Most Islamic bonds should be treated as equity instruments, the top scholar of a body that sets Islamic financial standards across the Middle East said, marking a shift for Muslims seeking fixed-income returns.

Shaikh Mohammad Taqi Usmani, chairman of the board of scholars at AAOIFI – the Accounting and Auditing Organisation for Islamic Fin-ancial Institutions – said two key types of Islamic bonds, or sukuk, should not promise guaranteed returns.

“That’s the basic objective … from an ideal Sharia point of view you can have either equity or quasi-equity sukuk,” said Usmani.

Islam bans lending on interest as usury. Instead, returns derived from underlying physical assets are paid to bondholders. These physical assets may be financed through profit-sharing ventures, such as musharaka and mudaraba deals.


Some 60 per cent of Islamic bonds were structured this way in 2007, ratings agency Standard & Poor’s said in a March report. “Maybe you can have fixed-income in ijara, but not musharaka or mudaraba,” Usmani said.

Sharia stipulates that members of a joint business venture should share risk and reward and not guarantee returns regardless of venture success for any one party.

Most Gulf Islamic bonds have been sold with a repurchase undertaking – a promise that the borrower will pay back their face value at maturity, or in the event of a default, mirroring the structure of a conventional bond.

This promise contravenes the obligation to share risk in the case of mudaraba and musharaka sukuk, Usmani said. The bonds should be bought at market value at maturity, effectively turning them into an equity instrument.

Sukuk based on an ijara, or leasing structure, do allow a repurchase guarantee, as bond returns are derived from rental payments, and not from a joint business venture.

Usmani roiled Islamic bond markets in November when he said that about 85 per cent of sukuk did not comply with Islamic law because of repurchase agreements.


AAOIFI scholars have since met in February to review sukuk guidelines and again confirmed the prohibition on repurchase agreements, although previously issued sukuk were deemed valid.

Commodity murabaha is another mainstay of Islamic banking that has also drawn the ire of top Islamic scholars. By far the most common Islamic financial transaction, the contract involves a bank buying a commodity for a client, who later pays the bank back the commodity cost plus a bank charge.

The contract is often used by the client to secure a loan by selling the commodity on again, effectively buying money from the bank for the cost of the profit rate.

While Islamic law permits the practice in some heavily proscribed cases, the extent to which the contract is used on a daily basis has alarmed many scholars, who see the purchase of cash for a fee as too close to an interest-bearing deal.

“People ask me how you can say this is a permissible transaction, but you should minimise its use,” Usmani said. “My answer is that this is first aid or a painkiller provided to a patient. It is necessary. You cannot say it is not valid, but it is not ideal,” he said of the contract.

Aside from Sharia concerns about sukuk and commodity murabaha, the greatest challenges facing the Islamic banking industry is a lack of regulatory support from governments.

Usmani praised the United Kingdom for removing double taxation on property exchanged in Islamic mortgages, where the bank buys a property and sells it on to a customer for a fee.

In other countries, each purchase of the property – by the bank and its client – might be taxed.

“Only the UK has abolished this double duty … I am not aware of any Muslim country which has done this,” Usmani said.