An Introduction to Sukuk: The Islamic Finance Debt Instrument that Has Transcended Global Capital Markets
Posted on Mar 25, 2025Simone Noorali
Over the last few decades, markets have carved out a growing space for “Sharia-compliant, fixed-income capital market instruments” – these are popularly known by their Arabic name, sukuk.[1] Sukuk originated in geographies with largely Muslim populations to reflect consumer demand for financial products with terms and structures that were compliant with Sharia law.[2] Sharia-compliant finance has not only been long-prevalent in the Middle East and Southeast Asia, but has recently made its mark on global capital markets and the broader Western commercial finance systems.[3] Islamic Finance broadly has seen its greatest applications in project finance and has even made its way into American bankruptcy courts.[4]
What Is Sukuk?
While sukuk are often referred to as ‘Islamic bonds’, this analogization is somewhat misguided. A bond, defined by the United States Securities and Exchange Commission, is a “debt obligation, like an IOU,” – a written obligation of debt from one transacting party to another.[5] An investor purchasing a corporate bond assumes the role of a lender, lending money to the issuing corporation or entity. In exchange, the borrowing party generally makes a twofold legal commitment: first, to pay interest on the principal amount; and second, to return the principal amount when the bond matures.[6] The proceeds from bond issuances can be used to serve numerous purposes, including research and development, financing new projects, stock buybacks, paying shareholder dividends, financing mergers, and in debt refinancing.[7] There are three fundamental differences between an asset-backed sukuk and a conventional bond: first, the underlying ownership interest; second, repayment based on performance rather than interest; and finally, the return on principal.
The underlying structural framework for a sukuk is more appropriately a trust certificate, bringing attention to the key fact that there must be some undivided beneficial ownership interest in an underlying asset, notably in such a way that the return on the investment is based on how the underlying asset performs.[8] Because of this, sukuk are often linked to this asset through an ijarah[9] arrangement in order to ensure the generation of revenue to mirror coupon payments that would be received under a conventional bond structure. This structure justifies the generation of the return because the ‘bond-holder’ assumes ownership risks associated with owning the underlying asset.[10] While there are other types of sukuk, sukuk al-ijarah is widely accepted as the most appropriate mechanism for structuring and issuing sukuk, primarily for two reasons: first, the compliance with overarching principles of Islamic finance; and second, due to law firm and issuers’ familiarity with structuring a sale and leaseback structure.
Sukuk and Western Markets
Despite the upward trend in adoption of sukuk issuances by Western markets in the last decade, certain qualities of these Islamic law-compliant debt instruments have prevented their full integration into American capital markets. These barriers are largely cultural, administrative, and pertain to the restrictions surrounding the assets that can be backed by Islamic securities. One possible approach to the increased proliferation of sukuk in Western markets is to employ ‘sustainable bonds,’ in line with the demands of sustainable corporate practice as well as the notion of ‘halal’ investing. Environmental protection has always fallen squarely within Sharia principles,[11] but sustainable sukuk issuances before 2020 remained fairly low. These emerging green bonds, as discussed below, are designed to fund investments with direct or indirect environmental or social benefits, including renewable energy projects or social infrastructure.[12] In doing so, they keep with the Western financial push towards ESG and sustainable investing while maintaining the structural integrity of an Islamic finance instrument.
It cannot be ignored that there are many larger market benefits for issuers when sukuk offerings are introduced into new markets. For one, Islamic finance exposes a market to new sources of capital. Investors looking for returns structured in accordance with Sharia principles are still a largely untapped investor base that can contribute significantly to the developmental needs of a corporate or sovereign issuer. Additionally, there is considerable room for crossover into other niche financial markets such as ethical investing, which has recently seen a huge growth through ESG principles.[13] Finally, to the extent that this is a priority for issuers, there are overall reputational benefits associated with structuring investments in accordance with Sharia.
This is not to say that the path forward is completely clear – sukuk offerings are not without their complications, which have largely posed sometimes-insurmountable barriers to their proliferation among a greater number of markets. At a high level, these can be filtered into a few key categories: (a) the challenges posed by attempting to execute Sharia-compliant contracts in legal and regulatory environments unaccustomed to Islamic law; (b) structuring an investment around a Sharia non-compliant underpinning asset – typically at issue when a sukuk al-ijarah funding agreement requires the obligor to have a suitable income-producing asset that can underpin the transaction; (c) overcoming the compliance and transactional costs associated with more complex sukuk structuring, particularly when the administrative regime surrounding sukuk paperwork is far more amorphous than that of the well-established conventional bond issuance; (d) tax planning of foreign assets, which can diverge from that of conventional bonds; (e) the struggle for recourse in bankruptcy proceedings; (f) choice of law when determining Sharia jurisprudence, securities, and trading rules; and (g) the lack of accessibility of seeking and receiving specialized legal counsel. These recurring issues are among the many reasons that Western markets have naturally resisted the wider incorporation of sukuk at the same rate as conventional debt instruments.
Reconciling Ethical Investing and Sukuk Issuances
Over the last few years, the emergence of a new category of sustainability-linked fixed-income securities presents a new opportunity for Islamic finance to make its mark in the green investing space through sukuk offerings. This transition marks a shift away from the practice of ‘Green Sukuk’ [14] and towards ‘Sustainable’, or ‘Sustainability-Linked’ Sukuk. More clearly, while a ‘Green Sukuk’ requires that the core of the debt instrument be investing in an entirely sustainable project, a ‘Sustainability-Linked Sukuk’ allows from the investment returns from a project to generally work towards achieving sustainability strategies. While these models have historically applied primarily to the European Union and been derived from the EU Taxonomy, they provide a framework for how countries such as the United States can adopt a similar model to become more inclusive spaces for sukuk.
Shifting from the green sukuk to sustainability-linked bond (or sustainability linked-sukuk) has yielded a number of benefits for the scope of the financial instrument. Primarily, it shifts the core requirement of the debt instrument from requiring investing in a specific project to allowing for the investment returns to generally work towards achieving sustainability strategies. Allowing for the proceeds to apply to a general corporate purpose rather than requiring them to continue servicing a specific asset opens the market up to issuers who are not financially positioned to allocate entire funding amounts to specific green projects or investments.
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[1] Debashis Dey, What are sukuk and how do they work?, The Association of Corporate Treasurers, https://www.treasurers.org/hub/treasurer-magazine/what-are-sukuk-and-how-do-they-work (last visited 13 Nov. 2024).
[2] Sharia law, used interchangeably with ‘Islamic law’ for the purposes of this paper, is an interpretation of the sharia – “divine counsel” that guides Muslim life.
[3] According to Fitch Ratings, Global sukuk volumes are projected to cross USD 1 trillion outstanding in 2025. Sukuk continues to remain a key part of the international debt capital markets, not only in the Muslim World (denoted by the Organization of Islamic Cooperation countries), but also in American and European markets. Notably, sukuk represents 12% of all Emerging market US dollar debt issued in 2024 excluding China. See Bashar Al Natoor, Global Outstanding Sukuk to Cross USD1 Trillion in 2025; Overall Credit Profile Stable, Fitch Ratings (Jan. 8, 2025), https://www.fitchratings.com/research/islamic-finance/global-outstanding-sukuk-to-cross-usd1-trillion-in-2025-overall-credit-profile-stable-08-01-2025.
[4] One recent example of a sukuk default that has made its way into American courts is the In re Certain Funds case, involving investment vehicles managed by affiliates of Fortress Investment Group who applied ex parte to the United States District Court for the Southern District of New York for an order to authorize them to obtain discovery from domestic auditors including KPMG and PricewaterhouseCoopers LLP. The case involved the Golden Belt 1 sukuk, a financial instrument issued by the Kingdom of Bahrain. See In re Certain Funds, Accts., &/or Inv. Vehicles Managed by Affiliates of Fortress Inv. Grp. LLC, No. 14 CIV. 1801 NRB, 2014 WL 3404955 (S.D.N.Y. July 9, 2014), aff'd sub nom. Certain Funds, Accts. &/or Inv. Vehicles v. KPMG, L.L.P., 798 F.3d 113 (2d Cir. 2015).
[5] Securities and Exchange Commission, Investor Bulletin, What Are Corporate Bonds?, at https://www.sec.gov/files/ib_corporatebonds.pdf.
[6] Id.
[7] Id.
[8] World Bank, PPPRC, Overview of Assets Recycling Through Islamic Finance, https://ppp.worldbank.org/public-private-partnership/applicable-all-sectors/overview-assets-recycling-through-islamic-finance#:~:text=In%20an%20asset%2Dbacked%20sukuk,the%20related%20underlying%20transaction)%20themselves.
[9] Ijarah is the term used to describe the alternative to a conventional lease contract developed by Islamic Finance in order to remain Sharia-compliant. Understood in its most simple form, ijarah refers to the legal contract that involves hiring or renting an asset or commodity in order to receive compensation, consideration, and return from it. Unlike a conventional sale contract, ownership of an ijarah asset remains with the lessor while possession is transferred to the lessee. Blossom Finance, Introduction to Ijarah (Lease) Contracts, 18 Apr. 2020, https://www.blossomfinance.com/posts/introduction-to-ijarah-lease-contracts.
[10] Supra World Bank, note 5.
[11] Ahmed Al-Dawoody and Sarah Gale, Protecting the environment during armed conflict: IHL and Islamic law, International Committee of the Red Cross, Jun. 3, 2021, https://blogs.icrc.org/law-and-policy/2021/06/03/protecting-environment-armed-conflict-ihl-islamic-law/.
[12] Laura Slater and Shamaila Khan, Portfolio diversification with Sukuk, UBS Asset Management (Sept. 23, 2024), https://www.ubs.com/au/en/assetmanagement/insights/asset-class-perspectives/fixed-income/articles/portfolio-diversification-with-sukuks.html/.
[13] See supra Dey, note 1.
[14] Until recently, sustainable debt securities have been largely structured in accordance with the Green Bond Principles, designed for funding dedicated sustainable projects. Sharia-compliant sukuk that are intended to fall within the “green” investment category also fall within this GBP umbrella. Unlike the sustainability-linked bond, proceeds from green sukuk could not be used for general corporate purposes and had to be tied to specific sustainable projects. See Debashis Dey, Sustainability-linked sukuk: a new opportunity for the Islamic finance market, 10 JIBFL 680 (1 November 2020).