Long Run Performance of Islamic Debt Issue:

Role of the Agency Environment

Yusnidah Ibrahim, Md Mohan Uddin and Mohd Sobri Minai

World Islamic Banking, Finance and Investment Conference17 – 18 December, 2012; Hotel Istana, Kuala Lumpur, Malaysia

Corporate Financing Environment in Malaysia

Continuous restructurin

g of financial

market by govt.

Innovative and

diversified alternative securities

High concentrati

on of ownership

High degree of earning

management

Corporate Debt Financing Environment in Malaysia

Dominance of

Islamic securities

Coexistence of

Islamic and

conventional bonds

Debt financing encourag

ed

Growing bond

market

Corporate Debt Financing Environment in Malaysia

Since 1997 crisis, domestic private debt securities has been an important substitute of bank loan and equity financing

Since 2000, the corporate bond market has been growing at an average rate of 8%

Current share of corporate bond market in total debt financing is 2.5 times compared to what it was in 1997

The Islamic segment of the private debt security market is growing rapidly. Currently, 39% of total bond outstanding in Malaysia are Islamic bonds

Islamic Bond Market in Malaysia

Malaysia is the largest Islamic capital market in the world

YearOutstanding Islamic Bond(billion RM)

As percentage of outstanding

corporate bond

2008 152.8 57

2009 167.73 58.2

Dominance of Islamic Bonds

Increasing dependence on debt financing

Corporate bond issuance relative to GDP is highest among emerging markets

Increasing dominance of Islamic bond

Response to continuous regulatory initiatives and

influences

Drift developed toward debt financing/Islamic debt financing

Motive for wealth maximization?

Effect on Shareholder

Islamic debt

issues

Capital structur

e changes

Effect on sharehol

der wealth

Determinants of Islamic Bond Performance

Knowing the determinants of the debt issue performance is necessary to

Identify the source of

wealth creation

Guide corporate financing decision

Test the applicability

of capital structure theories

Literature: Short vs Long Run Performance

Short term announcement effect of security issuance is the subject matter of many studies, for instance, Antweiler and Frank (2006), and Eckbo and Norli (2004).

However, Malaysian market may not be efficient enough (Kim & Shamsuddin, 2008; Hoque, Kim, & Pyun, 2007) to capture future implications of capital structure changes in the short run.

Scholars link long run underperformance of security issuances to market timing behavior combined with slow reacting investors’ (Wu and Kwok, 2007; Coakley, Hadass, & Wood, 2008; Farinós, García, & Ibáñez, 2007; Autore, Bray, & Peterson, 2009).

Therefore, the better way to appraise present debt choice decision is to investigate long run stock return performance.

Literature: Short vs Long Run Performance

Available empirical studies of long run value effects in the emerging markets are limited in number, and restricted to the study of equity issuances, particularly to the study of initial public offerings (IPO).

No study is found to uncover the long run value effect of Islamic debt issuance in the emerging markets.

Moreover, some recent methodological development are yet to be implemented.

Literature: Determinants of

Performance The sources of wealth effects in Islamic debt financing can be studied by examining the relationship between firm characteristics and the wealth effects.

The literature is scant and inconclusive on the determinants of wealth effect of capital structure changes (Masulis, 1983; Myers, 2001; Carpentier, 2006; Rahim, Nor, Alias, & Yaakob, 2009).

The capital structure theories such as the agency theory may also explain long run value effect of firms’ financial actions. The link between capital structure changes and the actions of both the inside agents and the outside parties is supported by many studies (Campello, 2006).

• AD ↑ but is mitigated by debt covenants

• AE ↓

↑ Debt

• AD ↓• AE ↑ and lack of

mitigating AE

Debt ↓

Effect on shareholder

wealth

Literature: Determinants of

Performance

However, very rare studies, if any, have used the agency theory to explain the long run value effect of capital structure changes following Islamic debt security issuance.

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Theoretical Framework• One, two, and three year

buy and hold abnormal returns (BHAR)

DV

• Growth Opportunity (GO) [Myers, 1977; Jensen, 1986; Frank & Goyal, 2009]

• Managerial Ownership (MO) [Jensen & Meckling, 1976; Douglas, 2006]

• Ownership Concentration (OC) [Lins, 2003; Earle et al., 2005; Bena & Hanousek, 2008]

• Free Cash Flow (FCF) [Jensen, 1986; Opler & Titman, 1993; Gangopadhyay & Yook, 2009]

IVs

• Capital structure change (CSCH)Interaction

Theoretical Framework1) Growth opportunity (GO) The higher the GO the higher is the agency cost

of debt lower performance -ve relationship with long run performance

2) Managerial ownership (MO) Firms with low MO have high agency cost of

equity (Jensen and Meckling, 1976) and they benefit more from debt monitoring imposed by debt issuance

- ve relationship with long run performance

Theoretical Framework1) Ownership concentration (OC) OC can effect the conflict of interest between

minority shareholders and insider large shareholders’ (Earle et al. 2005; Lin, 2003)

Debt can mitigate this type of agency cost- +ve relationship with long run performance

2) Free cash flow (FCF) firms with high FCF have higher agency cost increase in debt can reduce the agency cost +ve relationship with long run performance

Theoretical Framework

–

–

+

+

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Data and Methods - Sample

→ Initial Sample: all bond issuances during January 2001 to October 2009

→ extracted from the Securities Commission Malaysia website.→ comprises a total of 720 in one year performance sample, 675 in two year

performance sample, and 591 in three year performance sample.

→ Exclusions: → Conventional bonds→ convertible issues→ non-listed companies→ banks and financial institutions→ absence of Bursa Malaysia announcement→ multiple issues during analysis period and on the same day→ data unavailability

→ Final sample size: → 113 for one year sample→ 101 for two year sample→ 86 for three year sample

18

Data and Methods - Benchmark

› Non-event firms that are very similar to the event firms based on size and book-to-market are used as benchmark firms (Barber and Lyon, 1997)

› The similarity is measured by Euclidean distances between each of the issuers in the sample and the benchmark candidates.

› For each sample firm, two closest firms matching firms are used.

19

Data and Methods - BHAR

□ The holding period return of firm for the analysis period in months, ,

where, is the monthly raw return of firm in month .

□ the holding period return for the benchmark is,

20

Data and Methods - BHAR

□ The buy-and-hold abnormal return for each firm in month after benchmark adjustment,

□ The mean buy-and-hold abnormal return for month ,

where, is the number of securities in the portfolio for month , and .where, is the monthly raw return of firm in month

21

Data and Methods – Measurement of Variables

¤ Growth Opportunity (GO) ¤ (Total Assets – Equity Capital + Market Capitalisation) / Total

Assets

¤ Managerial Ownership (MO) ¤ the percentage of total outstanding shares held by the

executive or managing directors of the debt issuing firm during the last year before the issue

¤ Ownership Concentration (OC) ¤ Herfindahl Index which is calculated as the sum of the squared

percentage of shares held by the five largest shareholders

¤ Free Cash Flow (FCF) ¤ (operating income – current tax + change in deferred tax –

interest expense – preferred dividend – ordinary dividend)/net tangible asset

22

Data and Methods – OLS Model

¤ Following regression is tested for one, two, and three year analysis periods in this study:

where, variable related to agency cost.and = capital structure change measured by the difference between the year-end debt ratio before and after the issue

23

Data and Methods – OLS Models

∆ Three models are tested for each of the one, two, and three year analysis periods.∆ Model 2 is formed by adding the interaction terms with

Model 1.∆ The final model is the restricted models derived from

stepwise omission of insignificant variables from Model 2.

∆ Heteroscedasticity test is conducted by Breusch-Pagan test∆ Heteroscedasticity robust standard error has been used

to correct the heteroscedasticity problem.

∆ Multicollinearity is tested by variance inflation factor.∆ No significant multicollinearity problem is observed

Results of Long Run Performance

Analysis Period

SampleSize BHAR tc

TbsaLyon et al. (1999)

ThscJegadeesh and Karceski (2009)

1 Year 113 0.1073 1.91* 1.51 0.882 Year 101 0.1765 2.14** 2.77*** 1.683 Year 86 0.3725 2.90*** 1.61 2.43*

Thus, although not strongly supported by all statistical tests, the issuers of Islamic debt experience significantly positive performance in two and three year period following the issue.

Regression Results2 Year Sample 3 Year Sample 3 Year Sample

(Excl. Outl.)

Coeff. t-Stat Coeff. t-Stat Coeff. t-

Stat  

const. -0.1740 -1.58 -0.1766 -0.92 -0.0214 -0.20  CSCH 1.4101 2.18 ** 4.8276 2.24 ** 3.6676 1.96 **GO 0.1000 2.73 ***            MO                  OC                  FCF                  CSCH*GO -0.7877 -3.38 ***            CSCH*MO              CSCH*OC            CSCH*FCF   -55.05 -2.55 ** -51.59 -2.39 **

No. of obs. 101   86   85    

F-stat. 8.62***   3.28**   2.95**    

R-squared 0.0176   0.0865   0.1173    The model specification is based on the sequential elimination of insignificant variables from the model in equation 2. The dependent variable is the in two and three years following the debt issue. CSCH is the capital structure change, GO is the growth opportunity, MO is the managerial ownership, OC is the ownership concentration, and FCF is the free cash flow of the debt issuer. *, **, and *** indicate 10%, 5%, and 1% level of significance, respectively. The t-ratios are based on heteroscedasticity robust standard error as a remedy for the heteroscedasticity problem

Discussion Debt issuers with high growth opportunity are

found to create significantly more wealth in two year periodo If capital structure does not increase, no increase of

agency cost of debt due to GOo positive influence of the utilization of growth

opportunities o reduction of free cash flow problem

Opposite effect of growth opportunity when the issue of Islamic debt is associated with capital structure changeo growth opportunity increases agency costs of debt.

Discussion Debt issuing firms with higher free cash flow and

increased leverage experience low performance in three years.o in Malaysia debt issuances do not induce performance

by means of limiting management’s discretionary use of free cash flow

o Zhang (2009), who provides evidence that debt and executive stock options are substitutes in attenuating the free cash flow problem of a firm.

o Most probably, Malaysian firms already control the agency costs by employee stock option schemes (ESOS) (Ghazali, 2008; Bacha, Zain, Rasid, & Mohamad, 2009).

o issuance of debt may result further increase of cash flow, which may inflate the agency problem to result in a net effect of negative performance

Thank You