Structuring Islamic bond/sukuks:

Role of Bay’ al-‘Inah

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In the early years of Islamic banking in Malaysia, people had a hard time understanding if not pronouncing names such as al-bai-bithaman ajil, murabahah and mudarabah, but somehow we gradually got used to these unfamiliar terms. Now al-bai bithaman ajil is simply called BBA, sukuk al-ijarah is known as Sanif and so on.

Recently a few more new names came out, like those mentioned in Bank Negara’s guidelines on Islamic money market. These are bay’ al-‘inah and bay’ al-dayn. Some may wonder what bay al-‘inah and bay’ al-dayn really stand for. Non-Muslim practitioners must be having difficulty handling these terms especially when little is written about them, particularly for the layman.

I now will help explain the meaning of bay’ al-‘inah and bay’ al-dayn. First, let me say their application in banking and capital market is quite huge. For example, all Islamic personal financing products run on bay’ al-‘inah (INAH). Bay’ al-dayn is widely applied in money and capital market instruments such as Islamic accepted bills, negotiable Islamic certificates of deposits, Islamic treasury notes and private debt securities.

So, knowing these two contracts is pretty important, especially going global is no longer an option. When traditional portfolio investments are fast leaving the country, the reversal factor must come from global Islamic funds.

It is worth noticing that international Islamic portfolio fund managers are mostly advised by Middle-eastern Muslim jurists, most of who belong to the Maliki, Hanbali and Hanafi school of thought.

Malaysian are predominantly Shafi’. So, if the Malaysian Islamic system is Shafi’ oriented does it mean our products are also compatible with Middle-eastern standard? This we must investigate. One way is to investigate the nature of bay’ al-‘inah and bay al- dayn, as they are among the most popular. Let me explain what they stand for.

Normally, INAH is used to obtain cash, just like getting a loan. Using a plain BBA can only end with a purchase or ownership of an asset. It does not help people who want money. However, cash must be acquired through an interest-free loan (qardhu hasan), but not available commercially. As a business entity an Islamic bank seeks to maximize profit, so giving away qardhu hasan does not make sense.

Since the bank is willing to finance any transaction at a price and customers are ever willing to pay this price, Islamic banks devise a product that give people access to cash without implicating riba.

There is an easy way to do this. Suppose Mr. Salleh wants a $10,000 loan and he is willing to pay a price but does not want to do it via riba loan.

Figure 8.3 Bay al-‘inah

To do so, the bank sells asset X to Mr. Salleh at a credit price, say $15,000, which he pays by installment. Then, instantaneously, Mr. Salleh, who now owns asset X, sells it back to the bank for $10,000 cash.

Now Mr. Salleh gets the $10,000 in cash, while the bank makes a $5,000 profit over the period of financing. Both get what they want without implicating riba. The deal only applies to a sale and purchase (al-bay’) contract, namely a) al-bay’ bithaman ajil b) al-bay mutlak (cash sale) where the credit sale is followed in sequence by the cash sale. See Figure

Now, let us see what Muslim jurists have to say about this deal. Strictly speaking, juristic opinions can be divided into two, namely those represented by a) Hanafi, Hanbali and Maliki schools and b) that of the Shafi’ school.

According to the first group , what matters most is the implicit or real intention of Mr. Salleh and the bank who were both willing to pay and accept interest respectively but do it using the contract of buy and sell (al-bay’). This is because, as the Quran has commanded, al-bay’ is an alternative to riba.

But al- bay under one version known as Bay’ al-‘inah is used to by pass riba. Mr. Salleh is not interested to use asset X for consumption purposes. And the bank knows that very well. On this point, it is worthy to look at the eminent jurist Ibn Taimiyyah who divided sales into three groups executed according to the buyer’s intentions, namely:

i) that he purchases the goods in order to use or consume them such as food, drink and the like, in which case this is sale, which God has permitted.

ii) that he purchases the goods in order to trade with them; then this is trade, which God has permitted

iii) that the reason for purchasing the goods is neither the first nor the second, then the reason must be dirhams (money) which he needs, and it was difficult for him to borrow, so he purchases the good on credit (with increased dirhams) in order to sell it and take its price. This, then, is ‘inah which is Haram according to the most eminent of the jurists.

Based on these arguments, the contract of bay’ al-‘inah is considered invalid (bathil). In middle-eastern countries it is unlawful to practice bay’ al-‘inah.

Malaysian Islamic bonds/Sukuks:

Fixed Coupon and Capital Protection

Prof. Saiful Azhar Rosly

The positive note of the Capital Market Master Plan on Islamic banking will help boost the growth of Islamic bond market. The most recent issue is KL Sentral’s RM920 million al-bai-bithaman ajil notes issuance facility (ABBA). It will not be surprising if the revived Bakun Dam project too puts Islamic bond issuance in the fore.

A well known mega project Putra Jaya too has heavily use Islamic bonds to mobilize capital from institutional investors, Islamic and non-Islamic alike. Certainly, this is only logical. Why should Putra Jaya Holdings opt for interest-bearing bonds when only conventional investors can buy them?

The question now why is an Islamic bond in Malaysia is well-received by both Islamic as well as mainstream investors? The answer has a lot to do with the structuring issue. On this point I will further explain the nature of Malaysian Islamic bonds and the role of bay’ al-‘inah and bay’ al-dayn in making Islamic bond issues a success story in Malaysia.

Recall that the contract of bay al-‘inah generally involves using two contracts of sale applied in sequence namely; spot and deferred (credit) sale. It is a necessary condition for Islamic bond issues and constitutes a fundamental element in determining Shariah legitimacy.

As we also know a bond is a loan given by a creditor to a debtor. Unlike banking loans, obtaining a loan using bonds is cheaper. Although the transaction cost can be higher, interest rates paid by an issuer are much lower than bank loans. This is because funds are acquired directly from creditors,namely the investing public.

From a bond issues, a debt is created consisting of the principle amount and coupon payments to sunscribers. Within the capitalistic financial system, a loan that one obtained has a price, namely interest. A coupon bond is one in which interest or coupon is paid over time as the price of capital.

For example, if the face value of Bond X is $1,000 with a coupon rate of 5% per annum, then the interest income is $1,000 x 0.05 = $50. For a 5 year bonds, bondholders shall receive $50 annually plus a $1,000 upon redemption on maturity.

It is now clear that a bond investment guarantees capital protection and a contractual income. An Islamic bond investment too provides the same features. Investors will receive a contractual income plus a guaranteed redemption of capital. How this is possible is interesting to see.

Layman and market watchers must take note that the term “al-bay’” meaning trading or commerce or sale signifies the alternative to the payment and receipt of interest as riba. The Holy Quran says, “God has allow al-bay’ (trade/commerce) but forbids riba” (Al-Baqarah :275)

Therefore, anything that uses al-bay’ as opposed to debt in profit creation is lawful; implying that as long as an Islamic bond is free from taking or giving interest or implicating itself with an interest baaring debt or loan, it constitutes a legitimate Shariah instrument.

Using the contracts of “al-bay ‘inah” and “al-bay al-dayn” for Islamic bond issues is vital to claim Shariah legitimacy, at least in Malaysia. Using these contracts will make it possible to guarantee investors a contractual income and capital redemption. The Shariah Advisory Board of the Securities Commision (SAC) has approved sale of debt (dayn) at a discount.

In principle, structuring Islamic bonds usually involve three main steps:

Bay al- ‘Inah asset securitization: Here, two sale contracts (a buyback sale) will be applied in sequence. That is bay’ al-inah = spot sale + credit sale. Firstly, a spot sale (bay’ mutlak) is executed. If the issuer wants to raise, say, $100 million, assets worth this amount will be identified and subsequently sold to investors on a cash basis. By doing so, the issuer gets the $100 million in cash.

Secondly, a credit sale is instantaneously applied. Here, investors sell back the underlying assets to the issuer on credit, with the price no longer at $100 million, but higher. If investors want a 8% percent profit margin per annum with a 3 year tenure, the selling price should be $100 million + $24 million = $124 million. The underlying asset can be anything as long it has value. It ranges from plant and machineries to concessions awarded by the government.

Issuance of Bond certificates: The payment by issuer to investors via BBA sale is made through the issuance of debt certificate (Shahdah al-dayn). Technically, this simply means a bond sale is underway. However, a bond is only a piece of paper evidencing a debt obligation. How could one in Islam sell a piece of paper (i.e. bond certificates) for $1,000?

The answer lies in the juristic debate on bay al-dayn (sale of debt). The Malaysian jurists say that these papers are equivalent to property (al-mal). This is because they say that some underlying assets via the ‘inah sale support the paper. Since property has value, it can be sold at any price.

For example, when issuance involves a zero-coupon Islamic bond, it is sold at a discount (i.e. less than face value). An Islamic coupon bond, such as the KL Sentral ABBA, is sold at par value. Redemption at face vale has been the main attribute of ABBA bonds. The question now is how in ABBA or MuNif, investors are guaranteed profits and capital, a common feature found in conventional bonds. This will be explained as follows:

a) To guarantee repayment of capital, primary notes (PN) are sold to investors at par value redeemable on maturity. Primary notes represent the capital component of the bond issues. In our example, $100 million of BAIDS will be sold back to the issuer on maturity for $100 cash. This is bay’ al-dayn at par value.

b) To guarantee payment of profits, secondary notes (SN) are sold at par value redeemable annually or semi-annually. For example, $24 million will be paid by installments over a period of 3 years. With secondary notes maturing every 6 months, investors will receive $3.98m million in cash. Again, this is bay al-dayn at par value. Redemption of secondary notes at par value is equivalent to bay al-dayn at par value.

Each primary is represented by more than one secondary note. For example, if the ratio of primary notes to secondary notes is 1:10, then 500,000 primary notes support 5 million secondary notes. In this case, each primary note will cost $1,000 (i.e. $100,000,000 / 100,000) while each secondary notes is worth $48 (i.e. 24,000,000/5,000,000)

Figure 8.4 Al-Bai-Bithaman Ajil IDS (BAIDS or ABBA)

It is worthy to note that bay’ al-dayn at par value is permissible. All fuqahas agreed on this point, including those from the Middle-East. However, the Malaysia bay’ al-dayn is supported by bay’ al-‘inah. Jurists from the Middle-east countries have rejected bay’ al-‘inah as the contract is considered invalid. In this way, bay’ al-dayn in Malaysian Islamic bonds are not well accepted in the Middle-East eventhough these bonds are sold at par value.

Bond Trading: For liquidity purposes, the need for trading is vital. Equally important is capital gains arising from trading. Since Malaysian jurists at the supervisory level agree that a bond paper is property (al-mal), sale of primary notes at discount and premium is allowed. In other words, a debt (bond) can be sold for cash at par or more or less than the face value.

This is the Malaysian view, but we need to appreciate the Middle-eastern outlook as well. Remember, going global on raising fund campaigns must consider Middle-east juristic opinions too. Otherwise, we will have to contend with local funds and thus putting more strain on the economy.

Some viewpoints on Bay’ al-‘Inah

Prof. Saiful Azhar Rosly

A bond is actually the present value of future income streams arising from a) coupon interest payment to the maturity dates and b) its par value on maturity. These future income streams are contractual in nature. Apart from selling Islamic bonds at a discount involving bay’ al-dayn, the Malaysian Islamic bond has yet another problem. It applies bay’ al-‘inah to make the contractual coupon payments lawful.

It may sound academic to discuss bay’ al-‘Inah but rarely it is openly discussed in many Islamic banking seminars held in Malaysia. It is a taboo of some sort. The bay al-‘inah contract involves a cash sale of a fictitious object by say, Mr. Ibrahim to someone, say Mr. Ali who needs the cash. Mr. Ali then sells the same object to Mr. Ibrahim at a higher price payable in the future either by installment or lump sum. Thus, the ‘inah sale may consist of two parts, namely a spot sale as well as a credit sale (al-bai-bithaman ajil).

In the Islamic bond market, repayments are made by issuance of Islamic bonds, one of which represents the contractual coupon profits known as secondary notes. This is only possible by way of the ‘inah sale. However, there is no intention of either party to utilize the object of sale from which some form of usufruct or manfaat should be realized. For example, we buy food or medicine in order to protect the family from hunger and sickness respectively.

However, we will never buy them for say, decorations, as this is not a sensible thing to do. In bay’ al-‘inah, the object of sale is made to exist only to fulfill the requirements of contract (‘aqad) as the buyer has no intention to use the object of sale (mahallul ‘aqdi). Likewise the seller too is interested to conclude the deal as doing so brings profits to the bank. He can only make a loan with a contractual extra payment. However, both will not enter into a contract of debt bearing a contractual returns, but will use the contract of sale (al-bay’) to achieve the same end as any profits made from sale is deemed permissible (halal) in Islam.

Now, some may say the intention of the buyer and seller is not sincere, as there is no real intention to consume or utilize the object of sale. The object (‘ain or ‘in) holds a mere fictitious function. This transaction is pursued only to legalize making loan with interest. At least this is what many Middle-eastern jurists have been saying all along.

Whatever suspicion one has about bay’ al-‘Inah, the Shafi’ school of fiqh still considered legal and valid contract. The Shafi’ school says the intention or niyyah is not a significant element in determining the validity of a contract. This is the viewpoint taken up by the Shari’ah scholars in Bank Negara and the Securities Commission.

However, the niyyah element is a crucial factor in the Hanafi, Hanbali and Maliki schools. E.E. Rayner summarizes this debate with much grace some of which are quoted below. Interested observers can find more detains about this ‘inah sale in her book The Theory of Contracts in Islamic Law.

Rayner said that “although all transaction forming the ‘inah contract are correct in themselves, when put together they merely mask a loan with interest which is prohibited in Islamic law according to the rules of riba”.Therefore, the Hanbali, in according with their principles and taking into account of the illegal nature of the contract, condemn the ‘inah contract and regard it as null and void.

The Shafi’s regard it as perfectly valid on the basis that one has the right to sell an object at a diminished price to that which he himself paid (i.e. Mr. X sells an object worth, say RM1,000 for RM800 cash to Mr. Y and buys it again from Mr. Y at RM1,000 payable by installment). The hilah exert no influence on the validity of acts with the Shafi’s, accordingly, the ‘inah sale is regarded as perfectly valid within the Shafi’s school. The Hanafis are not unanimous in their decision regarding the ‘inah sale. Abu Hanifa himself admits only the case where the third party buys from the buyer to resell to the seller.

Figure 8.5 Bay’ al-‘Inah

Muhammad al-Shaybani, however, regarded the ‘inah sale as valid, but he categorizes it as blameworthy (makruh). The status of the ‘inah contract in the majority opinions of the Maliki School is less tolerant; ‘inah sale is not approved of, but it nevertheless forms a valid contract”. The central issue here is none other than the distinction between real and declared intentions. Rayner further says, “It may be concluded that the Malikis and Hanafis give due effect to the real intention or niyyah of the parties, but that as regards illicit motives both schools are reluctant to make such an uncertain element as motive a dependent factor of a legal act.

“The Hanbali School however, always gives precedence to real intention over declared intention. Indeed, in the Shafi’ school, this is not just a tendency but a doctrinal stance. Wahbah Zuhaili reasserted the Shafi’ school preference for declared intention over real intention as a means to protect the stability of contracts. If contracting parties are required to put their real intention into writing, it will bring economic transactions into disarray, as nobody can know what is contained in the heart of others.

The importance of declared intention over real intention is critical. It is for this reason, we see the contract of Muta’ or contracted marriage as invalid since both parties have declared their intention of divorce or separation after an agreed period of marital life. However, the nikah contract of similar marriage in which no declared intention is made is considered valid even though his real intention is to marry the woman only for a short while, after which he will divorce her.

One good example, contract may look despicably immoral but still valid in the eyes of the Shariah is the case of cina buta (nikah muhallil) as it is called in Malaysia. Here, a man has divorced his wife three times leaving him with no rights to reconciliation or remarrying her again. However, he can do so only if she is divorced after marrying another man. This is the only legal way to marry his ex-wife again. To do so, he will assign or pay a man known as the muhalil (or the cina buta) to marry her but with a directive to divorce her right away and prohibiting him from exercising his rights as a husband, say in consuming sexual relation.

The real intention in this marriage is not to observe the objectives of marriage but only to play with contract technicalities.This contract is valid in the Shafi’ school because no declared intention is evident to invalidate the principles of marriage. The religious officer (kadhi) who performs the marriage (nikah) has practically no idea what’s going on. He assumes the marriage is a normal one.

However, many people will definitely find this act disgusting and immoral. The Malikis and Hanbalis prohibit this shameful contract as both schools give due effect to the real intention. Having said all this, one can easily see now that bay’ al-‘Inah falls in the same category.