly helpful for investors during economic downturns, or periods of equity market volatility.
During the Covid crisis in March 2020, for example, Global Sukuk fell about 10% from peak to trough, in comparison to shariah compliant equities, which fell around about 20%. Since 2005, Global Sukuk Fund returns have been about 4% pa, and have outperformed high yield US bonds by 2.7% over the same period.
Interestingly, data shows that non-Muslims may also find diversification benefits from investing in Sukuk. Over the past 5 years Sukuk indices have shown a relatively weak positive correlation with fixed income and equities, indicating that they can offer further diversification to a traditional bond-equity portfolio. At the same time, Sukuk shows a strong positive correlation with ESG-weighted bond indices, likely due to the overlap between Shariah-compliant and ESG screening criteria. This makes Sukuk an attractive option for investors looking to fund the energy transition outside of North America and Western Europe.
What are the next steps for trustees?
As trustees representing members' investments, it is important to consider Sukuk as a viable option for Muslim members seeking shariah-compliant investment opportunities. Sukuk offers diversification benefits to an equity allocation, and contractual income via its asset-backed structure, making it an ideal choice for DC schemes looking to offer their Muslim members a means to access a greater range of asset classes consistent with their religious principles.
LCP realises the importance of helping trustees offer a range of suitable investment options to their members and as a result is conducting research in this area. For more guidance on how Sukuk could fit into your DC scheme, please reach out to your LCP contact.
