/ 61 Ellis: Islamic Bonds

The Piety Premiumof Islamic Bonds

by Theodore Reuben Ellis

Traditionally, the Islamic states have had to reach out to Western capital mar-kets to obtain funding for major projects. Islam’s prohibition on the collectionof interest (riba) made it difficult to find buyers within the Muslim world for

debt securities issued by sovereign nations, even predominately Muslim ones. In re-cent years, however, the invention of a financial instrument widely called sukuk—akind of bond structured so as to be acceptable under Islam—has enabled govern-ments of Islamic nations to tap into an entirely new capital market. Muslim investors,buoyed by the rise in the price of oil, have devoured the new sovereign issues ofsukuk, developed and marketed by the governments of Muslim-majority nations.

Islamic governments did not, however, abandon conventional bond issues withthe emergence of sukuk, which are still a small fraction of debt issues in the MiddleEast. In the past ten years, several governments have issued both sukuk and conven-tional bonds within a year of one another. These bonds have behaved very differentlyon secondary markets.

Though they cannot be paid traditional interest, investors in sukuk still expect tobe compensated for the money they lend sovereign borrowers. The traditional mea-sure of return on a bond is its “yield,” roughly put, the amount the borrower gets paidback annually relative to the market price of the bond. Traditional financial modelsexpect yield to rise with the riskiness of an investment. The yields on sukuk andconventional bonds, however, have behaved quite differently from one another—evenwhen the issuer is the same government. In some cases, the behavior of sukuk yieldshas seemingly defied principles of mainstream finance theory. The forces driving thisdisparity need to be considered in order to understand how and why Islamic nations

Theodore Reuben Ellis is a graduate student atthe University of Chicago, Booth School of Busi-ness. Prior to his graduate studies, he was a con-sultant at McKinsey and Company.

structure their borrowing as they do.To do so, evidence for a difference

between the investment bases for the twotypes of bonds must be examined. Ifpresent trends continue, parallel capitalmarket infrastructures could emerge in Is-lamic markets.

62 / MIDDLE EAST QUARTERLY SPRING 2012

Appreciating what drives investment deci-sions in Islamic capital markets is critical not onlyto those who participate in financial markets butto all parties affected by capital markets’ self-sufficiency in Middle Eastern economies.

ISLAM’S BANON INTEREST

Shari‘a, the changing body of Islamic lawintended as a system for governing all facets oflife, has long proscribed the charging of interestas it is typically construed. The restriction isbased on passages such as the following, fromthe Qur’an:

And whatever you lay out as usury, so that itmay increase in the property of men, it shallnot increase with God; and whatever you givein charity, desiring God’s pleasure—it is these[persons] that shall get manifold.1

Shari‘a’s limitations on fi-nancial transactions extend be-yond the mere charging of inter-est on loans. Generally speak-ing, Shari‘a does not allow forinvestors to make money frommoney. Accordingly, strict ad-herence to Islamic principles offinance frowns upon both inter-est-bearing loans themselvesand the secondary markets thatemerge to profit off them.

Yet Shari‘a law is not with-out an appreciation for the timevalue of money. Most Islamicscholars allow for goods to besold on credit (nasi’a) at a higherprice than they would be soldfor with cash upon delivery,2 apractice similar to many formsof Western consumer credit. TheHadith, the oral records of theteachings and actions of Mu-hammad, even point to a sev-enth-century version of futurescontracts (salam) whereby farm-

ers were paid gold in advance for wheat to bedelivered at the harvest.3

Islam’s prohibition on the collection of in-terest but acceptance of the time value of moneyhas been explained in terms of “certainty.” Islamaccepts that the lender is forgoing the opportu-nity to engage in profitable transactions withhis own capital while it is being used by another.He is, therefore, entitled to reimbursement formissed opportunities. However, since these op-portunities are, in theory, unknowable before-hand due to the uncertainty of business, it isdeemed wrong to determine interest paymentsin advance in the form of a contract guarantee-ing a particular interest rate. Payment for fore-gone opportunities must be made after the facton the basis of actual return on the borrowed

There are some fifty to 260 sheikhs worldwide who havethe recognized expertise necessary to approve sukuk bondissues. Dependence on such a small group of Islamicscholars, like those seen here, increases risk as bondsdeemed conforming to Shari‘a may turn out to be non-compliant. A crisis in confidence could threaten the entireIslamic finance industry.

1 Qur. 30:39.2 Frank E. Vogel and Samuel L. Hayes, Islamic Law andFinance (The Hague: Kluwer Law International, 1998), p. 78.3 Ibid., pp. 75-6.

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capital and can never be made legally binding.By the standards of modern Western financeand from the creditor’s perspective, this is nota favorable structuring of loans. Such an ar-rangement is known as an “unsecured loan”because the lender has no recourse should theborrower decide not to repay the loan. More-over, the lender has nothing to gain should theborrower’s investment turn out to be more prof-itable than expected. In practice, Islamic lend-ing becomes, as analysts Iqbal and Mirakhorwrite, “a charitable act without any expectationof monetary benefit.”4

The Qur’an’s distinction between gainsfrom loan interest and the ordinary profits mer-chants make from shrewd bargaining might seemarbitrary. After all, both are monetary gains madewithout any “tangible” production. Indeed, theQur’an makes the contrast by fiat and not byany explicit philosophy of economics: “Theysay: ‘Trade is just like usury,’ but God has per-mitted trade and forbidden usury.”5

It is no coincidence then, that Islam’s mod-ern methods for lending appear so similar to anordinary business joint-venture. By structuringdebt in such a way that it resembles trade, mod-ern Islamic finance has found ways of creatingan instrument previously impossible underShari‘a, namely, the Islamic sukuk bond.

STRUCTURINGISLAMIC BONDS

Although there are traditionally hundredsof ways loans can be made acceptable in Islamicsociety, only a handful of different structures areused in modern global sukuk issues. The pre-dominant forms of sukuk are known as mudaraba,musharaka, and ijara. Mudaraba, usually usedto finance specific capital-improvement projects,is a structure in which the lender is considered apart-owner in whatever investment is being made.

Coupon payments on the loan are drawn fromthe profits of the venture according to a ratioagreed upon when the contract is drawn. Shouldthe venture fail, the borrower is not responsiblefor reimbursing the lender regardless of its sol-vency as an institution.

The mudaraba agreement thus carries agreat deal of risk for lenders. Mudarabas werethe first kinds of sukuk issued in recent history,usually used to finance municipal improvementprojects with the investment of local lenders.Furthermore, under mudaraba arrangements,there is no expectation that the lender provideany managerial help.6

Musharaka arrange-ments are structured justlike mudaraba bondswith the exception thatthe lender is expected totake a role in the dailymanagement of whateverventure is receiving thefunds. Musharaka part-nerships are increasinglyrare in modern Islamic fi-nance because they re-quire a great deal of man-power investment on thepart of banks. Even mudaraba loans make uponly 5 percent of the assets of most Islamicbanks.7 (In fact, some 80 percent of Islamic banksare typically involved in still another loan typecalled murabaha which is extraordinarily con-troversial within the Islamic banking communitybecause it is virtually identical to an interest-bearing loan.)

The structure of choice for sovereign statesukuk issues is ijara. Under this arrangement,the borrower (a sovereign state in this case) sellstangible assets at a price agreed upon by con-tract to a “special purpose entity” (SPE). ThisSPE in turn issues sukuk bonds in an amountexactly equal to the purchase price of the as-

Ellis: Islamic Bonds

4 Zamir Iqbal and Abbas Mirakhor, An Introduction to IslamicFinance (Singapore: John Wiley and Sons, 2007), pp. 61-2.5 Qur. 2:275.

6 Vogel and Hayes, Islamic Law and Finance, pp. 138-45.7 Ibid., pp. 140-1.

Islamic loans are“unsecured”because thelender has norecourse shouldthe borrowerdecide not torepay the loan.

64 / MIDDLE EAST QUARTERLY SPRING 2012

sets. The SPE then leases the assets back to thestate at an amount equivalent to the couponpayments of the sukuk. At the maturity of thesukuk, the SPE sells the assets back to the sov-ereign state at a price agreed on beforehand. Atthis point the SPE dissolves and the ijara con-tract is concluded.8

For example, one particular Pakistanisukuk is issued by an SPE called the PakistaniInternational Sukuk Company Ltd. and notthe Pakistani government itself. The sukuksecuritization is backed by the 250-mile Islamabad-Lahore motorway, also known as M-2 within Pa-kistan. This highway was “sold” to the SPEfor $600,000,000 in January 2005 with an agreedijara, or lease-payment, of 5.6 percent on theface value of the bonds with a maturity of fiveyears.9

Thus, sukuk bond issues are backed byreal assets to which all bondholders can claimpartial ownership. According to Islamic law, thesukuk issuer cannot guarantee the return ofprincipal or interest payments without turning

the agreement into anordinary interest-bear-ing loan. The money thatbondholders receivemust be considered leasepayments on the under-lying assets and, presum-ably, reported as such forpurposes of taxation.Hence, owners of the Pa-

kistani sukuk backed by the M-2 road must intheory consider their returns on the bond as pay-ments derived from tolls on the motorway. Fi-nancial services providers who sell their clientssukuk have an obligation to inform them of wheretheir returns are coming from. In theory, the bor-rower can legally stop making coupon paymentson a sukuk if the underlying asset is not profit-able (for example, if drivers stop using the M-2)even if the borrower has other sources of in-come (such as oil revenues).

THE GLOBAL SUKUKMARKETPLACE

The sovereign sukuk introduced a newclass of investors to government debt financingquite different from the one that had previouslybought sovereign debt. While conventional in-vestors have certainly participated in sovereignsukuk issues, Islamic investors and institutionsare by far the predominant players. Indeed, ac-cording to the Islamic banking unit of the Lon-don-based HSBC, the global banking concernthat managed Pakistan’s 2005 sukuk issue, 47percent of demand for that bond came from theMiddle East, 31 percent from Asia, and 22 per-cent from Europe.10

Calculating the size of the sukuk market hasbeen notoriously difficult due to the lack of acentral regulatory body or even a standardizeddefinition of what constitutes sukuk. The mostwidely cited source, the Islamic Research andTraining Institute, puts the size of the entire Is-lamic finance industry at between $700 billionand $1 trillion dollars with an annualized growthrate of 63 percent in 2005.11 The Islamic FinanceInformation Service estimated the size of totalsukuk issuance in 2007 at $47 billion, an increaseof 73 percent over the previous year.12 The totalvalue of active sukuk worldwide was most re-cently put at $120 billion by the First Interna-tional Conference for Islamic Sukuk in Bahrainon March 18, 2008.13

These numbers might be even larger were itnot for a critical sticking point. The main bottle-neck in the creation of new Islamic bonds hasbeen a shortage of scholarly boards to approvethe bonds. In fact, only somewhere between fiftyand 260 sheikhs worldwide have the recognizedexpertise necessary to approve sukuk bond is-sues. Within this group, about a dozen take on

The total valueof active sukukworldwide wasput at $120billion in 2008.

8 Richard, Kristel, “A Closer Look at Ijara Sukuk,” BankerMiddle East, Feb. 2005, no. 57.9 Khaleej Times (Dubai), Jan. 23, 2005.

10 AMEinfo.com (Dubai), Mar. 17, 2005.11 “Islamic Financial Services Industry Development: Ten-year Framework and Strategies,” Islamic Research and TrainingInstitute, Jeddah, and Islamic Financial Services Board, KualaLumpur, May 2007.12 Financial Times (London), Feb. 7, 2008.13 Gulf Daily News (Dubai), Mar. 19, 2008.

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the vast majority of bond approv-als. The Financial Times quotesYusuf Talal DeLorenzo at invest-ment firm Shari‘a Capital as sayingthat “to sell products into the mar-ket, to give them credibility, yougo to the tried-and true guys whomeverybody knows.” Investmentbanks have spent millions of dol-lars seeking the fatwas (religiousedicts) of this small group of Shari‘aexperts.14

Such a small band of preferredShari‘a scholars and the millionsof dollars at stake give all the indi-cations of an emerging moral haz-ard problem within the sukuk in-dustry. In fact, since the recent fi-nancial crisis, there have been afew cases of sukuk being retroac-tively declared noncompliant. Forexample, in 2009, the Shari‘a Com-mittee of the Accounting and Au-diting Organization for Islamic In-stitutions tightened its standards for Shari‘a com-pliance after a number of semipublic sukuk is-sued by Dubai were found noncompliant.15

There is concern that should sukuk bondsregularly be found religiously unacceptable af-ter issuance, investors who demand Shari‘acompliance might pull out not only from the af-fected bond but from sukuk bonds in general. Acrisis in confidence could threaten the entire Is-lamic finance industry. The theological researchthat Shari‘a boards do for a particular sukuk is-sue is entirely out of sight for the average inves-tor. Thus, the failure of a single bond couldthreaten the credibility of the entire approvalindustry.

It is not known how widespread this fear ofa crisis in confidence is within the Islamic in-vestment community. Any perceived risk of sucha crisis would probably reduce the trading priceof such bonds vis-à-vis bonds that do not con-

tain that risk. All other things being equal, onewould expect investors to demand additionalreturn from sukuk bonds over conventionalbonds issued by the same sovereign authoritydue to the potential risk of a crisis in Shari‘acompliance. Surprisingly, and contrary to whatmainstream risk-return models would suggest,there is little evidence that sukuk investors de-mand a premium for this risk, at least thus far.

One additional potential risk of the currentsystem for judging sukuk compliance withShari‘a is that religious regulatory bodies coulduse their power for political ends—perhaps byimplicitly threatening to declare noncomplianceon the bonds of sovereign nations that supportunpopular geopolitical positions. Another areaof broad uncertainty is whether religious authori-ties will declare Islamic banking activities (pre-sumable including sukuk) subject to zakat, akind of tax Islamic governments have histori-cally imposed on wealthy Muslims to fund chari-table activities.16

Ellis: Islamic Bonds

A surging demand for major public works projects in manyIslamic countries spurred the invention of sukuk bonds,structured to be acceptable according to Shari‘a. A sukukissued by the Pakistani International Sukuk Company issecuritized, in part, by tolls collected on the 250-mile-longM2 highway between Lahore and Islamabad, seen here.

14 Financial Times, Nov. 19, 2007.15 The New York Times, Nov. 30, 2009. 16 Emirates Business (Dubai), Sept. 3, 2009.

66 / MIDDLE EAST QUARTERLY SPRING 2012

borrowing government could in theory withholdpayments, despite having plenty of other profit-able assets. The fact that the sovereign sukukexamined for this study have in practice issuedfixed coupons rather than coupons based onthe actual returns of the underlying trust assetssuggests sovereign issuers wish to eliminate (orat least hide) this source of potential risk. Sover-eign entities seem committed to making theirsukuk appear as dependable and steady in cashflow as their conventional bonds.

With the possible exception of the troubled,quasi-public Dubai sukuk mentioned above,there have been no sovereign sukuk defaults todate. Like conventional bonds, private sectordefaults on sukuk are relatively common. Sov-ereign defaults should presumably be rarer be-cause the government can raise money throughtaxation or, particularly in oil-rich Middle East-ern states, licensing of resource exploitationrights. However, specific provisions in the sukukbond issues shield sovereign governments fromhaving to repay creditors should the underlyingassets not provide adequate funds to pay theagreed lease. For example, the offering for QatarGlobal Sukuk’s 2003 issue includes the follow-ing protection for Doha:

Proceeds of the Trust Assets are the solesource of payments on the Certificates. TheCertificates do not represent an interest in orobligation of any of the Issuer, the Trustee,the Government … or any of their affiliates.… If, following distribution of the proceedsof the Trust Assets, there remains a shortfallin payments due under the Certificates, sub-ject to Condition 12, no holder of Certificateswill have any claim against the Issuer, theTrustee, the Government.17

According to these terms, bondholders notonly lack a means of recourse should the sover-eign issuer decide not to pay its lease but alsolack the ability to take control of the underlyingassets (which they technically own due to thestructure of the “special purpose entity”) and

17 “Qatar Global Sukuk: Offering Circular,” HSBC Bank,London, Oct. 2003, p. 12.

The intrinsicstructure ofsukuk puts themat greater riskof default.

UNDERSTANDINGTHE RISK

Conventional bonds and sukuk issued bythe same country are extremely similar exceptfor the underlying religiously-informed techni-cal structure. What factors then determine theyield spread, (i.e., the difference in bond yields),sometimes a substantial one, between the two?Normally, riskier bonds have higher yields. Yet,

with sukuk, the situationis reversed: Sukuk, whichare inherently riskier, oftenhave lower yields thancomparable conventionalbonds. This fact alone in-dicates there is more to thesukuk-conventional bondspread than risk of default.

While the yields ofIslamic and conventional bonds issued by thesame country might differ at any given time formaturity-based reasons, it is worthwhile to com-pare the way market valuations of Islamic andconventional bonds change relative to one an-other over time. That is, looking at how thespread between valuations of sukuk and regu-lar bonds has varied over time can shed insightinto what determines the relative pricing of thetwo.

Of course, fluctuations in the likelihood ofdefault of conventional and sukuk bonds areone clear explanation for the changes in the dif-ference in bond yields between the two. Afterall, bond returns themselves are highly depen-dent on the risk of default. While the credit wor-thiness of the entity behind the bonds is identi-cal (the sovereign nation issuing the bonds),there are two factors that could contribute to adisparity in default risk.

First, the intrinsic structure of sukuk putsthem at greater risk of default. An ijara form ofsukuk, backed in theory by only the operatingincome of a subset of the government’s totalassets is most likely riskier than one tied to theentirety of the government’s assets. Should thespecific assets linked to that bond produce in-sufficient income during the allotted period, the

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Table 1: Sukuk and Conventional Bonds to be Compared

Bond Maturity Offering Size (USD

Millions) S&P Rating

Pakistan

2005 Sukuk 5 600 B+ 2004 Conventional 5 500 B+

Malaysia

2002 Sukuk 5 600 A- 2001 Conventional 10 1,750 A-

Qatar

2003 Sukuk 7 700 A+

1999 Conventional 10 1,000 A+

Sources: Richard Kristel, et al, Standard & Poor’s Ratings Direct: A Closer Look at Ijara Sukuk (New York,

Standard & Poor’s, 2005); Datastream, Thomson Reuters, New York.

liquidate them or use them to more remunerativeends. Sometimes the assets the government sellsto SPEs are not ones that could easily produceimmediate operating income even if bondhold-ers could take control of the assets themselves.The sukuk from which the above passage isdrawn, for example, is backed by a parcel of un-developed land. The government’s guarantee tomake timely and complete payments on sukuk isthus for all intensive purposes merely implied.

GAUGINGTHE “PIETY PREMIUM”

For the purpose of this study, sovereignconventional and sukuk bonds from three pre-dominantly Muslim countries were compared(see Table 1) and the following hypothesis wastested: Do changes in certain macro factors—those economic variables, like gross domesticproduct or inflation, that affect the broader na-tional and global economies and not just a par-ticular investment—have a different effect onthe yields of sukuk than the conventional bondsissued by the same country?

The macro factors selected were not cho-sen haphazardly: They correspond to possibledifferences between how conventional inves-tors and sukuk investors view market shifts (See“Methodology” Table 3 for a summary of ex-

planatory variables). Moreover, in some caseschanges in macro risk factors would affect thedefault risk premium—i.e., the amount an inves-tor expects to be compensated for taking on ad-ditional risk—between the bonds, and these situ-ations were also examined and tested.

Overall, the results (Table 2, page 68) sup-port the hypothesis that sukuk markets behavedifferently from conventional bond markets inthe same country by virtue of varying sensitivi-ties to external macro factors. Each macro factor(for example, the risk-free interest rate: rt

free) istested for its significance in determining thesukuk-conventional yield spread. The first num-ber (for example, 0.865 for the risk-free interestrate on the Pakistani bonds) indicates what ef-fect an increase of one will have on the yieldspread. In other words, a 1 percent increase inthe risk-free interest rate is predicted to corre-spond with a 0.865 increase in the spread be-tween sukuk and conventional bonds.

The number beneath each value is its “t-statistic.” This number is simply a measure ofhow “significant” or strong the result was.Strong results have a single asterisk next to them,indicating at least 95 percent confidence the re-sult did not happen because of chance. Verystrong results have two asterisks, indicating atleast 99 percent confidence the result did notoccur because of chance. Those values withoutasterisks were found not to be significant in pre-

Ellis: Islamic Bonds

Sources:

68 / MIDDLE EAST QUARTERLY SPRING 2012

dicting the yield spread between sukuk and con-ventional bonds.

A wide range of highly significant t-statis-tics across entities suggests that the creditspread between these types of bonds fluctu-ates predictably according to movements in theexplanatory variables. There were also indica-tions that the model as a whole predicted a largeshare of the variation in the sukuk-conventionalyield spread. In the cases of Malaysia and Qatar,adjusted r2 values (the higher the r2 the greatershare of the variation has been accounted forby the model. An r2 of .05 means 5 percent hasbeen explained; an r2 of .99 means 99 percenthas been explained) of the multiple regressions

when combining all the explanatory macro fac-tors together were extraordinarily high (Malay-sia: 0.953, Qatar: 0.926). Pakistan also had an im-pressive, but slightly lower adjusted r2 of 0.649.

What the results reveal are that a few macrofactors can explain a great deal of the fluctua-tion in yield spread between sovereign sukukand conventional bonds. The macro factors thathad the most significance across all three coun-tries examined were the risk-free interest rate(rt

free), the price of oil (lnoil), developing worldstock markets (developmentt), growth in otherShari‘a-compliant industry (islamt), and the Stan-dard & Poor’s 500 index (spx). Changes in eachof these variables affected the spread between

Table 2: Determinants of Sukuk to Conventional Bond Credit Spread

Pakistan Malaysia Qatar

Intercept -0.213 -4.902** -7.71**

-0.16 -11.18 -19.51 free

tr 0.865** 0.7888** 0.113**

24.67 22.83 3.51

)ln( toil -0.635* 1.175** 1.444**

-2.01 13.54 16.57

ttdevelopmen -1.483 x 10-3** 1.822 x 10 -3** 3.362 x 10-3**

-2.91 4.82 12.4

tpolitics -0.737* -0.835** -0.02

-2.03 -8.68 -1.28

tislam 8.027 x 10-3* -6.656 x 10-3** -8.406 x 10-3**

6.75 -12.01 -16.19 i

tequity -6.918 x 10-3** 5.82 x 10-5 4.792 x 10-3**

-8.62 0.12 18.93

tspx -7.01 x 10-3** 4.69 x 10-3** 7.281 x 10-3**

-6.28 9.63 17.69

tVIX -9.47 x 10-3 -0.036** -0.028**

-1.41 -7.68 -7.74

tbonds -0.039 7.706 x 10-3 -0.012

-1.1 0.86 -0.76

Adjusted r2 0.649 0.953 0.926

Root MSE 0.458 0.292 0.274

N 803 1283 1140

Notes:

1) Associated t-statistics reported beneath coefficient values.

2) Single asterisk (*) indicates significance at the two-tailed 5 percent significance level (p<.05), double(**)

asterisks denotes significance at the two-tailed 1 percent significance level (p<.01), for the null hypothesis

that the given coefficient equals zero.

(**)

3) See Table 3, page 72, for summary of explanatory variables.

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conventional and sukuk bonds.What this means is that investors in sukuk

are either more or less sensitive to these particu-lar macro variables than the conventional inves-tor. There are logical reasons why investors inIslamic bonds might be more sensitive to thesevariables than conventional investors. The gen-eral finding is that sukuk investors reacted withmore passivity to changes in macro factors thanconventional investors—as if their investmentin sukuk was fixed and not determined bychanges in the outside economy.

The first and most striking difference in in-vestor behavior between sukuk and conven-tional bonds is in the reaction of the market tochanges in the risk-free interest rate (rt

free). Therisk-free interest rate is defined here as the yieldon 10-year U.S. Treasury bonds, widely consid-ered in financial markets to be one of the safestand most liquid investments available. Inves-tors in the conventional sovereign bonds reactedto changes in the risk-free interest rate as wouldbe expected: That is, as the risk-free rate wentup, the yield on the conventional bonds issuedby Islamic nations went up in tandem to match.Strangely, however, the sukuk market remainedrelatively stable at the same time.

The trend could be an indication that whilea rosier global economic picture—rising risk-freeinterest rates normally correspond with a grow-ing economy—encouraged investors to in-crease investments to sovereign bonds, it didnot encourage them to increase investment insukuk where they would be taking on unneces-sary risk of default due to the problematic reli-gious element of the bonds. Sukuk investorswere not as influenced by changes in the risk-free rate because investing in U.S. treasury bondsis not permissible under Shari‘a.

Investors’ reactions to changes in oil priceswere highly surprising. The model suggests thatconventional bond investors reacted to increas-ing oil prices by buying bonds from oil produc-ing nations and selling those from oil importingnations. This is consistent with the idea that agovernment awash in oil revenues will be morecapable of paying its debts. Sukuk buyers’ pur-chases of Islamic bonds did not offset the move-ments of conventional bond traders in these in-

Ellis: Islamic Bonds

stances. Sukuk investors did not react tochanges in the price of oil as dramatically. Thisis particularly interesting in light of the fact thatmany sukuk investors are more likely to haveeconomic ties to the petroleum industry and,consequently, would have more investable fundsas oil prices rise.

Growth in developing world economies(developmentt) was associated with increasingdemand for conventionalbonds in Malaysia andQatar. As the index rose,signaling greater healthin emerging markets,conventional investorsfelt more comfortable in-vesting in the debt ofthese countries, bringingdown the yields of sov-ereign issues. The oppo-site effect was found inPakistan, probably dueto country-specific fac-tors: Pakistan’s political instability over the pe-riod, including terrorism in the autonomous re-gions and the assassination of Benazir Bhuttoin December 2007, made it an undesirable placeto invest relative to other booming, emergingmarkets. Pakistan’s history of leadership upheav-als raised fears that the country could defaulton its debt should the government topple. Thus,while emerging markets as a whole grew, inves-tors chose safer havens for their funds than Pa-kistan and fled its debt, raising yields. Sukukinvestors, investing mainly for a “piety premium”rather than for fundamental changes in the un-derlying economy, stayed put; consequently, thedifference in yield between the two types ofbonds shrank.

The calculated coefficients on politicst(value of index measuring the amount of politi-cal instability in the Middle East region) and VIXt(implied volatility of stock markets), showed aweaker and less consistent impact across thebonds examined. The results suggest that con-ventional bond investors react more aggres-sively to adverse changes in the perceived riski-ness of markets. As the political instability indexrose, yields on emerging-market debt shot up

Sukuk investorsreact as if theirinvestmentwas fixed andnot determinedby changesin the outsideeconomy.

70 / MIDDLE EAST QUARTERLY SPRING 2012

without a concomitant rise in sukuk yields. Thus,sukuk investors appear less sensitive to increas-ing volatility, perhaps because they have feweralternative low-risk investments. Also, the rela-tive illiquidity of the sukuk market could con-tribute to a sense that rising volatility in othermarkets would not affect a market where there isaltogether less turnover.

The effects of the changes in the developedworld economy as measured by the Standard &Poor’s 500 index reinforce what was found withthe risk-free interest rate. That is, sukuk inves-tors were more passive about changes in theS&P 500 index. Again, this is probably a func-tion of the fact that sukuk investors were lesslikely to be invested in the S&P 500 in the firstplace for religious and geographic reasons.

CONCLUSION

It seems likely then that the differing inves-tor bases of the two kinds of bonds are at theroot of the differences in bond yield betweensukuk and conventional bonds issued by the

Qur. 2:275: “They say: ‘Trade is just like usury,’ but God haspermitted trade and forbidden usury.” Islam’s injunctionsagainst the charging of interest have traditionally hamperedthe growth of financial markets in the Muslim world. Newfinancial instruments that have received the blessing ofreligious leaders skirt this prohibition and have contributedto a burgeoning market in these products.

same country. The two bondmarkets are essentially isolatedfrom one another due to thesukuk’s religious underpin-nings. Consequently, differentexpectations about changes inreturns stemming from system-atic risk would create a spreadbetween their yields.

It would appear that thesukuk market is a mostly pas-sive one. While conventionalbond yield fluctuations canusually be explained by the logi-cal responses of the conven-tional bond market to changesin macroeconomic risk, sukukmarkets evidence little varia-tion in sukuk returns as a re-sult of macro risk. Thus, con-ventional markets react to ad-verse or positive news in eq-uity, oil, or risk-free interestrates as would be expected with

emerging-market debt securities but sukuk in-vestors mostly ignored these movements.

This could be a result of the importance ofthe “piety premium” to sukuk investors: Theunseen utility benefit of holding a Shari‘a-com-patible bond for Muslim investors is not sensi-tive to changes in macroeconomic risk. Alterna-tively, the passivity could be a function of a lackof alternative assets for sukuk investors.Whereas conventional bond investors can eas-ily move to risk-free or less risky assets, sukukinvestors have far fewer options.

The relative passivity of investors in sukuksuggests that they are not as responsive to con-ventional financial signals. These results areconsistent with the notion that sukuk investorsare in general less sensitive to changes in theconventional business markets. For example,while conventional investors increased exposureto debt in developing markets like Pakistan andMalaysia as their economies grew, sukuk inves-tors kept exposures constant.

Sukuk research is still in its very infancy.Future research will be greatly aided by the ac-cumulation of new data and issuance of even

/ 71 Ellis: Islamic Bonds

Methodology

more sovereign sukuk. While perfect matchesof sukuk and conventional bonds from the samecountry are currently impossible, the presentanalysis, nonetheless, was able to show thepeculiar nature of the relationship between thetwo markets. Only time will tell if the strange

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t

iii

t

ubondsVIXspxequityislam

politicstdevelopmenoilrCS

98765

43210 )ln(

1 Richard Roll and Stephen Ross, “An Empirical Investigation ofthe Theory of Arbitrage Pricing,” Journal of Finance, Dec. 1980,p. 1074.

All sukuk and conventional bonds included inthe study are sovereign-issued, quoted daily exceptfor weekends and major holidays. The periods varyby bond pairing with the earliest starting in June of2002 and some continuing until mid-February 2008.All bonds are U.S.-dollar denominated, which elimi-nates potential foreign exchange rate effects on yieldspreads.

Analysis was conducted in two stages. First,the standard ordinary least squares estimators (OLS)were used to build the multiple regressions wherethe credit spread, CSi

t, of bond-pairing i in time t isthe dependent variable, and nine explanatory vari-ables related to theoretical determinants of creditspread are included as regressors.

The Arbitrage Pricing Theory (APT) was usedas the starting point for security valuation. Simplyput, the essence of APT is that in market equilib-rium no arbitrage profits can be made (because inefficient markets, traders will eliminate riskless prof-its immediately). Analysts Stephen Ross and Rich-ard Roll show that a consequence of this assumptionis that “asset returns can only come from increasingexposure to market risks. Every equilibrium will becharacterized by a linear relationship between eachasset’s expected return and its return’s response am-plitudes, or loadings, on the common factors.”1 These“common factors” are the common components of allassets considered in a multifactor model of securitypricing. They are typically construed as sources ofmacro risk. The “factor loadings” are the coefficientson the factors indicating the sensitivity of a particularasset to sources of macro risk. Here, the APT model

is chosen over its alternative, the capital asset pricingmodel (CAPM), primarily because CAPM requiresall investors to hold identical market portfolios.2 Thisassumption conflicts with two of the key areas of ex-ploration of this study: (1) Muslim investors are morelikely to buy sukuk than non-Muslim investors, and (2)sukuk investors, on the whole, have fundamentally dif-ferent market sensitivities than ordinary investors.

Figuring out where factor weightings are substan-tially different between the two yields will be the keyto unlocking what determines the credit spread. Hence,the choice of explanatory variables (see below) will beguided by the search for variables that are weighteddifferently between the two bond types. The net ef-fect of the difference between two factor loadings (i.e.bk,sukuk –bk,conv) for any given explanatory variable willset that variable’s effect on credit spread.

Note that CSit is the yield premium of sukuk over

conventional bonds. Unlike spread comparisons be-tween risky assets and risk-free assets, the credit spreadbetween sukuk and conventional bonds can take onboth positive and negative values (indeed, all four se-ries studied have credit spreads that turn negative atsome point, if not much of the time).

A number of different variables representingchanges in macroeconomic states both domesticallyand internationally are studied to explain fluctuationsin the sukuk and conventional bond spread. For everyseries i, a set of nine explanatory variables are used inthe multiple regression estimated as such:

2 Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 7th ed. (NewYork: McGraw-Hill/Irwin, 2008), pp. 342-3.

behavior of the Islamic bond yield spread is aconsequence of an immature sovereign sukukmarket or a permanent feature of the different sen-sitivities to systematic risk of the two markets.

72 / MIDDLE EAST QUARTERLY SPRING 2012

Descriptions of the regressors can be foundin summary in Table 3. The above regression isrun three separate times for each entity i usingthe OLS estimators for the beta values.

A subset of the data from January 19, 2005,to May 25, 2007, is drawn from three of theentities. This time segment is chosen because itis the lengthiest period during which the six bondsincluded overlap. This panel data set has 613observations for each of the three entities. Thefollowing fixed effects regression model with en-tity fixed effects ai is estimated:

Where ai is the entity fixed effect and E(ui| Xi1…Xin, ai ) = 0 and ut

i is a term for all otherunexplained variation in the regression. The en-tity-fixed effect is included to account for coun-try-specific omitted variables that vary acrosscountries but not over time. As earlier, the coef-ficients are estimated using OLS.

i

t

t

t

i

i

ii

t

i

t

i

t

i

t

i

t

ifree

t

i

i

i

t

ubondsVIXspxequityislam

politicstdevelopmenoilrCS

98765

4321 )ln(

Table 3: Summary of Explanatory Variables

Explanatory

Variable Description

rtfree

The risk-free rate of return; defined

as yield on 10-year US Treasury

bonds

)ln( toil OPEC Reference Basket value in

$/bbl

ttdevelopmen Return on MSCI Emerging Markets

Index

tpolitics

Value of index measuring the amount

of political instability in the Middle

East region

tislam Return on the Dow Jones Islamic

Market Index

i

tequity

Return on the major stock market

index of the country that issued series

i

tspx Return on the S&P 500

tVIX

Implied volatility of stock markets, as

indicated by options activity on the

Chicago Board Options Exchange

tbonds Return on the Lehman Brothers

Middle East Sovereign Bond Index

Multi-Million BoyA Saudi man put up his son for sale on Facebook for a whopping $20 million (Dh73.4m) tobeat poverty.

According to al-Sharq newspaper, Saud bin Nasser al-Shahry took the extreme stepwhen all doors closed on him. His business of collecting debts and settling disputes had tobe shut down following a court ruling, which stated it was not a legal firm, he alleged.

Thereafter, he approached the Labor Office for monthly financial assistance. Healleged that he was refused aid because he was above 35 years—the age limit of receivingministry help.

Therefore, he decided to sell his child to offer “a decent life to his mother and sisterrather than living in poverty,” the report added.

His only condition for the “sale” is to know the city where the buyer resides.He is willing to take the matter to court to complete the “sale procedures,” the paper

added.Emirates247.com, Jan. 3, 2012

U.S.

ExplanatoryVariable

Description