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Article Review: Are Sukuk Securities the Same as Conventional Bond Securities?

Introduction
Sukuk and the conventional bond have salient structural and epistemological differences. However as
noted by the authors, some public and academics opine that they are indeed the same instrument.
Therefore the authors seek to find evidence to support these claims by empirically analyzing the
yields of both these securities.
The literatures reviewed by the authors are based on the bond valuation theory (Williams, 1938)
which uses the Yield-to-maturity (YTM") and is currently applied to the valuation of sukuk as well
as the Capital Structure theory as proposed by Miller-Modigliani which states that leverage could
impact the firms beta. The basis of their analysis is on the YTM, in which they assume when holding
the issuer, maturities, and ratings of the securities the same, it should yield similar YTMs between
both sukuk and bond pairs. The authors postulate that if yields are the same between pairs of sukuk
and bonds, then valuation the methods used in bonds are appropriate for sukuk and that the two
instruments are indeed the same.
This analysis was conducted by comparing the yield curves of these securities as well as employing
parametric paired-sample t-test, conducted on pairs of data (1 Sukuk and 1 Bond; same issuer, rating,
and maturity). Granger Causality (1969) were also tested on the collected data to determine if sukuk
yields are Granger caused by bond yields as the author assumes since the former only encompasses
40% of the Malaysian bond market, causality may run from conventional bond market to the sukuk
market. They note if the test establishes causality then the two markets may be characterized as being
similar, if not different funding markets altogether. Separate from the discussion and comparison of
Yields the author tested if the issuance of Sukuk al-Ijarah will impact the firms beta (the authors used
Sharpe (1964) Market model to compute this).
Discussion of Results
In the first area of the authors analysis, they discuss and contrast yield curves for both sukuk and
bonds. This comparison was made by holding the credit rating and maturity equal for the same issuing
entity. To further strengthen their analysis the authors divided their comparison to four entity-types,
namely; 1) Sovereign issuers; 2) Quasi-Sovereign issuers; 3) Financial institutions; 4) Corporate
Issuers; as there are differences in risk rating with Sovereign issues being the lowest risk class and
corporate issues being the riskiest. In general, and as presented 1, the authors find that there are
differences in YTMs of sukuk and bonds. Throughout all four entity types, majority 2 of the results
show that for maturities between 10 years to 20 years Sukuk tends to yield higher between 3-9 basis
points. Consequently based on the authors initial postulation, since the yields are different Sukuk and
bonds are not the same, therefore a separate valuation model is needed.
Paired-sample t-test was also conducted on these yields using both mean and medians 3. The null
hypothesis of this test is that yields of sukuk and conventional bonds are equal, holding issuer and
tenure the same. Overall results indicate significant differences in yield to maturities of sukuk and
1 View appendix for the breakdown of results.
2 Results for Khazanah Nasional for securities with 1-2 year maturities yielded
lower than bonds by -1.23.

bonds. Results were significant at 0.01 4 therefore rejecting the null hypothesis. The results generated
by the authors study suggest that sukuk are not similar to bonds statistically. Whilst the authors have
managed to find support for their assumptions based on differences in yields and statistical
significance, this however does not make it a factual inference in our humble opinion.
Primarily we review the authors postulation in which it is assumed that when holding credit rating
and maturity equal for the same issuing entity yields for both sukuk and bonds should be the same.
This assumption does not conform to the various financial and economic theories already established.
Based on the financial theories, yield5 varies due to the numerous factors impacting the risk premium 6.
Among which are, 1) Type of issuer; 2) Term of maturity; 3) Credit Rating 4) Provisions of Options
(i.e callable bond, convertible bond); 5) Taxability of interest; and 6) Expected liquidity of the
security. As the authors hold issuer and maturity constant, we do not comment on this as it wont
cause differences to the risk premium, however credit rating is also held constant but it is to be noted
that it only represents the capacity of the issuer to repay its obligation and not an indication of
identical risk premium meaning that Sukuk and bond yields should not be the same.
As the author uses benchmark yields of a basket of issued securities in their analysis, the difference
between provisions of options will generally impact the risk premium in which if the options favours
the issuer a larger premium is requested and if it benefits the investor a smaller premium is given.
Next is the taxability of interest or after tax yields of the security, in which Malaysian sukuk has more
favourable tax incentives compared to bond issuances. As for expected liquidity, the greater the
expected liquidity the lower the required yield will be. Based on the current market scenario, there is
ample market liquidity for the pre-issuance of sukuk but it lacks the tradability post-issuance,
therefore it is justifiable why most sukuk yield higher.
In view of the economic theories they are namely four in relation to debt capital markets which is the
market expectations theory, liquidity premium theory, preferred habitat theory and market
segmentation theory. The market expectation theory proposes that various maturities are perfect
substitutes and the shape of the yield curve is dependent on the markets expectation of the short-term
interest rates. This theory however ignores the inherent risk brought by the uncertainty of future
interest rates that is the price risk and reinvestment risk. Therefore in view of Sukuk, one can
conclude that differences occur in the yields since its fairly a new security and the price of 20 year
maturities are even more uncertain and also since the structure is different there are greater
uncertainties on the rate proceeds are reinvested, therefore it generally should yield higher. The
liquidity premium theory assumes that long term interest rates are a reflection of investor expectation

3 The median was included as the authors note that use of mean are more likely
to have errors due to distribution of yields being leptokurtic.
4 Based on the total of 64 pairs tested, results were significant for 73% (47 pairs)
of total mean pairs tested and 60% (38 pairs) of total median pairs tested.
5 Yield = base interest(profit) rate + risk premium
6 Premium demanded by investors based on the perceived risk generated from
the financing.

on future interest rates plus a premium for the added risk of having their money tied up for a longer
period. Reverting back to the expected liquidity theory, sukuk should yield higher.
The next theory is preferred habitat theory in which the assumption is that in addition to interest rate
expectations, investors have distinct investment horizons and require a meaningful premium to buy
bonds with maturities outside their "preferred" maturity, or habitat. An extension to this theory is the
market segmentation theory in which it is assumed that financial instruments of different terms are not
substitutable. As a result, the supply and demand in the markets for short-term and long-term
instruments is determined largely independently. Both these theories cannot however be distinguished
between Sukuk and bonds emanating an area for further research especially in relation to the supply
and demand effect on prices and profit rate relationship. We find that most of the established finance
and economic theories can justify reasons as to why YTMs should be different as well as support for
why Sukuk yield higher in the long run, hence the supposition by the author in relation to YTMs
being equal cannot be theoretically justified. Therefore their empirical inference is inaccurately
represented.
The second area of the authors study is to test if there is causality between yields of sukuk and bonds.
The authors tested this three times, videlicet; does sukuk yields Granger cause bond yields; does bond
yields Granger cause sukuk yields; and a bi-directional Granger causality between yields of sukuk and
bonds. The results for all three approaches produce insignificant results, whereby yields of sukuk and
bonds are not Granger caused by each other signalling a third variable that Granger causes yields (not
defined or explored). In summary, the authors find statistically that there is no causal relationship
between sukuk and conventional bond yields therefore affirms that the two types of instruments are
indeed different. This supposition is tenuous as the authors did not perform cointegration tests to first
establish if indeed one variable has a causal effect to any other variables 7. As noted by the noble
laureates Clive Granger and Robert Engle (1987), spurious relationships 8 (correlation) can be
established when running linear regressions, therefore the use of Granger Causality without first
establishing cointegration would provide a third variable 9 as found by the authors.
As to explain the third variable there is an abundance of literature that analyse causal relationships
between yields. Joriah & Masron (2009) examined the impact of macroeconomic factors on bond
yields, in which they found that IR, CPI and IPI have significant influence on the yield spreads of
corporate bonds. Similarly Said and Rihab Grassa (2013), showed that GDP per capita, economic size,
trade openness, and percentage of Muslims have a positive influence on the Sukuk market.
Differences in yield are also related to the burgeoning literature on the importance of liquidity. While
there is little debate that the liquidity of a security affects its price (e.g., Chen, Lesmond, and Jason,
2007; Jack Bao, Jun Pan & Jiang Wang, 2010), the debate has shifted toward determining whether the
7 Cointegration is a test which establishes if two or more times series data
(variables) share the same stochastic drift.
8 Mathematical relationship in which two events or variables have no direct
causal connection, yet it may be wrongly inferred that they do, due to either
coincidence or the presence of a certain third, unseen factor.
9 A causes B or B causes A, this generally the area Granger causality tests,
though C causes A & B is also an occurrence when data are not cointegrated
therefore no causal relationship exist between A and B. The third variable is C.

level of liquidity, the change in liquidity (liquidity risk), or both, have an impact on security prices
and yields. In this paper as the issuer and term of the issued security are same, it can be assumed that
the driving force behind difference in yield is due to liquidity. As sukuk is using the same
computational methods of a bond, there is no reason that these factors should not impact sukuk yields
correspondingly.
Finally, the third and last area of the authors study is on the impact of Sukuk al-Ijarah issuance on a
firms beta. Accordingly, 16 companies that issued this type of security were chosen for the analysis.
The author notes that the selection criterion was imposed as the Ijarah sukuk requires transferring of
an asset from the issuers balance sheet to the SPV. The beta for each of these firms was calculated
one year pre issuance and one year post issuance to determine the impact. The authors found that the
impact of the issuance to the firms risk (beta) was both positive and negative, however reasons as to
why this occurred was not inferred. This change is consistent with capital structure theories of MillerModigliani in relation to changes of leverage.
There are numerous literatures that further discuss the determinants of changes in capital structure.
Corporate characteristics (firm size, firm risk, firm growth rate, firm profitability and asset tangibility)
are the main drivers of capital structures (Najjar & Hussainey, 2011). Respectively, growth is also an
important determinant of capital structure choice, followed in order by profitability, collateral value,
volatility, non-debt tax shields, and uniqueness (Chingfu, Lee and Cheng, 2009). There are two kinds
of Ijarah sukuk namely asset-based (on-balance sheet) and asset-backed (off-balance sheet). As the
authors strived to analyse the impact of asset-backed Ijarah, hypothetically the movements of the
assets off- balance sheet should be knocked-off with the increase on cash received (liability is
contingent), therefore the firms beta should not be impacted. We therefore find these results warrant
further investigations. Taking every research aspect into account, we conclude that the lack of
substantive arguments and theoretical build-ups by the authors to support their findings have led them
to inconclusively support their suppositions.
Conclusion
This article is best described as an ambitious effort by the authors albeit the weaknesses highlighted in
the discussion. Although not entirely accurate, the authors has made a commendable effort as
literature in relation to Sukuk in regards to yields, pricing, capital structure, financial and economic
theory is limited. Therefore, this article has defined several research areas that warrant further
scholarship.
Sukuk is currently the poster child for Islamic finance. Although it is structurally and
epistemologically different, in practice it still uses computational and theoretical foundations of its
conventional counterpart. Is this erroneous? Affirmative, as it has various additional features, such as
the equity like addition to the debenture, this changes the risk premium and also cannot be entirely
accounted as debt in the capital structure (equity is a composition of both common stock and preferred
stock) therefore as the product continues to expand into more exotic forms a need to review its
computational practices is merited in the future. Is the current practice acceptable? Confirmatory, as
highlighted by Bacha & Mirakhor (2013), the underlying logic is similar with several of the
associated risk common among the securities; therefore techniques of valuation in conventional bonds
can be used to value Sukuk. The underlying reason for the success of bonds in terms of pricing,
returns, and function can be attributed to the efforts of conventional scholars who have dedicated
copious amounts of literature to actually advance these fields. Therefore as Islamic scholars we should

shadow this exertion in our field. The novel effort by the authors although flawed, is a first step in the
right direction of research.

References:
Al-Najjar & Hussainey, 2011, Revisiting the capital-structure puzzle Journal of Risk
Finance, Vol.12
Ali Said and Grassa, 2013 The Determinants of Sukuk Market Development: Does
Macroeconomic Factors Influence the Construction of Certain Structure of Sukuk?
Journal of Applied Finance & Banking Vol. 3
Chen, Lesmond, & Jason, 2007, Corporate Yield Spreads and Bond Liquidity The
Journal of Finance Vol. 62
Chingfu, Lee & Cheng, 2009, Determinants of capital structure choice: A structural
equation modeling approach The Quarterly Review of Economics and Finance, 49
Engle, Robert & Granger, Clive, 1987, "Co-integration and error correction:
Representation, estimation and testing" Econometrica, Volume 55, Issue 2 (Mar,1987)
251-276.
Jack Bao, Jun Pan & Jiang Wang, 2010, The Illiquidity of Corporate Bonds Journal of
Finance Vol. 66

Murray Z. Frank & Goyal, 2009, Capital Structure Decisions: Which Factors Are
Reliabiy important? Financial Management Vo. 38
Norliza, Joriah & Masron, 2009, Factors Influencing Yield Spreads of the Malaysian
Bonds Asian Academy of Management Journal Vol. 14
Noureddine Krichene, 2013. Islamic Capital Markets: Theory and
Practice. John Wiley & Sons.
Obiyathulla Ismath Bacha & Abbas Mirakhor.Islamic Capital Markets: A
Comparative Approach. John Wiley & Sons.

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