Are sukuk cheaper than conventional bonds?

I was thinking about sukuk tonight and it occurred to me that sukuk might not have an advantage compared to conventional bonds in a way that I had not thought.  The basis for this idea is how sukuk work in practice, not how they work in theory.  I am also thinking more about mudaraba or musharaka sukuk than ijara sukuk, since the former cannot have clauses stipulating repurchase of the underlying assets at par like the latter can (according to the AAOIFI guidance issued in 2008).

In a mudaraba or musharaka sukuk (I will focus on an unsecured mudaraba sukuk because the analysis is simpler), the issuer becomes the mudarib and will manage the funds provided by the investors, to fund a particular business.  These types of sukuk are often used by banks to fund their lending, for example, to fund ijara contracts under which funding is provided to acquire a real estate asset.

The sukuk are structured so that the bank sets up an SPV to issue the sukuk and the SPV funds the bank, which issues the financing, secured by the real estate.  The bank finances the ijara contracts to receive a higher rental income than the required coupon on the sukuk.  The mudaraba stipulates that the rental income is split 99% to the investors and 1% to the mudarib, with the income used to pay a coupon to the investors anticipated at 5%, while the rent is set to generate a 7% return.

The excess return (2% in the example) generated is placed in a reserve account, to cover shortfalls in the future from non-payment or late payments of rents, which will be paid out to the mudarib as an incentive fee if left at the maturity of the sukuk.  However, if there is a shortfall at the redemption date, the investors are required to bear the loss.  In this case, where the mudaraba is based on these specific assets, the investor would be worse off for a given coupon on the sukuk compared to if it were an unsecured corporate bond, backed by all the assets of the company, except for those used to issue secured debt.  As a result, they would demand a higher coupon to compensate for the risk compared to a conventional bond issue.

Of course, this is not how these sukuk work in practice.  In one that I was reviewing recently, the bank that issued the sukuk (and managed the mudaraba assets), non-performing assets could be swapped out for performing assets of the same type.  The sukuk is also set up to be pari passu with the bank's other creditors, and so the assets backing the sukuk are not the only ones whose performance will determine ultimate repayment of the sukuk.  In this case, the investors would likely demand a similar coupon to conventional bond investors for the same issuer and maturity of bonds.

In neither case would the issuer find a sukuk to be a cheaper alternative than a conventional bond.  There are of course market considerations, like relative demand for conventional bonds versus sukuk, that could make the issue of a sukuk cheaper than a conventional bond.  Yet, the sukuk is not on the basis of its structure, cheaper than a conventional bond because, even where the risks are limited to put them on par with a conventional bond, the upside is returned to the issuer as an incentive payment, while the downside is limited to the same downside as for conventional bond investors.

If the goal of Islamic finance is to create financial products that Muslims (or companies run to be Shari'ah-compliant) who avoid conventional finance are willing to avail themselves of, then this is not problematic.  If, however, the goal is to design a product that is different in its risk and return profile from a conventional bond (as the rhetoric suggests, especially relating to mudaraba and musharaka), then all the mudaraba sukuk described above has done is to create a mudaraba that functions like an ijara, without any ownership of the underlying asset and cloaked in the mudaraba structure.  It has essentially been stripped of its risk and return sharing that is supposed to make mudaraba an 'optimal' structure for Islamic finance.