The german version of this article was published HERE.
Luxembourg, 12th November 2024 – An article by Stephan Blohm (Board of Directors, securities.lu SA)
Islamic finance principles have long aligned with many of the core values found in ESG (Environmental, Social, and Governance) investing. Islamic finance emphasises co-ownership and shared responsibility, inherently fostering sustainable investment practices. This alignment provides a valuable model, especially as Western financial systems work to reintegrate values-based investment principles that have at times faded from mainstream focus. Sharia-compliant investments, which prioritise social and ethical considerations, hold significant potential as models for European markets, particularly in addressing the often-overlooked “S” in ESG. Luxembourg is a notable example where demand for Sharia-compliant investments is steadily rising, with such investments making a shift from niche to mainstream.
The EU’s increasingly rigorous ESG requirements are fuelling interest in investments that offer measurable environmental and social impacts. Sharia-compliant investment approaches are therefore attracting attention from both Muslim and non-Muslim institutional investors across Europe, as their ethical frameworks resonate with the growing call for impactful investing. Over the past year, Luxembourg specifically has witnessed a surge of new Sharia-compliant investment vehicles designed to appeal to a broader audience.
The direction of co-ownership and co-responsibility
The foundation of Sharia-compliant investing lies in principles of co-ownership and, by extension, co-responsibility. Rather than merely providing capital in exchange for returns, this approach emphasises active co-entrepreneurship. Investors in Sharia-compliant assets participate in the business akin to partners or shareholders, although the mechanisms of liability, security and structure differ. This creates a keen sense of shared responsibility – a particularly positive aspect in the context of sustainable investing. Historically, Sharia-compliant investments have avoided the exclusive focus on figures and returns characteristic of conventional Wall Street investing, embracing a broader perspective that values social impact alongside financial success.
In Sharia-compliant investments, returns are not based on traditional interest; rather, they are tied to the actual performance of the enterprise. This means investors share in the company’s successes, prompting them to carefully evaluate where they place their capital, considering not just potential returns but the quality and impact of the investment itself.
While the principles of Sharia-compliant investing date back centuries, sustainability, in a modern sense, aligns seamlessly with these traditional values. Before the advent of industrialisation, sustainable investing was simply the norm, reflected in the phrase, “Don’t bite the hand that feeds you”. Sharia-compliant investments strive to uphold this ethos, providing a framework that encourages investments that benefit individuals, society and the environment.
Focus on sustainability over returns
While the Western financial world developed swiftly, it often prioritised returns, market growth and expansion over the enduring wisdom of traditional values and Christian ethics. By contrast, the Arab financial sector evolved later and then prospered, allowing religious principles, cultural values and corporate legal norms to maintain a noteworthy influence on investment decisions.
Sharia-compliant investing, in this context, serves as a guiding framework that marries financial decisions with common sense. Although some may view its principles as restrictive or overly ideological, Sharia compliance establishes rules that certain investors find not only acceptable but inherently logical. This has led to an increasing number of suitable investment products, drawing interest from non-Muslim investors who recognise the economic promise within this structured, values-driven approach.
The EU’s efforts to steer finance toward sustainability and responsible decision-making through ESG standards reflect a return to a financial landscape that values long-term impact. Conscious and sustainable investing has always existed; it has simply been overlooked because its benefits are rarely immediate and often take generations to manifest. Today, Sharia-compliant investments stand as a precursor and perhaps a role model for this renewed emphasis on responsible, sustainable finance.
Sukuk bonds: A unique form of social investment
Sharia-compliant bonds, widely known as sukuk bonds, are gaining traction in the international capital market as a form of ethical and sustainable investment, appealing to a broad range of investors beyond the Muslim community. Sukuk bonds adhere to the Sharia prohibition on interest while enabling investments in economically productive projects. Typically structured as asset-backed securities, Sharia-compliant bonds represent an ownership share in a specific asset or income-generating source, rather than offering fixed interest payments. This structure follows a partnership model in which investors share both the potential returns and the inherent risks of the investment.
When viewed through the lens of conventional Western asset and portfolio management, Sharia-compliant investing emerges as a specialised form of social investment, particularly addressing the “S” in ESG. Like other socially responsible investments, Sharia-compliant decisions are governed by ethical screening or exclusion criteria. For example, companies engaged in industries like alcohol, casinos or gambling are excluded – a practice also common in ESG-focused non-Islamic investment strategies.
In this sense, Sharia compliance functions as an ethical investment standard, transcending its cultural, religious and historical roots. However, the distinct structure of sukuk bonds also offers a unique alternative for portfolio diversification, making them a compelling option for investors seeking both financial and ethical alignment.
Complex structures with greater flexibility
Growing demand for Sharia-compliant investments is particularly evident in Luxembourg, where the market is transitioning from niche to mainstream. Luxembourg’s securitisation law provides an ideal regulatory environment for Sharia-compliant bonds. Sukuk bonds, often more intricate than conventional bonds, benefit from Luxembourg’s securitisation framework, which accommodates the establishment of special purpose vehicles (SPVs). These SPVs enable issuers and investors to craft products tailored to specific needs – though successful implementation typically requires the expertise of a seasoned partner.
The most prominent difference between Sharia-compliant structures and traditional bonds is the explicit prohibition of interest, stemming from the principle that money serves only as a vehicle for real economic value and is not an asset itself. This principle prohibits the earning of money purely from money. Consequently, while conventional bonds offer fixed interest, sukuk bonds derive income from leasing fees, actual revenues of underlying assets or profits from the financed business activities.
Structured products in general pose significant entry barriers for individual and smaller investors, often due to high minimum denominations, typically around USD 10,000 or more, as well as the complexity of payout structures and risk profiles. However, innovations in Islamic finance aim to lower these barriers, offering accessible products, services and securities. The standardisation of Sharia-compliant products is increasing the appeal of sukuk bonds among value-focused investors, family offices and retail investors. Transparent, comprehensible bond terms, coupled with consistently applied ethical standards, support this trend toward broader participation in the sukuk market.
Bond structuring resembling leasing arrangements
In a conventional bond, the issuer provides the investor with a securitised financial claim in exchange for the invested amount, granting the investor interest payments and the right to principal repayment. This type of transaction typically centres solely on a financial claim, though certain bonds may offer specific collateral in addition to the claim.
In contrast, sukuk bonds and other Sharia-compliant investment structures employ an asset-based transaction model, often resembling a leasing arrangement commonly used in corporate finance. With an asset-based structure, the issuer sells a partial or full stake in a real asset or business unit to the investor or syndicate, collecting proceeds from the issue. Typically, the issuer transfers the underlying asset to an SPV beforehand, streamlining cash flow management and enhancing the bond’s tradability. This structure ensures that all relationships between the issuer, investors and third parties are governed by a defined, regulated process.
Investors formally become the owners of the SPV, entitling them to receive income generated by the asset. Depending on the contractual structure, returns flow from the issuer to the investors through the SPV as fixed lending or leasing fees. Meanwhile, the issuer retains possession of the SPV and the underlying asset, maintaining practical control throughout the term. Upon maturity, ownership of the asset typically reverts to the issuer, with the redemption value aligning with the bond’s face value. This re-transfer marks the conclusion of the asset-based financial product, mirroring the lifecycle of a lease.
Bond Terms and Conditions: The devil is in the details
With traditional corporate bonds, issuers may back bond repayment and regular interest payments by pledging certain assets as collateral. However, if the issuer defaults, the company’s liability to bondholders is not necessarily complete or direct and may exclude other assets. This structure makes it challenging for subordinated creditors, such as bondholders, to predict whether they will recover any funds or what the compensation amount will be in the event of a default. Moreover, traditional debt financing and corporate bonds rarely impose any specific obligation for additional contributions, typically limiting losses to the initial capital invested.
In contrast, sukuk bonds formally secure investor claims through the transfer of ownership rights to the underlying assets themselves. Sukuk investors receive direct collateralisation of their claims via specific assets tied to the bond’s conditions. This arrangement sometimes grants sukuk holders a legal standing that can closely resemble that of equity investors, depending on the terms of the bond.
While liability limitations are generally established, ensuring that maximum losses on sukuk bonds do not exceed the invested capital, bond conditions can still vary greatly. As a result, investors should carefully review terms before purchasing a sukuk bond – particularly to assess any potential obligations for additional contributions in case of a loan event and to understand the maximum potential loss if the bond defaults.
Sharia-compliant investments offer a compelling risk/return profile, fundamentally distinct from traditional investments, and thus can serve as a valuable element for portfolio diversification. Given their compatibility with ESG strategies and robust reporting capabilities, sukuk bonds are especially appealing to institutional and semi-institutional investors.