Tokenized Corporate Bonds: Understanding Shariah non-compliant instruments

Investing has always been about balancing risk and reward, finding the right vehicles to grow one's wealth while managing potential downsides. Among the myriad options available, corporate bonds have long stood out as a cornerstone for conservative investors seeking stable, long-term returns. These debt instruments offer a predictable stream of income and relative security compared to the volatility of the stock market. Over the years, they have provided companies with a means to raise capital for various business needs, from refinancing debt to expanding operations. The allure of corporate bonds lies in their promise of fixed interest payments and the return of principal upon maturity, making them an attractive choice for risk-averse investors.

However, the financial landscape is ever-evolving, and the advent of blockchain technology has introduced a new paradigm in the world of investments. Enter tokenized bonds, a modern twist on traditional debt instruments that leverage the power of blockchain to enhance efficiency, transparency, and accessibility. Tokenized bonds represent a digital transformation of bonds, where each bond is represented as a digital token on a blockchain. This innovation has the potential to democratize access to bond markets, offering fractional ownership and increased liquidity. For tech-savvy investors and institutions, tokenized bonds are not just a novel concept but a significant advancement that could reshape the way we think about debt securities.

More importantly, bonds have never been a Shariah compliant instrument, and they lack fundamental value from a Shariah perspective. In this article, the description and features of bonds are presented, thereafter, a description of tokenized bonds is offered, followed by an insight into why such instruments are not not compliant with Shariah principles.

Corporate Bonds: An Overview

Corporate bonds are debt instruments issued by companies to raise capital. These funds can be used for various purposes such as refinancing existing debt, expanding business operations, or financing mergers and acquisitions. When an investor purchases a corporate bond, they are essentially lending money to the company in exchange for periodic interest payments (known as coupons) and the return of the bond’s face value at maturity.

For instance, consider Company XYZ issuing a corporate bond with a face value of £100, a 5% annual coupon paid semiannually, and a 10-year term. An investor would receive two payments of £2.50 each year and, after 10 years, get back the £100 initially invested. Over the bond’s lifetime, this would result in £50 in interest, yielding a 50% return on the original investment.

Corporate bonds are typically issued in denominations of £1,000 or more, and the interest rate, or coupon, can be fixed or variable. Fixed-rate bonds pay the same amount of interest over the life of the bond, while variable-rate bonds have interest payments that fluctuate with market interest rates.

Types of Corporate Bonds

Corporate bonds can be categorized based on their maturity:

• Short-term bonds: These bonds mature in one to three years. They are less sensitive to interest rate changes and are considered less risky compared to longer-term bonds.
• Medium-term bonds: These bonds mature in three to ten years. They offer a balance between risk and return, making them a popular choice for many investors.
• Long-term bonds: These bonds mature in more than ten years. They offer higher yields but come with greater interest rate risk.

Additionally, corporate bonds are classified by their credit risk:

• Investment-grade bonds: These are bonds issued by companies with high credit ratings. They are considered low risk with lower yields. The ratings, provided by agencies like Moody's, Standard & Poor's, and Fitch, indicate the issuer's ability to meet interest and principal payments.
• Junk bonds (high-yield bonds): These bonds are issued by companies with lower credit ratings. They offer higher yields to compensate for the higher risk of default. While they can provide substantial returns, they also carry the risk that the issuing company may not be able to meet its debt obligations.

Permanent interest-bearing shares (PIBs) are a type of fixed-interest investment issued by building societies, similar to bonds but without a fixed redemption date. They can be bought back by the issuer at certain times, adding a layer of complexity and risk.

Why People Invest in Corporate Bonds

Investors are drawn to corporate bonds for several reasons:

• Predictable Income: Regular interest payments provide a stable income stream.
• Capital Preservation: Assuming the issuer remains solvent, the bondholder will receive the bond’s face value at maturity.
• Relative Safety: Since bonds are loans, their risk profile is different.

In many jurisdictions, Investing in corporate bonds can also provide tax advantages, as interest income from bonds may be taxed at a lower rate than dividends from stocks. Furthermore, bonds can offer diversification benefits, as they often perform differently from stocks and other assets in an investment portfolio.

Risks of Investing in Corporate Bonds

Investing in corporate bonds carries several risks:

• Default Risk: The risk that the issuing company may become insolvent and unable to meet its debt obligations. This is more common with lower-rated bonds, but even high-rated issuers can default in rare circumstances.
• Inflation Risk: The risk that inflation will erode the purchasing power of future interest payments. This is a concern for fixed-rate bonds, as the interest payments remain constant while the cost of living may increase.
• Interest Rate Risk: The risk that rising interest rates will make existing bonds less attractive, potentially lowering their market value. When interest rates rise, the prices of existing bonds typically fall, as investors can obtain new bonds with higher yields.

Tokenized Bonds: The New Frontier

Tokenized bonds represent a modern evolution of traditional bonds, leveraging blockchain technology to offer new advantages. A tokenized bond is a digital representation of a bond issued and traded on a blockchain.

Tokenized bonds are similar to traditional bonds in that they represent a debt obligation issued by a company or government. However, instead of physical certificates, these bonds exist as digital tokens on a blockchain. Each token represents a fraction of the bond, making it possible to own and trade smaller portions of the bond than would be feasible with traditional bonds.

The concept of tokenized bonds is part of a broader trend towards the digitization of financial assets. By representing bonds as digital tokens, issuers and investors can take advantage of the benefits of blockchain technology, such as increased efficiency, transparency, and accessibility.

How Tokenized Bonds Work on the Blockchain

Blockchain technology underpins the creation, issuance, and trading of tokenized bonds. Here’s a step-by-step look at how they work:

1. Issuance: A company issues bonds in the form of digital tokens on a blockchain platform. This process involves creating a smart contract that defines the terms of the bond, such as the coupon rate, maturity date, and payment schedule.
2. Distribution: Investors purchase these tokens through a digital marketplace or exchange. This can be done through an initial bond offering (IBO), similar to an initial coin offering (ICO) for cryptocurrencies.
3. Ownership: The blockchain ledger records ownership of the tokens, ensuring transparency and security. Each transaction is recorded on the blockchain, providing a clear and immutable record of ownership.
4. Interest Payments: Coupons are paid automatically to token holders through smart contracts. These payments are executed according to the terms defined in the smart contract, reducing the need for manual intervention.
5. Trading: Investors can trade tokenized bonds on secondary markets, benefiting from the blockchain’s efficiency and reduced transaction costs. This can provide greater liquidity compared to traditional bonds, which can be more difficult to trade.
6. Maturity: At maturity, the face value of the bond is returned to the token holders. The smart contract ensures that the principal amount is paid back to the investors, completing the bond’s lifecycle.

Differences of Tokenized Bonds

Tokenized bonds offer the following over their traditional counterparts:

• Fractional Ownership: Allows smaller investors to participate by purchasing fractions of a bond. This can democratize access to bond investments, making them more accessible to a wider range of investors.
• Enhanced Liquidity: Easier and faster to trade on digital platforms. The use of blockchain technology can reduce settlement times and transaction costs, improving the overall efficiency of the bond market.
• Transparency: Blockchain’s immutable ledger provides a clear record of ownership and transactions. This can increase trust and confidence in the bond market, as investors have greater visibility into the ownership and trading history of each bond.
• Efficiency: Reduced transaction costs and faster settlement times. The automation of interest payments and other processes through smart contracts can streamline the bond issuance and management process.

Tokenized Bonds in Practice

Several real-world examples highlight the potential of tokenized bonds. In 2019, the World Bank issued its second blockchain-based bond, called the “Bond-i” (Blockchain Operated New Debt Instrument). This bond was created and managed using blockchain technology, demonstrating the feasibility and benefits of tokenized bonds in practice.

Another example is Santander, which issued a $20 million bond on the Ethereum blockchain in 2019. This bond was fully managed on the blockchain, including the issuance, trading, and redemption processes. By leveraging blockchain technology, Santander was able to reduce costs and increase efficiency in the bond issuance process.

Shariah Analysis of Tokenized Bonds

Tokenized bonds are not Shariah compliant instruments. A bond is a debt obligation for which the issuer pays a pre-determined rate of return to the bondholder. There is no investment in any underlying asset; rather, the issuer has a personal right and a liability on his legal personality. A repayment of debt with interest is due to the bondholder. The payment for the bond is effectively a loan (Qard) from a Shariah perspective.

In Islam, a loan (Qard) is considered a gratuitous contract, and it is commendable for a lender to provide a loan to a borrower who is in need of money. Both the Qur’an and Sunnah promise reward to a lender who provides a loan to a person in need. The fact that the Shariah prohibits the lender to derive any conditional benefit from the loan further emphasises its gratuitous nature. It also implies that the loan contract should not be used for profiteering purposes. Thus, any profit or additional return in lieu of the loan is impermissible and non-Shariah compliant. Both the Qur’an and the Sunnah have prohibited the lender from charging the borrower any additional amount. The Qur’an emphasises that the lender is entitled to receive the principal amount. It states:

“O you who believe! Fear Allah, and give up what remains of your demand for usury, if you are indeed believers. If you do it not, take notice of war from Allah and His Messenger. But if you turn back, you shall have your capital sums: Deal not unjustly, and you shall not be dealt with unjustly” (al-Qur’an, 2:278-279).

A famous juristic maxim states: “Any loan which draws an increment is Riba” (Ibn Abi Shaybah).

Riba is more than just simple interest and compound interest; Riba is an unjustified excess in a bilateral contract which is stipulated for one of the two transacting parties and is without consideration. To elaborate, there are two types of Riba:

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1)    Riba al-Nasi’ah is the advantage and excess gained without consideration by deferring delivery of any homogenous counter exchanges.  This excess manifests upon default or delay in payment where time is factored as a consideration.

2)    Riba al-Fadhl is a contractually agreed excess in units without any consideration in an exchange of homogeneous goods.

Shariah has not considered money to be a commodity but a medium of exchange. When money of the same genus is exchanged, it must be on spot and in equal quantity. Exchanging different amounts at different times brings into effect both forms of Riba: Riba al-Nasi`ah and Riba al-Fadhl.

Jabir stated that Allah’s Messenger cursed the accepter of interest and its payer, and also one who records it and the two witnesses, and he said, “They are all equal.” (Abu Dawud)

An Alternative to Tokenized Bonds

An alternative to bonds is Sukuk. The AAOIFI Shariah Standard No.21 proposes an alternative to bonds by stating:

“The Shari’ah substitute for bonds is investment Sukuk.” The overall risk profile and economic return for a Sukuk investor has some similarities albeit differences to a conventional bond where the bondholder is a debtor of the issuer.

AAOIFI defines Sukuk as being: “Certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activities.” Unlike a conventional bond (secured or unsecured), which represents the debt obligation of the issuer, a Sukuk technically represents an interest in an underlying funding arrangement structured according to Shariah, entitling the holder to a proportionate share of the returns generated by such arrangement and, at a defined future date, the return of the capital.

Sukuk is a financial instrument that shares characteristics with bond and stock which are issued to finance trade or the production of tangible assets. Similar to a bond, Sukuk has a maturity date and in some of them the holder will receive a regular income over the period and a final payment at the maturity date. While the conventional bonds price is determined only by the creditworthiness of the issuer, Sukuk price is determined by the creditworthiness of the issuer and the value of the asset. Although Sukuk is also similar to stocks in the sense that it represents ownership and no guarantee of a fixed return (at least theoretically and in the standard model of Sukuk) but stocks have no maturity date. Sukuk also have to relate to a specific asset, project or service.

Among the benefits of Sukuk are that most Sukuk are a tradable capital market product providing medium to long-term fixed or variable rates of return. It is assessed and rated by international rating agencies, which investors use as a guideline to assess risk/return parameters of a Sukuk issue. It has regular periodic income streams during the investment period with easy and efficient settlement and a possibility of capital appreciation of the Sukuk. Finally, most Sukuk are liquid instruments and tradable in secondary market.

Conclusion

In conclusion, corporate bonds, whether traditional or tokenized, are not considered Shariah-compliant financial instruments. The fundamental reason for this is that bonds represent a debt obligation with a predetermined rate of return, which is essentially a loan (Qard) from a Shariah perspective. Islam considers loans to be gratuitous contracts, and any additional return or profit derived from a loan is deemed impermissible and non-Shariah compliant. The Qur'an and Sunnah have explicitly prohibited the charging of interest or excess on loans, emphasizing that the lender is only entitled to receive the principal amount.

The introduction of tokenized bonds, while offering advantages such as fractional ownership, enhanced liquidity, transparency, and efficiency through blockchain technology, does not change the underlying nature of bonds as interest-bearing debt instruments. As a result, tokenized bonds remain non-compliant with Shariah principles.

As an alternative to bonds, Sukuk has been proposed by the AAOIFI Shariah Standard No.21. Sukuk are certificates representing undivided shares in the ownership of tangible assets, usufructs, services, or specific projects or investment activities. Unlike bonds, which represent a debt obligation, Sukuk entitles the holder to a proportionate share of returns generated by the underlying arrangement and the return of capital at a defined future date.

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