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THE ISLAMIC BONDS   POSSIBILITIES AND CHALLENGES

Bonds are long-term debt obligations that are secured by a specified asset or a promise to pay. In effect, a bond investor has lent money to the bond issuer. In return, the issuer of that bond promises to pay interest and to repay the principal on maturity¹ .

The certificate itself is evidence of a lender-creditor relationship. It is a “security” because unlike a car loan or home improvement loan, the debt can be bought and sold on the open market. In fact, a bond is a loan which is intended to be bought and sold.²

It is clear from this definition that in the conventional system of bond issuance and trading the issue of interest is at the centre of any transaction. In contrast, in the Islamic financial system usury and interest are the first elements to be avoided. However, this does not mean that the door of debt financing or, more generally, the possibility of bonds issuance and trading is closed to Islamic finance. However, it shall be noted that beside the rejection of the obvious system of interest in bond trading, the Islamic alternative must also avoid any transaction of debt and credit on future basis which may result in usury and interest.

Considering the fact that bond issuance and trading are important means of investment in the modern economic system, Muslim jurists and economists are striving to find the Islamic alternative. However, to meet the various demands of investors Islamic bonds and certificates should be diversified. We have so far the mudarabah or muqaradah bonds, the musharakah bonds, the Ijarah bonds, the istisna‘ bonds, the salam bonds and the murabahah bonds. However, it should be noted that although some of these instruments have been generally accepted as being in compliance with Islamic principles so that they can be traded in the secondary market, the negotiability of certain others is still a point of debate and controversy due to their legal acceptability or compliance with shari‘ah. Therefore, some of these bonds can be traded in the secondary market while the trade of others is limited to the primary market because they can be exchanged only at face value.

In Malaysia for instance, almost all of the domestic Islamic debt papers issued so far have been based on the
principles of murabahah and bay‘ bi al-thaman al-ajil despite the controversy surrounding the issuance of
tradable bonds in the secondary market based on the above two contracts. At the same time, there is a perceptible
increase in the willingness amongst Malaysian issuers of bonds to explore other Islamic principles of financing,
namely the profit-oriented based musharakah as well as the asset-backed mode of ijarah. The progress of
developing Islamic securities based on these financing codes, nonetheless, has been painfully slow and, to some
extent, stalled by the 97 economic recession.³   However, the economy is picking up again and it is hoped that the
future issuance of Islamic bonds will focus on the widely accepted bonds such as musharakah bonds, mudarabah
bonds and ijarah bonds.

In this paper we will try to investigate the possibilities and challenges of developing an Islamic bonds market free from usury and interest and capable of making use of the existing financial resources.

Salam Bonds

Salam is the sale of a specific commodity, well defined in its quality and quantity which will be delivered to the purchaser on a fixed date in the future at the price paid at the spot as it is the condition according to the majority of Muslim jurists or three days according to the Maliki school. To illustrate the possibility of issuing a salam certificate let us consider the following assumption of a corporation which is in need of funds.

1.  If a corporation requires for instance, 500 million ringgit, it can use salam certificates equalling that amount in
      small denominations, say 10,000 ringgit each.

2.  Each certificate represents a salam contract. The seller is the corporation while the buyer is the holder of that
      certificate who paid its nominal value.

3.  Each certificate promises that on maturity (one year for example) the corporation will deliver to the holder a
      specified quantity of the underlying commodity, which is described fully on the back of the certificate or in the
      prospectus.

4.  Once the corporation receives the cash, it can use it for any purpose.

5.  On maturity the seller will be delivering the sold goods in kind. For this purpose the corporation will certainly
      buy on the open market and deliver to the certificate holder. However, it should be noted that salam is possible
      only for fungible goods or mithli. These are standardised into identical units. For instance, wheat, rice, barley
      and other grains are of this type. Oil, iron and copper are also mithli. Similarly, electricity measured in kilowatt
      could be considered a mithly. Seats on a aeroplane flight can also be mithli⁴ .

Later, the corporation floats these salam certificates and it will receive immediately the face value of each certifi-
cate in cash according to the majority of Muslim jurists or three or more days later according to the Malikis and
certain contemporary Muslim jurists⁵ . The parties can use this flexibility of paying immediately or some time later.
However, a viable salam-based bonds market will not be possible if the issued bonds cannot be liquidated easily.

Liquidity is one of the most important aspects of short-term investment, second only to profitability. A money market instrument that is not negotiable will not be very useful. Thus, an investor will buy a salam certificate if he expects prices of the underlying commodity to be higher on the maturity date. But if his expectations change before that date, he can offload his investment and dispose of his certificate. Furthermore, when an investor knows that it is possible to resell the salam certificate before maturity in an organised market, more and more people will invest in this instrument and subscribe to this venture.

However, there is a difference of opinion among Muslim jurists regarding the legality of selling the purchased goods in a salam contract prior to taking delivery. Thus, the majority⁶  maintains that it is illegal to resell the subject matter in salam before taking possession, relying on the hadith of the Prophet (PBUH)  “whoever makes salam shall not exchange it before taking possession”.⁷  They argue that in this hadith it is clear that the buyer should not exchange the subject matter of salam with the seller or with another person. However, this is a weak hadith as pointed out by Ibn Hajar.⁸  Therefore, it could be not the basis for any ruling.

Ibn Taymiyyah and his disciple Ibn al-Qayyim maintained that there is no legal problem in exchanging the subject matter of salam before taking possession. However, if it is sold to the seller himself it should be at the same price or a lower price but not a higher price as the case may be. However, if it is sold to a third party it could be at the same price, a higher price or a lower price. Moreover, Ibn Abbas and Imam Ahmad in one of his opinions have the same opinion on the issue. This is also the Maliki stand. However, they maintained that it is illegal to resell salam before taking possession, if it is foodstuff.⁹

The contemporary position of Muslim scholars is also divergent. Thus, Nazih Hammad for instance, maintains that
it is legal to resell salam before taking possession as it is maintained by Ibn Taymiyyah and Ibn al-Qayyim because
there is no text from the Qur’an or sunnah, ijma‘ or qiyas to prohibit this. On the contrary the texts as well as the
qiyas convey its legality.¹⁰  This stand has also been backed by other scholars such al-Qaradaghi,¹¹  al-Zuhaili¹² ,
Jasim Ali Salim,¹³  Hashim Kamali¹⁴ , Sami Hammod¹⁵  and Majd al-Din Azzam.¹⁶  On the other hand, Siddiq al-
Darir, Ajil Jasim al-Nashmi¹⁷  and others have maintained that it is illegal to resell anything before taking possession
of it.

However, it seems that it is logical to take into consideration the opinion of those who uphold the legality of reselling salam before taking possession since there is no genuine text to prohibit that and as a result the idea of salambased bonds will materialize.

Murabahah is basically the sale of goods at a price covering the purchase price plus a margin of profit agreed upon by both parties concerned¹⁸ .

The possibility of having legally acceptable murabahah-based bonds is only possible in the primary market. However, the negotiability of these bonds or their trading at the secondary market would be illegal due to the fact that they constitute debt and it is illegal in shari‘ah to trade debt for debt on a deferred basis if it will result in riba. However, their use in the primary market alone has its own benefits.

Suppose the required commodity in murabahah is too expensive for an individual or a banking institution to buy
alone e.g. 50 million dollars for an oil refinery. This requires the participation of many financiers. The financing of
the project could be mobilized on an understanding with the would-be ultimate owner that the final price of the
refinery would be 70 million dollars to be repaid by installments over five years. The various financiers may share
the 20 million dollars murabahah profit in proportion to their financial contribution to the operation.¹⁹

Despite the fact that the murabahah instruments are debt instruments, and given the fact that debt cannot be sold to another debt, it is permissible to sell these instruments if mixed with other assets such as commodities, services and cash provided that real assets and services overwhelm debt and cash. In other words, the murabahah bonds could be negotiable if they are the smaller part of a package or a portfolio, the larger part of which is constituted of negotiable instruments such as mudarabah bonds, musharakah bonds or Ijarah bonds.²⁰

It is perhaps on such a basis that it has been proposed by Sami Hamoud for instance, at the Second al-Barakah forum, that a company specializing in murabahah investment should be set up as a part of al-Barakah Islamic Bank in Bahrain and its instruments would be tradable on the grounds that although these instruments are debtbased they are just a small part of the total assets of the company. In fact, the idea has been developed and the company has been set up after a ministerial decree, to specialize in such trading.²¹

In Malaysia, the Islamic benchmark bonds were issued in 1990 and it is believed to be based on the murabahah concept. They are one of the most popular forms of Islamic financing methods used in Malaysia today and they are used as a substitute for the zero-coupon bond.²²  Therefore, it is necessary to look at these bonds in order to examine their conformity to shari‘ah principles.

The benchmark bond is a non-coupon-paying bond issued on a zero coupon basis to eliminate the coupon effect on yield. Zero coupon bonds are bonds sold at discount.

The Islamic benchmark bonds are issued on the assets backed by the murabahah concept. This concept requires
Khazanah to buy a pool of assets and investments at the behest of Private Debt Securities (PDS) investors for an
agreed up-front lump sum cash payment comprising a cost and profit element. Then Khazanah agrees with the
Private Debt Securities investors to purchase this pool of assets and investment from the investors at an agreed

^{purchase price at the end of the agreed duration e.g. three years. Pending the resale of the pool of assets and} investments to Khazanah, PDS investors appoint Khazanah as trustee and manager of the pool of assets and investments. Until the resale of the pool of assets and investments any income arising from this pool is accrued to Khazanah as trustee and management fees. As documentary evidence of the arrangement entered into between Khazanah and PDS investors, Khazanah will issue to PDS investors the Islamic benchmark bonds. PDS investors may hold the benchmark bonds to maturity or sell them at the secondary market. In order to avoid reinvestment risk from the perspective of PDS investors, and interference with the benchmark yield curve, Khazanah is not given the right to early redemption of the benchmark bonds. In this respect, should PDS investors want early exit from the benchmark bonds, they can do so by disposing of these bonds in the open market²³ .

However, some objections have been raised against the Islamic benchmark bonds based on murabahah because
of the structure of murabahah itself and the possibility that such a transaction will result in bay‘ al inah and bay‘
al-dayn bi al-dayn traded at discount which are generally considered as prohibited transactions by Muslim jurists.

However, Abdul Rashid Hussein for instance, while defending the viability of murabahah bonds says: “Questions have been voiced as to why murabahah has been chosen as the operative concept for the Islamic benchmark bonds issuance as compared to other Islamic operative concepts such as Ijarah (leasing) mudarabah (profit sharing) musharakah (joint venture) and qard hassan (benevolent loan)?²⁴  Abdul Rashid Hussein maintains that murabahah provides a sufficiently flexible structure to create, in essence, a choice of action owed by Khazanah to PDS investors without necessitating payment of coupon.

He further argues that if the financing is structured under the Ijarah concept as it is commonly understood,
Khazanah being the lessee to the pool of assets and investments has to pay periodic lease rental which is not
appropriate to the non-coupon structure. In the case of mudarabah concept, Khazanah and PDS investors are
deemed to have entered into a venture to invest in assets and projects and as a result PDS investors have to bear
any financial losses arising from such ventures. This is unacceptable to PDS investors from a risk return perspec-
tive.

Moreover, according to Abdul Rashid Hussein if the financing is structured under the musharakah concept, Khazanah is required to contribute part of the initial outlay to the joint venture with PDS investors to invest in the assets and projects that are inappropriate under the circumstances. Moreover, under musharakah, PDS investors, being co-partners to the joint venture, have the right to participate in the management of the assets and project which is inappropriate under the circumstances.

Finally, if the concept of qard al- hasan were to be used, Abdul Rashid Hussein argues Khazanah would be deemed to have received the bond subscription proceeds from PDS investors as a benevolent loan. Therefore, Khazanah being the borrower, is only obliged to return to PDS investors the entire principle amount of the benevolent loan borrowed and is not obliged to return a guaranteed return either as a gift (hibah) or as a kind of appreciation to the PDS investors²⁵ .

To illustrate the basic feature of the Khazanah Islamic bonds, suppose that through the bidding process, a RM1000 bond at par value is sold at RM 800 per unit. For one million unit issues, the market value of the securitized asset is therefore RM 800 million while the buy back price is 1billion. The return to investors is 200 million.²⁶  Thus, given the above fact about the involvement on this transaction of bay’ al-inah, Abdul Rashid Hussein’s argument in favour of the above kind of bonds could not be justified from the shari‘ah point of view.

Ijarah Bonds

^{Ijarah is a contract according to which a party purchases and leases out equipment required by the client for a rental fee. The duration of the rental and the fee are agreed in advance and ownership of the asset remains with the lessor. Hence, the relationship between the parties differs from that of a debtor-creditor relationship since it is based on buyer-seller of an asset.} Ijarah bonds, on the other hand are securities of equal denomination of each issue, representing physical durable assets that are tied to an ijarah contract as defined by shari‘ah ²⁷ .

The basic feature of Ijarah bonds is that they represent leased assets, i.e. without relating the bonds holders to any common organisation, company or institution. For instance, an aircraft leased to an airline can be represented in bonds and owned by a thousand different bondholders, each of them, individually and independently, presenting his bond (s) to the airline company and collecting the periodic rent without having to have any relation with other bondholders. In other words, the Ijarah bondholders are not owners of a share in a company that owns the leased airline, but simply a sharing owner, who only owns one thousandth or more of the plane itself.

In a second example let us assume that a group of investors bought an office building and divided up the ownership
rights into many certificates of equal face value. The group may rent out the whole building for the next ten years,
then sell these certificates to the public. A buyer of a such certificate is acquiring a share in the ownership of the
office building, and an equal share in the net income from it for the term of the lease. Such certificates could be
easily traded in the market. Moreover, their generation of steady rental income renders them even less risky than
common stocks. This is because in common stocks both annual net income and capital gains or losses are variable,
whereas in rent sharing certificates part of the future income stream is the contractually fixed rental payments.²⁸

There may be multiple forms of Ijarah bonds depending on the nature of the asset and the method and procedure
of issuance of the bonds. Thus, besides the simple forms of Ijarah bonds mentioned above, more sophisticated
forms of Ijarah bonds can be considered by including financial intermediaries. Let us suppose that the Ministry of
Defence needs a training field to be used for one of its training programs. A suitable piece of land in a suitable
location is needed. The Ministry of Defence resorts to an Islamic bank to prepare an issue of Ijarah bonds that
allow the Ministry to acquire the needed plot. The Islamic bank buys the plot for 10 million dinars and rents it to the
Ministry of Defence for 900,000 dinars a year. At the same time, the bank issues 1,000 Ijarah bonds, each bond
representing 1000^th of the plot and entitling its owner to 900 dinars per year as rent. The Ijarah contract has a
period of ten years after which the contract will be renewed perpetually for term of ten years. The Islamic bank
has an issuance commission of, say, 5% as premium above the purchase price of the land i.e., the bank sells the
bonds at 10500 dinars each. In this form of Ijarah bonds, the bondholders own the land that is rented and they are
entitled to the rent at the above-mentioned rate. The issuer of the bonds is the financial intermediary, not the
division of Real Estate Recording, nor the beneficiary of the lease.

In a somewhat different example, let us suppose that in the above mentioned case, the Ministry decides to under-
take the task of issuing the bonds on its own, without resorting to a financial intermediary, and it does not having the
money to buy the land it transfers its ownership to the bondholders. The Ministry of Defence begins with issuing
Ijarah bonds for the specific purpose of acquiring the land, whose purchase price is 10 million dinars. The bonds,
now, contain a new clause permitting that the Ministry the will collect the fund from the buyers of the bonds and will
purchase the lot on their behalf, on wakalah basis. In this case, the issuer of the bonds becomes the beneficiary of
the Ijarah contract, e.g. the user of the asset. Each bondholder has the same right to ownership and to a share of
the total rent, which equals one thousandth each (assuming there are 1000 bonds). There will be no premium paid
to a financial intermediary, although the Ministry of Defence may take some contractual compensation for its work
on behalf of the savers/ purchasers of bonds. ²⁹

Thus, from the above it is clear that the contract of Ijarah seems to be the most flexible of all nominated contracts in Islamic law and many forms of Ijarah bonds, whether short term or long term, could be issued from it.³⁰

Characteristics of Ijarah Bonds

^{The characteristics of Ijarah bonds stem from its nature and from the contractual relationship defined in the Ijarah contract governing it. These can summarised as follows;}  

1.  Ijarah bonds are securities representing the ownership of well defined existing and well known assets, that are
      tied up to a lease contract. This means that Ijarah bonds can be traded in the market at a price determined by
      market forces. This includes inter alia, the general market conditions in the economy and in the financial
      market, the opportunity cost  (current and expected return on new financing), prices of real investment assets
      and economic trends in the specific market related to securities and Ijarah bonds, etc. The Ijarah bonds are
      also subject to risks related to the ability and desirability of the lessee to pay the rental instalments. Moreover,
      these are also subject to real market risks arising from potential changes in asset pricing and in maintenance
      and assurance costs.

2.  Furthermore, the expected net return on some forms of Ijarah bonds may not be completely fixed and deter-
      mined in advance, since there might be some maintenance and insurance expenses that are not perfectly
      determined in advance. Consequently, in such cases, the amount of rent given in the contractual relationship
      represented by the bond, represents a maximum return subject to deduction of this kind of maintenance and
      insurance expenditure.

3.  Ijarah bonds are completely negotiable and can be traded in the secondary markets. Subject to market condi-
      tions, these bonds will offer a high degree of liquidity and therefore, have both the characteristics and neces-
      sary conditions for functioning as successful securities.

4.  Ijarah bonds will offer a high degree of flexibility from the point of view of their issuance management and
      marketability. The central government, municipalities, awqaf or any other asset users, private or public can
      issue the bonds. Additionally, they can be issued by financial intermediaries or directly by users of the leased
      assets³¹ .  It should be noted that Ijarah bondholders as owners bear full responsibility for what happens to
      their property. They are also required to maintain it in such a manner that the lessee may derive as much

      usufruct from it as possible.³² .

to be continued......