Why commodity-linked sukuks should be introduced
Sukuks – an overview
A sukuk is a sharia-based hybrid instrument that can have the features of both a conventional debt instrument and of equity.
An example of equity is the stock of an enterprise. The stock’s value depends on the performance of the company and can be held in perpetuity; the stocks are neither paid (pre-fixed) dividends at set future times nor are they guaranteed capital appreciation. The stock-holders share in the risk of the enterprise, and both the return and timing of the return on their investment depend on the performance of the enterprise.
In contrast to a stock, a conventional bond is a debt instrument; it has a fixed duration, with the principal usually paid at maturity. Coupons of a prefixed amount are paid at set future times.
Sharia requires all financial contracts to be rooted in real sector activities. This implies the prohibition of predetermined interest payments and hence excludes the value of the coupon being preset. In particular, the sharia requirement can be met by making the value of the sukuk’s coupons depend on the performance of the enterprise issuing the sukuk.
Since the sukuk depends on the performance of the issuing enterprise, a sukuk is similar to a stock in that it has a risk-sharing aspect. On the other hand, a sukuk is similar to a conventional bond in that a sukuk has a fixed maturity, and has coupons paid at preset future times – with the principal repaid when the sukuk matures.
In summary, a sukuk has coupons paid at prefixed times in the future – and in this sense is similar to a conventional coupon bond. However, similar to the case with equity, the quantum of the coupon is not prefixed, but depends on the performance of the sukuk-issuing enterprise: this ensures that the sukuk holders partake in the risk of the enterprise.
Sukuks are of many different types and their specific design depends on the financial needs of the issuing party. In 2010, 44% of sukuks were issued by governments and 56% by private parties.
In a resource-rich country like Malaysia, many major corporations are engaged in the processing and sale of primary commodities. We discuss a sukuk designed that could serve the needs of such a nation.
How sukuks can help Malaysian corporations
According to the International Monetary Fund, Malaysia’s total gross domestic product amounted to $310 billion in 2015. The country’s exports totalled $76 billion and accounted for 24.5% of total GDP. Commodities such as oil, animal/vegetable fats and oils (including palm oil), plastics, rubber and wood accounted for 35% of total exports.
Traditionally, Malaysian corporations have issued bonds with fixed coupon rates, regardless of cyclical variations in the prices of commodities. Given that Malaysia, and by extension its corporations, are heavily focused and dependent on natural resources, we decided to examine how a major Malaysian corporation was affected by having to pay fixed coupons on the bonds it has issued – while facing the downturn in the global commodity cycle.
Case study – Petronas
Crude oil accounts for 16.5% of Malaysia’s exports; here we examine the case of Petronas, the country’s national oil company.
Petronas sold US dollar-denominated bonds in August 2009, when the price of oil was $67; it issued $4.5 billion of securities, including $3 billion of 5.25% notes, which are due in August 2019. Oil prices today are lower than the price at the issuing date. The price of Brent crude was $44.74 on September 27, 2016.
The value of Petronas’ prime revenue driver – the oil price – is down almost 50% from the time of issuance of the bond. Petronas is seeing a bigger fraction of its revenue being used for the fixed coupon payments – in all likelihood affecting its profitability.
Why commodity-linked sukuks?
How can a corporation avoid such drastic changes of fortune? In the case of Petronas, a sukuk can be designed to have the coupon quantum dependent on the price of crude oil. The quantum of the coupon would be reset at every payment time. If the price of oil goes up when the payment of the coupon is due, the coupon quantum would be increased; and conversely, if the price of oil falls, the quantum of the coupon would be lowered. And there would be no coupon paid if the price of oil were to fall below the cost of production.
In short, the coupons would continue to be paid at the preset future times, but the quantum of the coupon would be based on the price of oil. Such a sukuk in many ways fulfils the requirement for risk-sharing partnerships.
Linking the quantum of coupon to the price of oil provides a transparent criterion for coupon payments and mitigates any information asymmetry between issuer and buyer. The world price of a commodity – in this case, crude oil – is a valid, reliable and transparent tool to be tied up with the coupon payment.
A similar sukuk can be issued for any commodity. It is not exclusive to oil – it could be palm oil, for a firm that produces palm oil or is involved in plantations. It could be even tied to a basket of commodities, which would include other commodities that have an influence or relationship with the issuer, complementary or otherwise.
The commodity-linked sukuk would not only be a win-win instrument for both investors and issuers, it would also be beneficial to society.
For investors, since the sukuk shares in the risk of the issuer, the rate of return will be higher than a fixed-coupon conventional bond, according to the general principles of asset pricing. Furthermore, the sukuk would be relatively inexpensive when commodity prices are low – with the potential of large gains if commodity prices rise.
On the other hand, linking sukuk to the commodity price, at least for the issuers, is akin to hedging, whereby risk mitigation is clearly evident. By linking the payment of coupons to the price of the commodity, the sukuk has a built-in stabiliser for the issuer. A sukuk lowers the burden of debt servicing. Moreover, a plunge in commodity prices would not lead to the possibility of default or bankruptcy.
As for society at large, investors would have confidence about the accuracy of the activities of firms involved, since all the information is in the public domain and cannot be easily influenced or manipulated. Commodity-linked sukuk also provide the benefit of partly stabilising the commodity price against speculative manipulation and ultimately mitigating price volatility.
Commodity-linked sukuk are presently not available in the market. To create a market for these sukuk, they need to be priced accurately, including the use of possible hedging techniques. A secondary market with sufficient liquidity could then evolve and ensure that investors can enter and exit the market – hence deepening and stabilising the market