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How Sukuk works: Introduction, structuring and application ofSukuk bonds
Posted on April 27, 2010 | 7 Comments
How Sukuk works: Introduction, structuring and application of Sukuk bonds
An ex cellent introduc tion to Sukuk bonds.
From:www.financeinislam.comAuthor: Shariq Nisar
ISLAMI C BONDS (SUKUK): IT S
INT RODUCT ION AND APPLICA T ION
What is Suku k
Sukuk in general may be understood as a shariah co mpliant Bond. In its simplest form sukuk
represents o wnership of an asset or its usufruct. The claim embodied in sukuk is not simply a claim tocash flow but an ownership claim. This also differentiates sukuk from co nventional bonds as the latter
proceed ov er interest bearing securities, whereas sukuk are basically investment certificates consisting
of ownership claims in a pool ofassets.
Sukuk (plural of word sak) were ex tensively used by Muslims in the Middle A ges as papers representing
financial obligations originating from trade and o ther commerc ial activities. Howev er, the pr esent
structure o f sukuk are different from the sukuk originally used and are akin to the conv entional conce pt
of securitization, a pro cess in which o wnership of the underly ing assets is transferred to a large number
of inve stors through certificates representing propor tionate value of the relevant assets.
Suku k v s. Conv entional Bonds
A bo nd is a contractual debt o bligat ion whereby the issuer is contractually obliged to pay to
bo ndholders, on certain spec ified dates, interest and princ ipal, whereas, the sukuk holders c laims
an undivided beneficial ownership in the underly ing assets. Consequently , sukuk holders are
entitled to share in the rev enues generated by the sukuk assets as well as being entitled to share in
the proc eeds o f the realization of the sukuk assets.
A distinguishing feature of a sukuk is that in instanc es where the certificate represents a debt to the
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holder, the c ertificate will not be tradable on the secondary market and instead is held until
maturity or sold at par.
Accounting and A uditing Organisation for Islamic Financial Institutio ns (A AOIFI) defines sukuk as
being:
Certificates o f equal value representing after clo sing subscription, receipt of the v alue of the
certificates and putting it to use as planned, co mmon title to shares and r ights in tangible assets,usufructs and serv ices, or equity of a given project or equity o f a special investment activity.
Benefits and Features
Tradable shariah-compliant capital market product prov iding medium to long-term fixed or
v ariable rate s of return. A ssessed and rated by inte rnational rating agencies, which inv estors use
as a guideline to assess risk/return parameters o f a sukuk issue.
Regular periodic income streams during the investment period with easy and efficient settlement
and a possibility of capital appreciation of the sukuk.Liquid instruments, tradable in seco ndary market.
Uses of Sukuk Fu nds
The most commo n uses of sukuk can be named as projec t specific, asset-specific, and balance sheet
specific.
1. Project-specific Suku k
Under this category money is raised through sukuk for spec ific projec t. For ex ample, Qatar Global
sukuk issued by the Government o f Qatar in 2003 to mobilize resourc es for the co nstruction of Hamad
Medical City (HMC) in Doha. In this case a joint v enture special purpose vehicle (SPV), the Qatar Global
sukuk QSC, was incorporated in Qatar with limited liability . This SPV acquired the o wnership of land
parcel, that was registered in the name of HMC. The land parc el was placed in trust and I jara-based
Trust Certificates (TCs) were issued worth US$7 00 million due by October 20 10 . The annual floating
rate of return was agreed at LIBOR plus 0.45 per c ent.
2. Assets-specific Suku k
Under this arrangement, the reso urces are mobilise by selling the beneficiary right of the assets to the
investor s. For ex ample, the Government o f Malaysia raised US$ 60 0 million through Ijara sukuk Trust
Certificates (TCs) in 2002. Under this arrangement, the be neficiary right of the land parce ls has been
sold by the gov ernment of Malaysia to an SPV, which was then re-sold to investors for five y ears. The
SPV kept the beneficiary rights of the properties in trust and issued floating rate sukuk to investors.
Another example o f Asset-specific sukuk is US$25 0 millio n five-y ear Ijara sukuk issue d to fund the
extension of the airport in Bahrain. In this case the underly ing asset was the airport land sold to an SPV.
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3. Balance Sheet-specific Suku k
An ex ample o f the b alance sheet spec ific use of sukuk funds is the Islamic Development Bank (I DB)
sukuk issued in August 20 03. The IDB mobilised these funds to finance v arious projects of the member
countries. The IDB made its debut re source mobilization from the international capital market by
issuing US$ 40 0 million five-year sukuk due for maturity in 20 08.
T ypes of Suku k
Sukuk can be o f many types depending upon the ty pe of Islamic modes of financing and trades used in
its structuring. Howev er, the mo st important and co mmon among those are ijarah, shirkah, salam and
istisna. Among the fourteen e ligible sukuks identified by the AA OIFI, following are more c ommon:
1. Mudaraba Sukuk
These are investment sukuk that represent ownership of units of equal value in the Mudaraba equityand are registered in the names of holders on the basis of undivided o wnership of shares in the
Mudaraba equity and its returns acc ording to the perc entage of ownership of share. The owners o f such
sukuk are the rabbul-mal. (AA OIFI). Mudarba sukuk are used for enhancing public participation in big
investment projects.
Salient Features:
Following are the salient features of mudarba sukuk:
Mudarba sukuk (MS) represent co mmon o wnership and entitle their holders share in the spec ific
projects against which the MS has been issued.
The MS contrac t is based on the official notice o f the issue of the prospec tus which must prov ide
all information required by shariah for the Qirad contract such as the nature of capital, the ratio
for profit distribution and other co nditions related to the issue, which must be co mpatible with
shariah.
The MS holder is give n the right to transfer the ownership by selling the deeds in the securities
market at his discretion. The sale of MS must follow the rules listed below:
If the mudarba capital, before the operations of the project, is still in the form of money , the
trading of MS would be like exchange of money for money . In that case the rules of bay al-
sarf would be applied.
If muqarda capital is in the form of debt then it must satisfy the pr inciples of debt trading in
Islam.
If capital is in the form of combination of cash, rece ivables, go ods, real assets and benefits,
trade must be based on market price ev olved by mutual consent.
The Manager/SPV who r ece ives the fund collec ted from the subscribers to MS can also invest his
own fund. He will get profit for his capital co ntribution in addition to his share in the pro fit as
mudarib.
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holders become the owners of the project or the assets of the activity as per their respective shares.
These Musharaka certificates c an be treated as negotiable instruments and can be bo ught and sold in
the secondary market.
These are c ertificates of equal v alue issued with the aim o f using the mo bilized funds for establishing a
new project, dev eloping an existing project or financing a business activity o n the basis of any
partnership contracts so that the cer tificate holders bec ome the owners o f the projec t or assets of the
activ ity as per their respectiv e shares, with the Musharaka certificates being managed on the basis ofparticipation or Mudaraba or an investment agency . (AAOIFI Standard 17 , 3/6)
Steps involv ed in the structu re:
Corporate and the Special Purpose V ehicle (SPV) enter into a Musharaka Arr angement for a fixed
period and an agreed pro fit-sharing ratio. Also the c orpor ate undertakes to buy Musharaka shares of
the SPV on a periodic b asis.
Corporate (as Musharik) contributes land or o ther phy sical assets to the MusharakaSPV (as Musharik) co ntributes cash i.e. the issue Proceeds receiv ed from the investors to the
Musharaka
The Musharaka appoints the Corporate as an agent to dev elop the land (or other physical assets)
with the cash injected into the Musharaka and sell/ lease the developed assets on behalf of the
Musharaka.
In return, the agent (i.e. the Corporate) will get a fixed agency fee plus a variable incentiv e fee
payable.
The profits are distributed to the sukuk holders.
The Corporate irrev ocably undertakes to buy at a pre-agreed price the Musharaka shares of the
SPV on say semi-annual basis and at the end o f the fixed period the SPV would no longer have any
shares in the Musharaka.
Mush araka Suku k in Practice
US$5 50 million sukuk transaction for Emirates airline, the sev en-year deal was a structured o n a
Musharaka contract. The Musharaka or joint v enture was set up to dev elop a new engineering centre
and a new headquarters building on land situated near Dubais airport which will ultimately be leased to
Emirates. Profit, in the form o f lease rentals, generated from the Musharaka venture will be used to pay
the periodic distribution on the trust ce rtificates.
Sitara Chemical Industries Ltd, a public limited c ompany , made a public issue of profit-and-loss sharing
based term financ e certificates (TFCs) wo rth Rs 360 million whic h were subscribed in June 20 02. The
TFCs had a fixed life tenor o f five y ears and pro fit and loss sharing was linked to the operating profit or
loss of the Chemical Division of the company .
Kuwait Finance House (KFH), Liquidity Management Center (LMC) and Al Muthanna Inv estment
Company (MIC), the mandated lead arrangers launched US$ 12 5 million Lagoon City Musharaka sukuk
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to support the Lagoon City residential and co mmercial real estate dev elopment as part of Kheiran Pearl
City project.
3. Ijara Suku k
These are sukuk that represent ownership of equal shares in a rented real estate or the usufruct of the
real estate. These sukuk give their o wners the right to own the real estate, rec eive the rent and dispose
of their sukuk in a manner that does not affect the right of the lessee, i.e. they are tradable. The holdersof such sukuk bear all cost of maintenance of and damage to the real estate. (AA OIFI)
Ijarah sukuk are the securities representing ownership of well defined ex isting and known assets tied up
to a lease contract, rental of which is the return pay able to sukuk holders. Payment o f ijarah rentals can
be unr elated to the perio d of taking usufruct by the lessee. I t can be made before beginning of the lease
period, during the period or after the period as the parties may mutually dec ide. This flexibility c an be
used to ev olv e different forms of contract and sukuk that may serv e different purposes of issuers and
the holders.
Features of Ijarah suku k
It is necessary for an ijarah contract that the assets being leased and the amount of rent both are
clearly known to the parties at the time of the contract and if both of these are known, ijarah can
be contracted on an asset or a building that is y et to be constructed, as long as it is fully described
in the contract provided that the lessor should normally be able to acquire, construct or buy the
asset being leased by the time set for its delivery to the lessee (AAOIFI, 200 3: 140-1 57 ). The
lessor can sell the leased asset prov ided it does not hinder the lessee to take benefit from the asset.
The new owner would be entitled to receiv e the rentals.
Rental in ijarah must be stipulated in c lear terms for the firs term of lease, and for future renewable
terms, it could be c onstant, increasing or dec reasing by benchmarking or relating it to any well-
known variable.
As per shariah rules, expenses related to the corpus or basic c haracteristics of the assets are the
responsibility of the owner, while maintenance expenses related to its operation are to be borne
by the lessee.
As regards procedure for issuance o f ijarah sukuk, an SPV is created to purc hase the asset(s) that
issues sukuk to the investo r, enabling it to make pay ment for purchasing the asset. The asset is
then leased to third party for its use. The lessee makes periodic r ental payments t the SPV that in
turn distributes the same to the sukuk holders.Ijara sukuk are co mpletely nego tiable and can be traded in the secondary markets.
Ijara sukuk offer a high degree of flex ibility from the point of v iew of their issuance management
and marketability. The central gove rnment, municipalities, awqaf or any other asset users, priv ate
or public can issue these Sukuk. Additionally, they can be issued by financial intermediaries or
directly by users of the leased assets.
Steps inv olved in the structu re
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The obligator sells certain assets to the SPV at an agreed pre-determined purc hase price.
The SPV raises financing by issuing sukuk certificates in an amount equal to the purchase price.
This is passed on to the obligator (as seller).
A lease agreement is signe d between SPV and the obligator for a fix ed perio d of time, whe re the
obligator leases back the assets as lessee.
SPV rec eives periodic rentals from the obligator;
These are distributed among the investors i.e. the sukuk holders.
At matur ity , or on a disso lution ev ent, the SPV sells the assets back to the seller at apredetermined v alue. That value should be equal to any amounts still owed under the terms o f the
Ijara sukuk.
Ijara Suku k in Practic e
In December 200 0, Kumpulan Guthrie Berhad (Guthrie) was granted a RM1.5 billion (US$400 million)
Al-Ijara Al-Muntahiy ah Bit-Tamik by a conso rtium of banks. The o riginal facility was r aise d to re-
finance Guthries acquisition o f a palm oil plantation in the Republic o f Indonesia. The co nsortium was
then invited to participate as the underwriter/primary subsc riber of the Sukuk Transaction.
US$35 0 million sukuk Trust Certificates by Sarawak Corporate Sukuk Inc. (SCSI) Sarawak Economic
Dev elopment Corpo ration (SEDC) raised financing amounting to US$35 0 million by way of issuance o f
series of trust certificates issued on the principle of Ijara sukuk. The certificates were issued with a
maturity of 5 years and under the proposed structure, the proc eeds will be used by the issuer to
purchase certain assets from 1 st Silicon (Malaysia) Sdn Bhd. Thereafter, the issuer will lease assets
procured from 1 st Silicon to SEDC for an agreed re ntal price for an agreed lease period o f 5 years.
4. Murabaha Suku k
In this case the issuer of the certificate is the seller of the Murabaha commodity , the subscribers are the
buyers of that commodity , and the realised funds are the purchasing c ost o f the c ommodity . The
certificate holders own the Murabaha commo dity and are entitled to its final sale price upo n the re-sale
of the Commodity. The po ssibility o f having legally acceptable Murabaha-based sukuk is only feasible in
the primary market. The negotiability of these Sukuk or their trading at the secondary market is not
permitted by shariah, as the certificates represent a debt owing from the subsequent buyer of the
Commodity to the certificate-holders and such trading amounts to trading in debt on a de ferred basis,
whic h will r esult in riba.
Despite being debt instruments, the Murabaha Sukuk could be nego tiable if they are the smaller part o f a
package or a portfolio, the larger part o f which is constituted of negotiable instruments such as
Mudaraba, Musharaka, or I jara Sukuk. Murabaha sukuk are popular in Malaysian market due to a more
liberal interpretation of fiqh by Malaysian jurists permitting sale of debt (bai-al-dayn) at a nego tiated
price.
Steps involv ed in the structu re:
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A master agreement is signed between the SPV and the borrower
SPV issues sukuk to the investors and receive sukuk proceeds.
SPV buy s commodity on spot basis from the commo dity supplier.
SPV sells the co mmodity to the borro wer at the spot price plus a profit margin, payable on
installments ov er an agreed period of time
The borrower sells the commo dity to the Commodity buy er on spot basis.
The investors receiv e the final sale price and profits.
Murabaha Suku k in Practice
Arcapita Bank, a Bahrain-b ased inv estment firm has mandated Bay erisc he Hy po-und V ereinsbank A G
(HVB), Standard Bank Plc (SB) and WestLB AG, London Branch (WestLB) (together the Mandated
Lead Arrangers), to arrange a Five Y ear Multicurrency (US$, and ) Murabaha-backed Sukuk. Sukuk
will hav e a fiv e-y ear bullet maturity and proposed pricing three month LIBOR +17 5bps.
5. Salam Suku k
Salam sukuk are certificates o f equal v alue issued for the purpose of mobilising Salam capital so that the
goods to be deliv ered o n the basis of Salam come to the ownership of the certificate holders. The issuer
of the certificates is a seller of the goods o f Salam, the subscribers are the b uyers of the goods, while the
funds realized from subscr iption are the purchase price (Salam capital) of the goo ds. The holders of
Salam certificates are the o wners of the Salam goods and are entitled to the sale price of the certificates
or the sale price o f the Salam goods so ld through a parallel Salam, if any .
Salam-based securities may be cr eated and sold by an SPV under which the funds mobilized from
investor s are paid as an advance to the co mpany SPV in return for a promise to deliver a co mmodity at
a future date. SPV can also appoint an agent to market the promised quantity at the time o f delivery
perhaps at a higher price. The difference between the purchase price and the sale price is the profit to
the SPV and hence to the ho lders of the Sukuk.
All standard shariah requirements that apply to Salam also apply to Salam sukuk, such as, full pay ment
by the buyer at the time of effecting the sale, standardized nature of unde rly ing asset, c lear
enumeration of quantity , quality, date and place of delivery of the asset and the like.
One of the Shariah conditions relating to Salam, as well as for cr eation o f Salam sukuk, is the
requirement that the purchased goo ds are not re-sold before actual possession at maturity. Such
transactions amount to selling of debt. This constraint renders the Salam instrument illiquid and hence
somewhat less attractive to inv estors. Thus, an investo r will buy a Salam certificate if he ex pects prices
of the underly ing commodity to be higher on the maturity date.
Steps involv ed in the transaction:
SPV signs an undertaking with an obligator to source both commodities and buy ers. The obligator
co ntracts to buy , on behalf of the end-Sukuk holders, the commodity and then to sell it for the
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profit of the Sukuk holders.
Salam certificates are issued to inve stors and SPV rec eive s Sukuk proceeds.
The Salam proceeds are passed onto the obligator who sells commo dity on forward basis
SPV rec eives the commodities from the obligator
Obligator, on behalf of Sukuk holders, sells the c ommodities for a pr ofit.
Sukuk holders receive the commodity sale proc eeds.
Salam Sukuk in Practice
Aluminum has been designate d as the underly ing asset of the Bahrain Gov ernment al Salam contract,
where by it promises to sell aluminum to the buyer at a specified future date in return o f a full pr ice
payme nt in advance. The Bahrain Islamic Bank (BIB) has been nominated to represent the o ther banks
wishing to partic ipate in the A l Salam contract. BIB has be en delegated to sign the contracts and all
other necessary do cuments on behalf of the other banks in the syndicate. At the same time, the buyer
appoints the Government of Bahrain as an agent to market the appropriate quantity at the time o f
delivery through its channels of distribution. The Gove rnment of Bahrain provides an additional
undertaking to the representative (BIB) to market the aluminum at a price, which will provide a return
to al Salam security holders equiv alent to those available through other conv entional short-term
money market instruments.
6. Istisn a Suku k
Istisna sukuk are c ertificates that carry equal v alue and are issued with the aim of mobilising the funds
required for produc ing products that are owned by the certificate holders. The issuer of these
certificates is the manufacturer (supplier/seller), the subscr ibers are the buy ers of the intended
product, while the funds realised from subsc ription are the cost o f the product. The certificate holders
own the product and are entitled to the sale price o f the certificates or the sale price of the produc t sold
on the basis of a parallel Istisna, if any. Istisna Sukuk are quite useful for financing large infrastructure
projects. The suitability of Istisna for financial intermediation is based on the permissibility for the
contrac tor in Istisna to enter into a parallel Istisna contract with a subco ntractor. Thus, a financial
institution may undertake the co nstruction of a facility for a deferred price, and sub co ntract the actual
construc tion to a spec ialised firm.
Shariah prohibits the sale of these debt c ertificates to a third party at any price o ther than their face
value. Clearly such certificates cannot be traded in the secondary market .
Steps involv ed in the structu re:
SPV issues Sukuk certificates to r aise funds for the project.
Sukuk issue proce eds are used to pay the contractor /builder to build and deliver the future
project.
Title to assets is transferred to the SPV
Property /projec t is leased or sold to the end buyer. The end buye r pays monthly installments to
the SPV.
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The returns are distributed among the Sukuk holders.
Istisna Sukuk in Practice
Tabreeds five-year global c orporate Sukuk (on behalf of the National Central Cooling Company , UAE)
prov ided a fixed c oupon of 5.50 %. It is a c ombination of Ijara Istisna and Ijara Mawsufah fi al dhimmah
(or forward leasing contrac ts). The issue was launched to raise funds to retire some existing debt, which
totals around US$136 million, as well as to finance ex pansion.
The Durrat Sukuk will finance the reclamation and infrastructure for the initial stage of a broader US$ 1
billion world class residential and leisure destination known as Durrat A l Bahrain, currently the
Kingdom of Bahrains largest residential dev elopment pro ject. The return o n the Sukuk is 125 basis
points over 3 months LIBOR payable quarterly , with the Sukuk having an overall tenor of 5 years and an
option for early redemption. The proc eeds of the issue (cash) will be used by the Issuer to finance the
reclamation of the land and the development of Base Infrastructure thro ugh multiple projec t finance
(Istisna) agreements. As the works carried out under eac h Istisna are completed by the Contractor and
delivere d to the Issuer, the Issuer will give notice to the Project Company under the Master IjaraAgre ement and will lease such Base Infrastruc ture on the basis o f a lease to own transaction.
7 . Hybrid Suku k
Considering the fact that Sukuk issuance and trading are important means of investment and taking into
account the v arious demands of investors, a mo re diversified Sukuk hybrid or mixed asset Sukuk
emerged in the market. In a hy brid Sukuk, the underlying poo l of assets can comprise of Istisna,
Murabaha receiv ables as well as Ijara. Having a portfolio of assets co mprising of different c lasses allows
for a greater mobilization of funds. Howev er, as Murabaha and Istisna contracts cannot be traded o n
seco ndary markets as securitised instruments at least 51 percent of the pool in a hy brid Sukuk must
compr ise of Sukuk tradable in the market such as an Ijara Sukuk. Due to the fact the Murabaha and
Istisna receivables are part of the pool, the return on these ce rtificates can only be a pre-determined
fixed rate of return.
Steps involv ed in the structu re:
Islamic finance originator transfers tangible assets as well as Murabaha deals to the SPV.
SPV issues certificates o f participation to the Sukuk holders and rec eive funds. The funds are used
by the Islamic finance originator .
Islamic finance o riginator purc hase these assets from the SPV ov er an agreed period of time.
Inve stors receive fixed pay ment of return on the assets.
Hybrid Suku k in practice
Islamic Development Bank issued the first hybrid Sukuk of assets comprising 65.8% Sukuk al-Ijara,
30.7 3% of Murabaha receiv ables and 3.4% Sukuk al-Istisna. This issuance r equired the IDBs guarantee
in order to secure a rating and international marketability. The $ 400 million Islamic Sukuk was issued
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by Solidar ity Trust Services Limited (STSL), a special purpo se c ompany incorpor ated in Jersey Channel
Islands. The Islamic Corporation for the Dev elopment o f Private Sector (ICD) played an intermediary
role by purc hasing the asset from I DB and selling it to The Solidarity Trust Serv ices Limited (STSL) at
the consolidated net asset value.
Conclusion
The market for sukuk is now maturing and there is an increasing momentum in the wake of interest fromissuers and inv estors. sukuk have c onfirmed their v iability as an alternative means to mobilise medium
to long-term savings and investments from a huge inve stor base.
Different sukuk structures hav e been emerging ov er the y ears but most o f the sukuk issuance to date
have b een ijara sukuk, since they are based on the undiv ided pro-rata ownership of the underly ing
leased asset, it is freely tradable at par, premium or disco unt. Tradability of the sukuk in the seco ndary
market makes them more attractiv e. Although less co mmon than Ijara sukuk, other ty pes of sukuk are
also playing significant role in emerging markets to help issuers and investo rs alike to participate in
major projec ts, including airports, bridges, po wer plants etc. The sovereign sukuk issues, followingMalaysias lead, are enjoy ing widespread and positive ac claim among Islamic investors and global
institutional investors alike.
7 RESPONSES TO HOW SUKUK WORKS: INTRODUCTION, STRUCTURING AND APPLICATION OF
SUKUK BONDS
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The Coraline Theme.
ARJUN M A| May 20, 2010 at 3:15 pm | Reply
i hope sukuk will leads as an asset to the global instututional investors as well as islamic
investors.
Rose Anderson| September 16, 2010 at 7:41 am | Reply
hi,
As I see in y our post there is goo d info rmatio n av ailable on sukuk .Sukuk is an alternate way
of investment where the inv estor get the benefits of investment and its treated as rent o n
investment, to av oid the interest on investment which is strictly prohibited in Islam.I have
also some site and blog ,I have write on same topic check my po st :
http://portfolioanalyst.blogspot.com/2010/09/islamic-debt-bond-market.html .
I want to write on guest post for yo ur blog based on c hange on the Islamic debt market.If you
agree than contact me at [email protected]
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ahmer hussain| January 11, 2012 at 7:01 pm | Reply
what is the difference between TFC and Sukuk
Pingback: Education | Whats Ijara Sukuk? | Nazaha Markets
Pingback: Education | What is Sukuk? | Nazaha Markets
gambling| May 11, 2013 at 8:03 pm | Reply
Normally I do nt read post on blogs, howev er I would like to say that this write-up very
compe lled me to chec k out and do so! Your writing sty le has been surprised me. Thanks,
very nice artic le.
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