Are Islamic bonds or sukuks now dead and buried?

The enormous bad publicity surrounding Nakheel’s $3.5 billion sukuk or Islamic bond repayment this month has exposed these debt instruments as nothing more than unsecured commercial bonds, with no recourse to underlying assets in the event of a default.

There is, of course, an irony in that Nakheel actually repaid its sukuk in full and on time thanks to the last minute intervention of the Abu Dhabi Government which dropped the Dubai Government a $10 billion lifeline.

Bond replaces sukuk

Actually it was a $10 billion conventional bond with interest of four per cent payable over five years. Abu Dhabi did not want another Islamic bond. Traditional bond finance is good enough for the richest city in the Gulf.

This does make it very easy to understand the rights and obligations of the parties. Sukuk come in a confusing number of varieties dressed up in an exotic language only understood by Islamic scholars and they seldom agreed on anything (see the ‘Diminishing musharakah’ above).

Yet in the Oil Boom of the 2000s such was the rush to invest in the Gulf States that nobody worried too much about the small print or the niceties of sukuk. Western bankers were assured that sukuk are just bonds under another name. They took the word of the sellers and ignored any protests from their lawyers.

After the Nakheel bond debacle a great many more questions will be asked about sukuks by both local and international lenders. For anybody trying to actually borrow money they will likely be more of a curse than a blessing, and a reversion back to more conventional financial instruments is clearly going to follow.

There will be exceptions to this rule. Saudi Arabia is the kingdom of the sukuk where all banks are Islamic, and not paying interest is highly profitable when your customers accept it, although the rental payments on sukuk should in theory amount to the same thing.

Financial innovation

Otherwise, it is perfectly normal after a boom period and what might be described as ‘financial innovation’ for there to be a swing back to more conservative banking practices. Lenders will be very particular in their due diligence on sukuk.

Confusingly and very significantly sukuk are asset-based but not asset-backed, so unlike a mortgage-backed security, for example, investors have no security over the asset if the issuer gets into financial difficulties and can not pay up.

No doubt sukuk will continue as a part of Islamic finance but their role in larger scale financing may now be sharply reduced.