What looks like a bond and acts like a bond but isn't a bond?

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1:25This is The Indicator from Planet Money. I'm Darian Woods. And I'm Waylon Wong. Back in 2021, the small island nation of the Maldives needed money. The country relies heavily on tourism, which dried up at the onset of the pandemic. The economy shrank over 30 % in 2020. When countries need money, they often sell bonds. These are like IOUs. Investors lend money to a government with the expectation that they will be paid back later with interest. The Maldives, though, opted for something different. It sold$500 million of something called sukuk. Sukuk are a way for governments to borrow money and for investors to make money while complying with Islamic law, which forbids interest.

2:07Economist Reza Bakir puts it like this. Sukuk, they look like bonds, they smell like bonds, they act like bonds, but they're not bonds. But do they default like bonds? This has become a pressing question for the Maldives because the country is struggling with a heavy debt load. If the island nation misses a payment, it would be the first ever default for government sukkuk. Today on the show, we explain how sukkuk works, how it fits into the larger world of Islamic finance, and what might happen in a default.

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3:33Just go to linkedin.com slash nprpod. That's linkedin.com slash nprpod. Terms and conditions apply. Only on LinkedIn ads. This message comes from Amazon Business. With smart business buying, get everything you need to grow in one familiar place, from office supplies to IT essentials and maintenance tools. Ready to bring your visions to life? Learn how at amazonbusiness.com. All right, Darian, let's say you are the finance minister of a country and you want to sell sukuk. I feel like you're about to hand me a brochure that says, so you've decided to sell sukuk. Yeah, I keep these pamphlets in my briefcase for occasions just like this one.

4:13So here we go. Step number one, find some kind of tangible government asset. It could be a piece of land. All right, I've got my eye on a nice grassy patch of government-owned land. What's the next step? Next, you're going to create a special legal entity. This entity will own the right to rental income that comes from that piece of government land. Okay, so we're expecting this grassy patch to generate rental income. I have signed the paperwork and I've created this special legal entity. Then this special legal entity is going to sell certificates to investors. These certificates essentially entitle investors to a share of those profits that we're expecting from this land.

4:57All right, so the investors hand over their cash. That cash goes to the special legal entity and flows back to me at the government. Now I, in the government, have cash. The investors have their certificates and they are expecting profits. How does this piece of land make money? Well, you, the government, are going to pay rent to that special legal entity. That's the income. And it's just money out of the government bank account, the same money that could be used to make interest payments on a traditional bond. This is a payment that more or less is fixed and is coming to the certificate holder or the sukuk holder.

5:33Economist Reza Bakir is the former governor of Pakistan's central bank. Today, he works at a consulting firm called Alvarez & Marcel, where he advises emerging market governments on economic matters. Reza says the process we've just laid out, where the government pays rent on a piece of land it owns, that's a common structure for a sukuk. That is generating a cash flow that is very similar to a bond. It's similar because with the traditional bond, the holder of that bond also receives a fixed amount of money at regular intervals. The experience for the investor is basically the same, whether they're putting their money in a traditional bond or sukuk.

6:13The difference is what's underneath the surface. So with sukuk, there are no interest payments and instead the money is coming from this tangible asset. In our example, we used a piece of land, but other assets can be commodities or public infrastructure projects. Reza told us there is a whole industry of lawyers who specialize in helping governments figure out these sukuk deals. You can find a lot of rich, gory detail on the types of Sukuk structures in, if I may say so, our excellent paper, which is on our website, where we document the different types of Sukuk structures that have come about over the years, really to try to cater to the growing demand for Islamic finance.

6:57Reza says the Sukuk market is around$800 billion. It's a slice of an even larger category known as Islamic finance. That broader market is around$3.2 trillion. It comprises different kinds of banking and lending that are compliant with Islamic or Sharia law. One of the core ideas in Islamic finance is the prohibition on interest, that is, charging a fixed amount for lending money. Now, I'm not a theologian, so I'm not going to go into why that has come to be, but it's broadly based upon the notion that interest was seen as inequitable and potentially exploitative. Exploitative and inequitable.

7:43Because Reza says you could argue that charging interest allows people with money to benefit from the privilege of having money. And so interest is not allowed. This prohibition on interest makes entire categories of investing off-limits, like traditional government bonds. So investors who want to be in line with Islamic law need other places to put their money. And Reza says this group of investors has gotten really big. They include pension funds and hedge funds. And their demand has helped the global sukuk market grow over the last decade or so. There is a large demand on the part of investors, people with pools of savings, too few assets which meet their criteria.

8:27This is a large, relatively untapped pool of capital. Muslim-majority countries like Saudi Arabia and Malaysia have been active in issuing sukuk to meet this investor demand. But Reza notes that secular, non-Muslim-majority countries like the United Kingdom and South Africa have also sold sukuk. Reza has also found that borrowing money by issuing sukuk is often cheaper for governments than traditional bonds. And that's because there is so much demand for Sharia-friendly investments and not enough Sukuk deals out there. And there was very high investor interest when the Maldives issued Sukuk back in 2021.

9:05Still, the country is in financial distress. The government's biggest creditors are actually China and India. Those larger countries have made huge traditional loans to the Maldives. Now the Maldives is running low on the reserves it needs to make those debt payments. And on top of that, it needs to pay its Sukuk investors. If it can't, it will be the first sovereign Sukuk default in history. Reza's assessment of that scenario, though, is relatively sanguine. He thinks everyone involved would be motivated to negotiate new payment terms. He doesn't see investors and the Maldives government getting mired in a long court battle over restructuring the debt.

9:43Any finance minister of a country that is experiencing default, first of all, is not in a good place. They've tried their very best not to be there. But once there, they want to get out of it as soon as possible. The lawyers, they're a big part of the story. They have no incentive to have an outcome where the headline is that sukuk's blow up. This is a very practical perspective that I'm giving you, just having been in some such situations. And so virtually every stakeholder that I see is going to have an incentive to have that restructuring happen in a manner that it's not a roadblock. And of course, there might not be a default or a need for debt restructuring at all.

10:25Earlier this month, the Maldives government successfully made a scheduled payment of$25 million to Sukuk holders. The Indian government also recently agreed to give the Maldives financial assistance. The next test for the Maldives Sukuk will come in April.

10:45This episode was produced by Corey Bridges with engineering by Valentina Rodrigues Sanchez. It was fact-checked by Sierra Juarez. Kicking Cannon is our editor, and The Indicator is a production of NPR.

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