The Structure and Application of Asset Based and Asset Backed Sukuk

The categorization of sukuk into asset based and asset Backed sukuk is something that is very
recent to the development of sukuk itself. The categorization nonetheless essential not only
for the academia, but also investors who are eager to venture into the world of Islamic
finance and investment especially in Islamic capital market. There are reason for the
categorization that is set to formalize the current practice of Islamic investment in sukuk and
for the most reason, asset based and asset backed sukuk categorization has been popular to
the point it became one of the division between shariah compliant sukuk versus non shariah
compliant (near bond-like).

Usually, sukuk are categorised into two main category; “trade-based’ and ‘participatory” and
this depends on the aspect of issuance whether finance trade or investment. But recently, the
issue of defaults has been highlighted as one of the main reason for the categorisation
between asset based and asset backed sukuk. According to Abdul Karim Abdullah (2012), the
default issue happened in 2008’s Financial Crisis where in the first time, sukuk defaulted in
modern history. Since all defaults were confined to the asset based category, investors were
asking not only why the sukuk defaulted, but why in particular the asset based sukuk
defaulted while the asset backed did not.

Generally, sukuk further classifies into three main category namely; Underlying Shariah
Contracts in Sukuk Structures (sale based, leased-based etc) , Nature and Type of Assets
represented by Sukuk (debt-based, tangible assets, usufructs etc) and Technical and
Commercial Features of Sukuk, where the classification is down further into asset based
(senior unsecured sukuk) and asset backed (secured sukuk).

Asset-based Sukuk

Asset based involve the issuer purchasing the underlying assets and then investing, trading or
leasing them on behalf the investors (sukuk holders), using the funds raised through the
issued certificates (sukuk). This structure, most often, takes the guise of a sale- lease to the
originator and is embedded with a binding promise from the originator to repurchase the
underlying assets at maturity. In this structure, the sukuk holders can only require the
originator to purchase the underlying assets. As such, the sukuk holders have an unsecured
debt claim against the originator embodied in the payment of the purchase price following an
execution of the binding purchase promise. This implies that Sukuk holders don't have full
recourse to the underlying assets and the underlying assets are not used as collateral. Asset-
based Sukuk grant only beneficial ownership to the Sukuk holders, so that in case of default,
the investor would be left without any claim on these assets. In this structure, the originator
typically transfers to the investors only the beneficial ownership of the SPV issuer. But shari'a
stipulates a transfer of assets to Sukuk holders. However, since investors have no recourse to
the assets, the structure doesn't pay any attention to the asset risk, but rather concentrates on
the creditworthiness of the sponsors of the Sukuk.

General Mechanisms of Asset based Sukuk:

It is a kind of securitization of leasing portfolio like as below:

1. Sukuk holders subscribe by paying an issue price to a SPV company.

2. In return, the SPV issues certificates indicating the percentage theyown in the SPV.

3. The SPV will then purchase a portfolio of assets, which are already generating an income
stream.

4. In return, the SPV obtains the title deeds to the leasing portfolio.

5. The leased assets will be earning positive returns, which are now paid to the SPV company.

6. The SPV then makes periodic distributions (rental and capital) to the Sukuk holders.

With an asset-based sukuk, ownership of the asset lies with the sukuk holders via the SPV.
The payment of rentals provides the return and the final redemption of the sukuk is at a pre-
agreed value. As the obligor is the lessee, the sukuk holders have recourse to him if default
occurs. This makes this type of sukuk more akin to debt or bonds.
Asset Backed Sukuk

Asset backed-Sukuk involved granting the investor (sukuk holder) a share of a tangible asset
or business venture along with a corresponding share of the total risk (that is, a share
commensurate with this ownership). In this structure, there is a true sale transaction, where
the originator sells the underlying assets to a special purpose vehicle (SPV) that holds these
assets and issues the sukuk backed by them. The buyers of Sukuk don't have recourse to the
originator if payments are less than usual. A true sale implies that the assets of the issuer will
not be added to the assets of the originator in the event of default and liquidation. The Sukuk
holders must assume any losses in case of impairment of sukuk assets. Asset- backed Sukuk
are, thus, closer to equity than debt and for that reason are not so popular in the market of
Sukuk offerings.

General Mechanism Asset Backed Sukuk:

It is a kind of financing acquisition of assets or raising capital through sale and lease back
like as below:

1. Sukuk holders subscribe by paying an issue price to a special purpose vehicle (SPV)
company.

2. In return, the SPV issues certificates indicating the percentage they own in the SPV.

3. The SPV uses the funds raised and purchases the asset from the obligor (seller).

4. In return, legal ownership is passed to the SPV.

5. The SPV then, acting as a lessor, leases the asset back to the obligor under an Ijarah(lease)
agreement.

6. The obligor or lessee pays rentals to the SPV, as the SPV is the owner and lessor of the
asset.

7. The SPV then make periodic distributions (rental and capital) to the Sukuk holders. Asset-
backed Sukuk certainly have the attributes of equity finance the asset is owned by the SPV.
All of the risks and rewards of ownership passes to the SPV. Hence, should the returns fail to
arise the Sukuk holders suffer the losses. In addition, redemption for the Sukuk holders is at
open market value, which could be nil. We can summarize the differences of these two types
of Sukuk as below table:

The Structure of Asset Based & Asset Backed

BBA Sukuk Structure (Asset Based):

1. Corporation sells certain assets that it owns for RM600 million (on spot payment)

2. The Underwriters will sells the asset back to the Corporation for say RM700 million

(on deferred payment) and issuing BBA Sukuk.

3. The Underwriters will sell the BBA Sukuk to the investors at a discounted price of
RM600 Million.

4. Instead of paying to the Underwriters, the Corporation pays monthly installments to the
BBA Sukuk Holders

5. BBA Sukuk holders will present the BBA Sukuk for redemption at the maturity (say at
the end of 5 years for RM600 million)
 Diagram 2: BBA Sukuk Structure

However there are certain issues regarding BBA sukuk structure that is mostly built on Bai’
Inah and Bai’ al-Dayn which is controversial and they were serious attempts to find more
acceptable, global shariah compliant sukuk structure. Thus, sukuk with ijarah basis were
emerged to replace sukuk on BBA basis.

Diagram 2: Sukuk Ijarah

1. Issuer (SPV) issues sukuk

2. The Investors subscribe for sukuk and pay the proceeds to Issuer SPV (the Principal
Amount). Issuer SPV declares a trust over the proceeds and any assets acquired using
the proceeds. Thereby acts as Trustee on behalf of the Investors.

3. Originator enters into sale and purchase arrangement with Trustee (SPV) to purchase
assets from the Originator

4. Trustee pays the purchase price to Originator as consideration for its purchase of the
Assets (in amount equal to principal amount)

5. Trustee leases the assets back to the Originator under a lease arrangement (ijara) on
the term reflect to the maturity of the sukuk

6. Originator (lessee) makes rental payment at regular intervals to SPV(trustee/lessor).

7. Issuer SPV pays to the Investors (Sukuk holder) using the rental it has received from
Originator

8. Trustee will sell and Originator will buy-back (in the event of default or maturity)
Sukuk Ijarah also can be asset backed sukuk in the structure are not built on the basis of debt
instrument (bond). In fact, all types of sukuk can either be asset based or asset backed
depending on the underlying structure. Here are some general rules in order for sukuk to be
asset backed sukuk:

1. There is an event of true sale happens between Originator/Seller & Trustee/SPV. Not
only beneficial ownership but also legal entitlement over the asset.
2. In the event of maturity or if the Originator fails to honor payment to the
Investors/Sukuk Holder, then the Trustee/SPV has the right to a full recourse to the
assets including right to repossess and liquidate the Asset
3. Both repayment of original capital and income belonging to the investor is directly
resulted from underlying asset and its is not guaranteed and they share both the loss
(in case the asset destroyed or malfunction) and profit.
4. The due dates for payment of profits are not predetermined. Thus, sukuk of this type
is resemble to that of stocks

5. The investment needs to be assess on the value of the assets and the related
underlying transaction.

References

• D. Baidin, S.Shahimi. (2013). Sukuk “Asset-Based” Berbanding Sukuk “Asset-

Backed”: Kes Kemungkiran Sukuk. Prosiding Perkem VIII, 2, 574-585

• A.Abdullah. (2012) Asset-backed vs Asset-based Sukuk. Kuala Lumpur:

International Institute of Advanced Islamic Studies.

• A.Herzi. (2012). A Comparative Study of Asset Based And Asset Backed Sukuk
from The Shariah Compliance Perspective, 13(1), 25-34

• S. Hidayat. (2013). A Comparative Analysis between Asset Based and Asset

Backed Sukuk: Which One is More Shariah Compliant?. International SAMANM
Journal of Finance and Accounting. 1(2), 24-31

• B. Woulters. (2011). Asset-backed Sukuk — Islamic Finance Going its Own Way,
22-24. Retrieved from www.Islamicfinancenews.com

• N. Muhamed, R.Radzi. (2011). Implication of Sukuk Structuring: The Comparison

on The Structure of Asset Based and Asset Backed. 2nd International Conference on
Business And Economic Research (2nd Icber 2011), 2444-2460.
• A, Mirakhor, et al,. (2015). Islamic Capital Markets: Principles & Practices. Kuala
Lumpur: ISRA