Two factors have been driving the issuance of ijara sukuk, the first involving Sharia compliance and the second relating to the cost of capital in uncertain times.

The Sharia-compliance issue arose from the comments of Sheikh Taqi Usmani, a leading Bahrain-based Sharia scholar, in November 2007 that most sukuk were not Sharia-compliant.

Not surprisingly, this caused a stir in the Islamic finance industry, with many issuers regretting that they had decided to raise finance through sukuk that were being questioned on Sharia grounds.

There was a fear that this would undermine the already fragile and underdeveloped secondary market for sukuk, with some issuers thinking they might have been better to have kept to conventional bonds paying interest. To avert these concerns, the Sharia Board of the Accounting and Auditing Organisation for Islamic Financial Institutions, of which Sheikh Taqi is chairman, issued a statement in February last year indicating that the previous remarks applied solely to musharaka and mudaraba sukuk.

With these sukuk, it was seen as not permissible to repurchase the assets from the sukuk holders at nominal values equal to those at the time of issuance.

As musharaka and mudaraba were viewed as profit-and-loss sharing contracts, guaranteeing the nominal value of the capital was a breach of contract.

But this did not apply to ijara sukuk, as ijara is a rental contract without profit-and-loss-sharing terms. Hence, as most investors in sukuk are willing to accept the possibility of default risk but do not want market risk, which Sheikh Taqi’s position implies, this rules out investment in musharaka or mudaraba sukuk.

The second factor favouring ijara is that it pays a variable return, usually linked to the interbank offer rate for the currency in which the sukuk is issued.

Although the interbank offer rate is an interest proxy, the payments to sukuk investors represent rents, not riba or interest, and are therefore acceptable under Sharia.

For the issuer, having the cost of funding (the rental payments) linked to market rates is attractive in uncertain times.

If the returns were fixed there could be a substantial difference between the payments made and market rates when these are falling, locking issuers into unattractive financial obligations.

In current depressed securities market conditions, there are few new fixed-return bond offerings, with floating-rate notes accounting for most of the issuance.

Given these circumstances it is not surprising to see Islamic securities issuance following what is happening conventionally, with ijara the closest substitute for floating-rate notes.