A Primer on Sukuk (Part 2)
7/11/2013 10:46:28 AM
In our last article, we talked in general about the structure of Sukuk, or Islamic bonds. This time we’ll dig a little deeper to explore a specific type of contract that often serves as the basis for a Sukuk issue, the Ijarah contract. And then we’ll look at a real-life example from General Electric.
Ijarah contracts versus leases
Like a conventional lease, an Ijarah offers the benefits of a good or service in return for rent. The technical definition is that an Ijarah is the lease of a specific asset or service for a set period of time in exchange for a payment of rental installments, which at the end of the lease period may result in transfer of ownership to the lessee, depending on the type.
One of the major differences between a conventional lease and Ijarah has to do with the responsibility for maintenance and insurance. In many conventional leases, that responsibility is with the lessee, but in the Islamic version, the lessor bears those upkeep responsibilities.
In case of a default with an Ijarah, the lessor has the right to reclaim the leased asset, although it is possible (and recommended) to restructure the repayment period. Also, the lessor also has the right to charge late payment fees and administrative charges. The administrative charges belong to the lessor, but the late penalty is paid to a designated charity.
In 2009, General Electric Co. became the first major U.S. company to sell a five-year, $500 million Sukuk. The income from the Sukuk comes from aircraft leases structured as an Ijarah. Here’s how it works.
The Sukuk is basically a lease-buyback arrangement. With the GE example, the company created something called a special purpose vehicle (SPV) to segregate the aircraft. The SPV sold the aircraft to Sukuk certificate holders, who receive periodic rental payments from GE in return for their use through 2014. Once the issue matures, the Sukuk certificate holders agree to sell back the aircraft to GE, receiving the agreed upon price for the assets.
To be clear, that is an oversimplification of the process, but it gives you an idea as to how the Ijarah structure can be used to help companies raise capital in novel ways.
Also, you may be wondering how the Ijarah Sukuk issuance gets accomplished in practice. A lot of the interactions between lessee and lessor are facilitated by a party known as the servicing agent. In the case of the GE Sukuk, the servicing agent procures the purchase of the aircraft assets from the SPV at an amount equal to the face value of the certificates. It also collects rental income from leasing the aircraft to GE customers, and provides periodic distribution amounts to Sukuk certificate holders. Unfunded and funded reserves administered by the servicing agent provide a backup source of funds to satisfy distribution requirements if rental income ever becomes insufficient.
For GE, access to new investors appears to have been worth the novelty involved in a nonconventional form of financing. And it’s that diversification of the company's sources of capital that make the Ijarah Sukuk a potential source of corporate interest in the coming years.
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