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Is the Long Profit Rate of Malaysia Sukuk a Good predictor of Short Profit Rates? Two Factor Model Analyses

ABSTRACT

Decomposition of yield factors which accounted for the shift in term structure of interest rates provides a parsimonious representation of term structure of interest rates. This is employed in pricing fixed income instruments, inflation management, and modeling term structure of interest rates to study the relationship between long and short term spread. Meanwhile, Sukuk which is a new phenomenon is based on profit and loss sharing principle as dictated by Shari'ah principle. investigating whether the long term profit rate on different classes of Sukuk (the tradable ones) is a good predictor of future spot profit rate considering the fact that forward profit rates also contains the reward for risk or term premium. If yes, how can this information contained in the Sukuk yield curve become useful in forecasting? Data on Malaysian Sukuk from 2001-2009 were used. MATLAB financial tool was employed in the analysis to gain computational efficiency. The output from the above OLS estimate led us to conclude that the predictor that is the forward rate has a very weak predictive power to forecast the spot profit rate. This indicates that the long term rates are not the average of future spot rates on long term Sukuk (Islamic bonds). Pure form of Expectation hypothesis may be rejected based on this statistical evidence. However, comparison within securities of the same credit risk but with different maturies revealed that there is inbuilt a support for term premium in the yield curves of corporate Sukuk. This is a support for Liquidity Preference Theory. It was observed from the extended two-factor HJM spot and forward curves that the term structure of Sukuk profit rate yield curve are humped. This shape is explained by market segmentation theory which implies that there is a segmentation of maturities in the Sukuk market. It also indicates uncertainty in the expectations of Sukukholders in the market.

Key words: Term structure, Profit rate yield curve, Sukuk (Islamic bonds), short profit rate, long run profit rates, Sukuk holders. JEL: C12, C53, G12

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1.0 Introduction

Maturity mismatches is an important issue for bank failure as well as corporate long term financing. Maturity mismatch is one of the main reasons of Asian financial crisis in 1997 which caused large number of bank and corporate failure in East Asian countries. Therefore the currency crisis that occurred in Thailand, Malaysia, Korea, Indonesia and other Asian countries in 1997 served as trigger for each Asian government to give priority to the promotion of the development of its bond market. Therefore it will be argued that two areas were substantial progress could be made are the corporate bond and sukuk (Islamic bond) markets which benefit the private corporations from having access to multiple sources of long-term funding at competitive term. , which would increase their ability to borrow at more competitive terms. Similarly, well developed debt and sukuk markets would also benefit commercial banks, which would be able to issue their own long-term paper. In this manner, banks could reduce their dependence on their depositor base and increase the menu of tools available to balance their maturity mismatches and reduce the vulnerability during the economy downturn.

Malaysia is one of the pioneer countries in Asia to develop the corporate bond market after Japan and Korea. In addition to the conventional bond market, Malaysia is the largest Islamic bond (known as a SUKUK) issuer country in the world (48 percent global sukuk). Within Malaysian capital market, Islamic bond is much larger than that of conventional corporate bond. Since the introduction of Islamic bond as well as conventional corporate bond, there is no any empirical research on pricing and predictable power of the yield curve of the Sukuk bond.

A graphical depiction of the relationship between the YTM and term-to-maturity of bonds with same credit risk but different term-to-maturity is referred to as the “yield curve”. Studying the yield curve assists both lenders and borrowers in making right investment decisions. Lenders that lend on short term are to worry about reinvestment rate after maturity while those that lend on long term are faced with risk of uncertainty in terms of liquidation value. In addition, borrowers that borrowed on short term are faced with risk of higher refinancing in the future while those that borrowed on long term faces the risk of locking in higher rate. Hence, the yield curve is important to market players. With the yield curve, market players can see possibly various rates of returns and investments in the future that can be locked in now. Also, with the different types of yield curves, investors can follow the government economic policy trends and direction of the future interest rates. When the coupon rate and the yield on a bond are equal, then the price of a bond shall be equal to its par value (Fabozzi et al 2005). The par value is the face value or the value at which the bond was issued. Yield-to-maturity (YTM) on a bond refers to the interest rate that an investor desires from investing on a bond. An increase (decrease) in the YTM means a decrease (increase) in the price.

Few studies on term structure of interest rates available on Malaysian bond market are all based on conventional bonds and not on Islamic bonds (Sukuk), though Sukuk is a nascent instrument in Malaysia capital market. The study aimed at investigating whether the long term profit rate on different classes of Sukuk (the tradable ones) is a good predictor of future spot profit rate considering the fact that forward profit rates also contains the reward for risk or term premium. If yes, how can this information contained in the Sukuk yield curve become useful in forecasting?

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Hence, this study shall contribute new findings not only to existing literature on term structure but also a unique and untraditional knowledge to existing literatures in Islamic Finance.

It was observed from the HJM spot and forward curve obtained from the extended two-factor HJM term structure model that the term structure of Sukuk profit rate yield curve are humped. This shape is explained by market segmentation theory which implies that there is a segmentation of the maturity in the market. It is possibly an indication of uncertainty in the expectation behavior of Sukukholders. The output from the above OLS estimate led us to conclude that the predictor that is the forward rate has a very weak predictive power to forecast the spot profit rate. This indicates that the long term rates are not the average of future spot rates on long term bonds. Pure Expectation hypothesis may not be supported based on the statistical evidence.

1.1 Conventional Bonds Yield-To-Maturity (YTM) and Profit Rates of Sukuk

The bond market literature has documented models for term structure of interest rate on conventional bonds most importantly for fixed income bonds. These models on interest rates usually employ fixed interest bonds in constructing the yield curves. Albeit, application of term structure has been developed and upgraded to accommodate term structure analysis on floating rates bonds using advance analytical tools. As for Sukuk, there are no established models derived yet to measure the term structure of profit rate. Moreover, different Sukuk structuring like murabahah, mudarabah, musharakah, bai bithaman ajil (BBA), istisna, salam, ijarah etc are usually applied to Sukuk contracts which may be fixed or floating rates. Murabahah is a mark-up transaction which does not involve profit/loss sharing; so also istisna and salam does not. Musharakah and mudarabah apply proft/risk sharing between the issuer and investors, hence fixed and floating rates applies respectively.

This study focuses on fixed income Sukuk like Musharakah and ijarah only since the existing models for conventional bonds are applied to the yield curve of profit bearing bonds in the absence of a profit rate model for Sukuk. Floating rate Sukuk will require much more involved modeling that is beyond the scope of this study. Profit rates on Sukuk with fixed income nature are used instead of fixed interest rates that conventional models usually employed while other data on Sukuk are similar to that of the conventional bonds to construct profit rate curves (the yield curve) for government Sukuk and credit curves for non-government Sukuk.

There are usually different interest rates (yield rate) on different bonds due to their term to maturity. Interest rate on a 3 month, 6 months; 12 months; 5 years; 10 years and up to 30 years period and above differs from one another. Yield to maturity {(YTM) also known as the spot rate} causes fluctuations in the bond price. In order to see a rate of return that can be locked in today on different maturities in the future, a graphical depiction of relationship between yields on bonds that have same credit quality but differ in maturities is constructed. In addition, bondholders that wish to hold the bond to maturity are given total expected returns based on the YTM (Ariff et al 2009).

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With the yield-to-maturity curve, various rates that can be locked in by lenders and borrowers on various maturities are shown. Long term investors' expectation on reward for investing on long term basis otherwise known as the risk-premium (also referred to as term premium) is another important factor which can affect the shift in the shape of the yield curve. Thus, mapping out the relationship that exist between default free securities that differs only in their terms to maturities and hence their yields is referred to as term structure of interest rate. Decomposition of yield factors which accounted for the shift in term structure of interest rates provides a parsimonious representation of term structure of interest rates. This is employed in pricing fixed income instruments, inflation management, and modeling term structure of interest rates to study the relationship between long and short term spread.

Meanwhile, Sukuk (Islamic bonds) which is a new phenomenon is based on profit and loss sharing principle as dictated by Shari'ah principle. A major principle underlining the Islamic transactions and profit on investment is that they are usually asset-backed because Islam encourages the use of underlying assets in contract such that the investors assume a certain degree of risk before a legitimate profit could be earned on such investment. By implication, investors must assume ownership risk of the assets before it can be used as an underlying asset. In other words, exchanging money for commodity is permitted while exchanging money for money is prohibited except when it is equal in amount and it is on the spot exchange.1 Where there is an underlying asset in a transaction, Islam has provided different types of contracts that could be applied to such transaction to sooth both the investor and borrower. These contracts are flexible in nature and are such that can be applied both at the Islamic money and capital market; hence, application of these contracts in the two markets depends on the term structure.

Sukuk income or stream of profit could be fixed or floating depending (has we have in the conventional bonds) on the type and term of contract. If for instance, the type of contract is Ijarah-leasing contract, there should be a fixed flow of rentals at specified periods in the contract agreements. If the contract is based on Mudarabah contract which applies principle of profit and loss sharing, then, the stream of flow should be floating and should not be predetermined (Usmani 2008). That said it means that the profit rate of Islamic bonds Sukuk is based on the changes in the economy.

Profit or loss is determined by the market forces of demand and supply. This is highly relevant to assist both investors and borrowers most importantly when changes in the market atmosphere, uncertainty in the financial and business environment are put into consideration. Hence the profit rates on Sukuk are not supposed to be predetermined especially where the structuring is based on profit and loss sharing and the investor’s capital is not guaranteed. The protection for investors in Sukuk is basically the underlying asset as they are entitled to the proceeds from its disposal. Theoretically, we may state a priori that Sukuk should have weaker predictability power since the profit rates fluctuates in accordance with the business cycle and economic environment.

Furthermore, the yield curve on Sukuk (Islamic bonds) is expected to give an insight into whether the market has allocated a fair value to the bond as changes in the yield rate will drive a change in the bond price. Since the curve is shaped by the spread between the yields, market players are

1 See Buhari Vol 3, Hadith 334

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mostly concerned with the yield spread at which a bond is trading rather than it price. Are investors able to obtain term premium (compensation for lending long) to compensate for the risk involved in lending long? Finding an answer to this question shall, among others, engage our attention in this research.

1.2 Sukuk market comparison to International Bond Market

Furthermore, it is worth to note that though the Sukuk market is in its infant stage but it holds a great potential in the ICM. Attractive return on it has resulted in robust growth in demand and supply of different varieties in the ICM though still a tiny fraction of the total international bond market. According to Bank for International Settlement, Sukuk is worth $1.2 Trillion during the first-half of 2006 (Nik 2007). Meanwhile, the size of the world bond market is estimated to stand at approximately $67 Trillion according to Merrill Lynch.2 That is, Sukuk market is approximately 2% of the total international bond market. A total of 283 issuances have being made so far in the sovereign and international market as at 2007 starting from Bahrain Monetary Agency Ijarah Sukuk of 2001 to Malaysia Total Mobile IMTN Ijarah Sukuk 2007 (Global Investment 2007). Issuance from Malaysia alone was 111; a figure that represent almost 40% of the global issuance.3

It is pertinent to note that Sukuk issued in Malaysia complied with the Malaysian Security Commission (MSC) guidelines on Islamic bonds with regulation from Bank Negara Malaysia (BNM). A notable feature of Malaysian Sukuk is that the issuances are mostly in Malaysian Ringgit. Also, Malaysia is operating a dual financial system that is the co-existence of conventional vis-à-vis Islamic Financial system. According to Muhammad Al-Bashir (2008) the Muslim Economists and Shari’ah scholars are yet to come up with Islamic indicator of profitability; indexing to London Inter Bank Offer Rates (LIBOR) has become a practice in Islamic Financial Institutions (IFIs). Thus, IFIs are compelled to benchmark their profit rate on the available interest rate for better competition. This practice has been seen as a distortion to true market value of underlying assets and hence, their returns (Muhammad Al-Bashir2008). It’s worth to note that out of the 111 sovereign issuances in Malaysia as at 2008, only 10 were indexed to LIBOR. In addition, the first sovereign Sukuk was issued by Malaysian government in 2002 with the application of Ijara contract after which many other countries followed. This research is done on Malaysia Sukuk because of it leading role in issuance of Sukuk. As at the end of 2007, Malaysia accounted for over two-third of the world outstanding Sukuk estimated at $62 billion (RM213 billion) by RAM (2009) and so far has the largest number of issuance.

The establishment of Malaysia international Islamic Financial Center in 2006 was aimed at facilitating more issuances of Sukuk and to further position Malaysia as the global hub for Islamic Capita Market.4 As at June 2007, the 1st quarter of the year, Islamic Finance Information Service (IFIS) database showed that there was a growth of 71.4% in the domestic Sukuk market and 83.3% in the international Sukuk market over 2006. Sovereign Sukuk grew by 521% while

2 PIMCO Bond Basics December 2007, accessed from www.pimco.com on 29th January 2009. 3 Sukuk: A New Dawn of Islamic Finance Era, Global Investment House Research, January 2008. 4 http://www.imf.org/external/pubs/ft/survey/so/2007 accessed on 8th May, 2008

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Malaysia Ringgit denominated Sukuk accounted for 70% of the market.5 Moreover, the use of underlying assets and the application of profit/loss sharing system embedded in Islamic Financial System (IFS) based on Shari’ah of Allah (SWT) is probably an attraction to risk-averse investors. Conventional and Islamic markets are regulated by the Bank Negara Malaysia (BNM), interest rate policy of BNM may effect on long term bonds and their yield curves; Islamic bonds included.

Existing literature on Sukuk discusses the development of financial instrument which are in compliance with the Islamic legal framework (Karf 1997). The literature is concerned with the synchronization of Sukuk within the conventional financial system without losing focus of the laid down principles for fixed income instrument in the Islamic context. There are also the Sukuk prospectus issued by different issuers (Tariq 2004) highlighting the price; amount; maturity and returns/redemption and other terms and conditions for the issuance of Sukuk. Despite the similarities in conventional and Islamic bonds, evidence could not be obtained that this nascent instrument term structure has been studied. The dynamics of Sukuk market as well as that of conventional bonds are from the same variables like economic atmosphere and business cycle. Perhaps that accounted for why Sukuk has been found to be similar in many aspect to Eurobond (Selim and Faezeh 2007), and why the increasing convergence between Conventional and Islamic financing especially in the case of conventional bonds and Sukuk has been foreseen by scholars in the field of Islamic finance (Mirokhar 2007).

Furthermore, Sukuk term structure is approach based on the assumptions that: the forward rate on Sukuk are closely related to expectation of market players about the future short term profit rates; that the investors’ expectation about excess return is constant over time irrespective of their maturity strategy due to their strong affliction to a segmented market that met Shari’ah compliance. Meanwhile, in the application of any form of Expectation hypothesis in term structure of profit rates of Sukuk, there is the need to consider the principle underlining the issuance; pricing; risk; and returns on the subject. Hence, the specification of fixed income market were considered while taking cognizance of the Shari’ah principles that delineate Islamic and conventional bonds; fixed income Sukuk based on Musharakah, ijarah, mudarabah and the likes were selected from tradable Malaysian Sukuk.

It is worth to know that there are 14 types of investment Sukuk approved by Auditing and Accounting Organization of Islamic Financial Institutions (AAOIFI) (refers to Table 1 for types investment Sukuk). Any other structuring outside this list is deemed unacceptable. Sukuk (especially sovereign ones) are rated by International Rating Agencies after having met the criteria for Shari’ah and AAOIFI compliancy. In this respect, reference benchmarking for credit risk has gone a long way in benefiting the Malaysian Sukuk market according to Rating Agency Malaysia Berhad (RAM 2007). This is because the rating of Islamic debt instrument in Malaysia in a similar manner to the way conventional instruments are rated had been made compulsory since 1992.

5 Global Sukuk Market Soar to $24.5bn H1, 2007, IFIS News, August 2007, accessed August 8, 2008 form www.ameinfo.com

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Table 1.1 14 Types of investment Sukuk Approved by AAOIFI

No Types

1. Certificates of ownership in leased assets

2. Certificates of ownership of usufructs

These certificates have various types, including the following from 2.1 to 2.4:

2.1 Certificates of ownership of usufructs of existing assets

2.2 Certificates of ownership of usufructs to be made available in the future as per description

2.3 Certificates of ownership of services of a specified supplier

2.4 Certificates of ownership of services to be made available in the future as per description

3. Salam certificates

4. Istisna’a certificates

5. Murabahah certificates

6. Participation certificates

6.1 Participation certificates managed on the basis of Musharakah contract

6.2 Participation certificates managed on the basis of Mudarabah contract

6.3 Participation certificates managed on the basis of investment agency

7 Muzara’a (sharecropping) certificates

8 Musaqah (irrigation) certificates

9. Mugarasa (agricultural) certificates

Source: AAOIFI Exposure Draft Shari’ah Standard No.18, 2002

Nevertheless, in terms of some features like rating, redemption procedure, coupon payment and default clauses for sovereign Sukuk; Sukuk are in many aspects similar to conventional bonds (Selim and Faezeh 2007). Albeit in terms of issuance and pricing there are some differences due to collateralization of Sukuk and the bid-side valuation as price for Sukuk due to illiquid nature of the bond as a result of less secondary market trading on it. In addition, Sukuk investors’ attachment to that segment of the bond market that meets Shari’ah compliancy necessitated identification of Sukuk with Market Segmentation theory which is one form of Expectation hypothesis. Based on these premises, one may conclude that application of Expectation Hypothesis to term structure of Sukuk may not be out of hand since there is no evidence of existing term structure theory on the subject matter.

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2.0 Data and Methodology

Two Factor HJM Model’s Partial Derivative Equations

In this section, one-factor HJM term structure model was introduced followed by the extended two-factor HJM term structure proposed. The proposed two-factor HJM model was extended with the addition of another state variable that is volatility which is one of the most important factors that can be use to explain the term structure of profit rate movement. Using interest rate volatility as the second state variable is intuitively appealing since volatility is a key variable in pricing contingent claims (Bali 2003).

The spot rate r(t) is assumed to be equal to the instantaneous forward rate f(t,T), then we have f(t,T) in equation (1.1)

( ) ( )[ ]T

TtPTtf∂

∂=

,ln, ………………………………………………….(1.1)

Intuitively, if the forward rate follow this process

( ) ( ) ( ) ( ) ( )sdWTsdsTsTfTtft n

ii

t

i∫ ∑∫=

++=0

10

,,,0, σα …………………..(1.2)

Where { iW } 1=i …..,n are independent Brownian motions, then the spot rate process is

( ) ( ) ( ) ( ) ( ) ( )sdWTsdsTsTfTtftrt n

ii

t

i∫ ∑∫=

++==0

10

,,,0, σα ……………… (1.3)

The bond price fluctuates as a result of the interest rate, with variation in spot rate; Let P(t,T) denote the price of a Sukuk bond at time t maturing at time T where t ≤ T. with the boundary P(t,T) =1, we have

[P(t,T)] = 1 ……………………………………………………………… (1.4)

Then to determine the movement on the price P of a bond at time t, maturing at time T

[ ] ( )

−= ∫

T

tdsstfTtP ,exp, ……………………………………………… (1.5)

And logarithm of P is:

[ ] ( )

−= ∫

T

tdsstfTtP ,exp,ln …………………………………………………..(1.6)

With mathematical derivations as detailed in HJM appendix; combined with equations 1.3 and 1.5, we have the following equation

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[ ] ( )( ) ( ) ( )[ ] ( )

( ) ( )tdWTta

dtTtadtTtbtrTPTtP

i

n

i

t

i

n

i

t

i

t

∑∫

∑∫∫

=

=

+−++=

10

2

100

,

,21,,0ln,ln

……………………(1.7)

Wherein:

( )Ttai , = ( )dtT

t Tti∫− ,σ ……………………………………………………………(1.8)

also

( )Ttb , = ( ) ( )∫ ∑=

+−t n

ii TtadtTt

0

2

1

,21,α ……………………………………………..(1.9)

Ito lemma differential equation was used to transform the dynamics of bond price into a stochastic process:

( ) ( ) ( )[ ] ( ) ( ) ( ) ( )tdWTtPTtadtTtPTtbtrTtdP i

n

ii ,,,,,

1∑=

++= ………………………….(2.0)

HJM proposed that if Q- the risk neutral probability is an equivalent martingale, and ( )tB is a discount factor; it follows that a zero-coupon bond with maturity time T will have this price:

( )( )tBTtP , …………………………………………………………………………..(2.1)

When Ito lemma is applied to the logarithm of equation 2.1

( )( )

( )( ) ( ) ( ) dtTtadtTtbtBTP

tBTtP n

i

t

i

t 2

100 2

1 ,,,0ln,ln ∑∫∫=

−+= ( ) ( )tdWTta i

n

i

t

i ,1

0∑∫=

+ …….(2.2)

In the context of two-factor model; if the above condition hold and further proposition of No-arbitrage condition and restriction on the forward rate process drift is given in equation (2.3):

( ) ( ) ( ) ( ) ( ) ( ) ( )

−−−+−−=

−−−−−−12, 22

222

122

211

tTtTtTeetTtqetqTt

λλλ

λσσσσα ……….(2.3)

Where:

( )Tt,α , is the drift on the forward rate process which is equal to:

( ) [ ] ( ) ( )

−−= ∫∑

=

T

t ii

n

ii dtTttqTtTt ,,,

1σσα ……………………………………….(2.4)

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And ( )tq1 is the arbitrage-free condition with

( ) ( )nii Ttqtq ,...,= i = 1,…,n ………………………………………….(2.5)

The forward rate process with long and short term factors is:

( ) ( ) [ ] ( ) ( )tdWtdWedtTtTtdftT

2212

1,, σσαλ

++=−−

……………………………… (2.6)

The terms

[ ] ( )tdWetT

12

1

−−λ

σ is the short term profit rate factor and

( )tdW22σ is the long term profit rate factor and

1W and 2W are Brownian motion for short and long term factors respectively.

With risk-neutral probability (a link between equation (2.3) and (2.6)) the forward rate dynamics will take this process:

( ) ( ) ( ) +

−−−

−

−+=

−1212

2,0, 22

222

1

tTtT eeeetTtTfTtfλλ

λλ

λσσ

( ) ( ) ( )∫−−

+t tT

tWdetW0 2

221

λ

σσ ……………………………………………………...(2.7)

While the spot rate dynamic process shall be:

( ) ( ) ( ) +

−−−

−+=

−− tt eettTftr 22

22

21 1212

2,0

λλ

λσσ ( ) ( ) ( )∫

−−+

t tTtWdetW

0 22

211

λ

σσ

………….(2.8)

By extension, the variables in the model discussed above shall be use to predict the ability of the forward rates to forecast the spot rates employing simple linear regression to regress the forward rate on the actual spot profit rates at time t with n years to maturity using the following equation:

tsrn = α + βt fr +εt ……………………………………………………(2.9)

Where tsrn is the actual spot profit rate of an n year bond at time t, βt is the slope coefficient of the forward rate; fr is the implied forward rate of 1 year bond at time t; while εt is the disturbance error term.

The research tested the validity of expectation theory, if the α which is the intercept have a zero value or very close to zero and the co-efficient of the forward rate as a value of 1 or a value close to 1; then the forward rate has a strong predictive power to forecast the future spot profit rate. The closer these values are to zero and 1 respectively; the stronger the predictive power. And if

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otherwise; that is, if the intercept presented a value not equal to zero and the co-efficient value is zero; then the theory is rejected on Sukuk bonds.

3.0 Results and Discussions

Prices and YTM Result Analysis from the Two-factor HJM Model

Incorporating multiple factors allows us to specify different types of shift in the shape and location of the interest-rate structure. The HJM Tree structure contains the time and forward-rate information needed to price the notes. Government and Corporate Sukuk were analyzed. Least maturity is 3 years government and corporate Sukuk and highest maturity Sukuk is 50 years corporate Sukuk. Prices and YTM obtained from the Sukuk two-factor HJM model for each Sukuk covered the maturity periods for Malaysian Government Sukuk and each categories of corporate Sukuk in the sample classified according to their credit or default risk. Yield curves were generated for the GII because they have no credit risk while the yield curve for non-GII or the corporate Sukuk are typically referred to as credit curve. These types of Sukuk are expected to offer additional yield to compensate investors for additional risk incurred and to make them relatively attractive. Hence credit curves plot the available yields on investment grade Sukuk with different credit qualities. There are eight risk classes namely: AAA, guaranteed A1; AA1, AA2; AA3; A1; A2; and A3.

Typically, there are ways to compare different types of yield curves in order to formulate good strategies to enhance portfolio returns. This study compares the model or fair yields and prices with the current yields and prices to see if the market offers a fair value for the bonds. Comparing the government treasury yield curve with the investment grade of higher qualities in order to see additional yield such bond can offer for assuming some credit risk was done. It also compared the relationship between maturities within the same type of securities i.e. comparing government or corporate bonds of three-year maturity to bonds with fifteen-year maturity in order to see if such bond offers extra yield to compensate investors for the extended maturities. Historical yield and prices of bonds within the same securities were not compared. This was due to inconsistency and missing data in the historical data on Sukuk.

The bonds in table 1.2 employed the first comparison and were arranged according to their issue dates. The obtained prices and YTM for 2010 are compared with the mark-to-market prices and YTM of the same year for each bond to see if the market offers a fair yield and price on these Sukuk.

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Table 1.2 Fair Prices and Yield for Malaysian Government Sukuk

Bonds Profit rate issue date

Maturity date

Price(2010 M2M)

Fair Price(2010)

Current yield[2010]

Fair YTM (2factor HJM )

3Y 3.57 15-Mar-07 15-Mar-10 100.19 99.97 1.86 3.58 3Y 4.363 30-Jun-08 30-Jun-11 102.77 99.91 2.34 4.41 3Y 3.077 13-Apr-09 13-Apr-12 100.7 99.95 2.74 3.15 3Y 3.288 15-Jan-10 15-Jul-13 99.7 100 3.38 3.4 4y 3.278 15-Sep-09 15-Mar-13 100.16 99.89 3.22 3.39 5Y 4.635 14-Jul-06 14-Jul-11 103.21 99.9 2.36 4.66 5Y 3.692 8-Dec-05 8-Dec-10 101.36 99.97 2.06 3.7 5Y 3.581 14-Sep-07 14-Sep-12 101.53 99.91 2.96 3.61 5Y 3.604 31-Mar-08 29-Mar-13 101.08 99.88 3.24 3.67 5Y 3.902 30-Jun-09 30-Dec-14 100.15 99.8 3.87 4.04 5Y 3.909 31-Jul-09 31-Jul-14 100.6 99.83 3.76 4.08 6Y 4.273 14-Aug-08 14-Feb-14 102.48 99.81 3.61 4.41 10Y 4.419 16-Mar-05 16-Mar-15 102.37 99.75 3.9 4.48 10Y 3.82 15-Nov-06 15-Nov-16 98.49 99.78 4.08 3.88 10Y 3.941 15-Jun-07 15-Jun-17 98.88 99.74 4.12 4.03 10Y 4.295 31-Oct-08 31-Oct-18 100.32 99.66 4.25 4.47 10Y 3.91 13-Feb-09 13-Aug-19 96.68 99.64 4.34 4.16 11y 4.492 30-Oct-09 30-Apr-20 100.8 99.54 4.39 5.43

It is worth to note that prices are calculated from the Sukuk2factorHJM forward rate tree generated after specifying the volatility specification; Rate specification and Time specification. The obtained prices are input to YTM calculations. Prices cannot be calculated without the forward rate tree and hence, YTM too. It was observed that 83.3% of the active Malaysian Government Sukuk were found by the model to have higher YTM when compared to the mark-to-market YTM, hence, lower price than the market price. While 16.7% has lower yield than the market-to-market yield, hence a slight drop in their prices as compared to the market-to-market prices as well. Interestingly, one out of the 3 bonds having lower yield than the mark-to-market yield has a higher fair price than the price offered by the market While the other 2 which constituted 11.11% has lower price. It should be recalled that investors are usually concerned with the yield on bonds rather its price. Given this fact, there is the likelihood to conclude that the market has not succeeded in allocation a fair yield to these Sukuk. By implication, and sequel to the prices obtained in the model, there is the probability to state that almost 88.9% of the Government Sukuk are overpriced and almost 11.1% are underpriced or rather, are not given a fair pricing.

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Table 1.3 Fair Prices and Yield for Corporate AAA Rated Active Sukuk

Bonds Profit rate issue date

Maturity date

Price(2010 M2M)

Fair Price(2010)

Current yield [2010]

Fair YTM (2factor HJM )

5y 6.3 26-Aug-05 26-Aug-10 101.51 99.93 2.59 5.32 6y 5.6 26-Aug-05 24-Aug-11 103.82 99.85 3.08 5.63 7y 6.1 26-Aug-05 24-Aug-12 106.48 99.75 3.44 6.16 8y 5.3 26-Aug-05 26-Aug-13 108.23 99.66 3.81 6.38 9y 6.4 26-Aug-05 26-Aug-14 109.23 99.57 4.16 6.5 10y 5.85 4-Dec-02 4-Dec-12 104.75 99.77 3.97 5.864 10y 6.5 26-Aug-05 26-Aug-15 110.27 99.49 4.4 6.62 11y 5.25 20-Jul-07 28-Dec-18 98.25 99.47 5.5 5.44 12Y 6.3 4-Dec-02 4-Dec-14 108.19 99.59 4.35 6.326

Under the Corporate AAA rated actived Sukuk in Table 1.3, all the bonds in the sample have higher YTM than mark-to-market yields and lower prices compare to the market pices. It should be recall from previous discussion in chapter two under rating of Sukuk as asset-backed security by RAM that AAA corporate Sukuk are classified as best quality Sukuk with highest safety of timely payment of profit and principal. Each of the bond in these sample showed increasing yields towards long term spectrum. This was observed on both the market allocated yields and the calculated fair yields. Lower prices were obtained on long term Sukuk while short term Sukuk prices were higher. But this pattern was not observed in the market prices. There was an irregular pattern in the market prices for each maturity. This may mean that each Sukuk in different maturitity behaves differently from one another. It may also be due to the absence of unifying trading exchange and poor trading activities in the market. Additionally, this result may be attributed to few market participant and expertise in the market.

Table 1.4 Fair Prices and Yield for Corporate Guaranteed A1 Rated Active Sukuk

Profit rate issue date

Maturity date

Price 2010 (M2M)

Fair Price(2010)

Current yield [2010]

Fair YTM (2factor HJM )

6y 6.5 25-Aug-06 24-Feb-12 101.1 99.74 5.92 6.58 6y 6.5 26-Aug-06 24-Aug-12 100.91 99.72 6.11 6.58 7Y 7 25-Aug-06 25-Feb-13 101.64 99.6 6.4 7.37 7Y 7 25-Aug-06 23-Aug-13 101.09 99.59 6.65 7.12 8Y 7.2 25-Aug-06 25-Feb-14 101.22 99.48 6.85 7.37 8Y 7.2 25-Aug-06 25-Feb-14 100.76 99.48 7 7.37

9y 7.5 25-Aug-06 25-Feb-15 101.58 99.35 7.12 7.72 9y 7.55 25-Aug-06 25-Aug-15 101.39 99.1 7.24 7.82

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Under the Corporate guranteed A1 rated actived Sukuk, 100 percent of the sample has higher YTM than mark-to-market yields, hence lower prices compare to the market prices (refer to tables 1.4). The yields followed an increasing pattern which is also observed in the market yields. This same pattern was observed under market yields for Malaysian government Sukuk. Decreasing prices was evidenced from the fair prices, this was not observed in the market prices. This may be a result of the use of on-the-run yields usually employed in calculation which may be misleading. The true yields usually tends to be greater than the quoted yields. This fact is supported by the fair yields on the examined Sukuk. Guaranteed A1 are government guaranteed corporate Sukuk, it behave in a similar way to Malaysian government Sukuk. More so, risk-averse investors that usually dominate the bond market sometimes behaves differently especial if there is expectation of credit crisis. Such behavior may increase the demand for government bonds which are deemed safer than other times of bonds. Thus, Malaysian government Sukuk and guaranteed A1 yield’s performances may be attributed to lower risk on them.

Table 1.5 Fair Prices and Yield for Corporate AA1 Rated Active Sukuk

Also, a look at the sample under the AA1 rated actived Sukuk also showed that 100 percent of the Sukuk has YTM far higher than mark-to-market yields, hence far lower prices compare to the market pices (refer to Tables 1.5). The fair prices deviated from the market allocated prices. This deviation is typically large and was also observed in the fair yields. This implies that investors’ expectation are realy on the high side. The floating cashflow shared using the fixed sharing rates may have kept the returns on Sukuk fairly high. Successful matching of dynamics of yields and the volatility of profit rates in the model; which may not be employed in market calculations; is probably a catalyst to fair yields obtained. This finding may further motivate investors on Sukuk in this credit class if market can allocate such a fair yield. AA credit class was rated best quality Sukuk with high safety of timely payment of profit and principal.

Bonds

Profit rate issue date

Maturity date

Price 2010 (M2M)

Fair Price(2010)

Current yield[2010]

Fair YTM (2factor HJM )

6y 5.85 8-Jul-04 8-Jul-10 100.97 99.92 2.87 5.876y 7.45 28-Jan-05 28-Jan-11 101.3 99.75 5.91 7.517Y 6.25 8-Jul-04 8-Jul-11 103.42 99.82 3.59 6.297Y 7.8 28-Jan-05 27-Jan-12 102.54 99.5 6.34 7.98Y 6.55 8-Jul-04 6-Jul-12 105.44 99.72 4.07 6.619y 7.05 20-Dec-01 20-Dec-10 103.21 98.88 2.85 7.229y 6.85 8-Jul-04 8-Jul-13 107.54 99.52 4.39 6.95 10Y 7.3 20-Dec-01 20-Dec-11 106.37 98.76 3.57 7.49 10Y 7.15 8-Jul-04 8-Jul-14 109.74 99.48 4.64 7.26 11Y 7.6 20-Dec-01 20-Dec-12 109.79 99.63 3.85 7.6611Y 7.5 8-Jul-04 8-Jul-15 112.31 99.34 4.85 7.6412Y 8 20-Dec-01 20-Dec-13 113.48 99.47 4.11 8.0813Y 8 20-Dec-01 19-Dec-14 115.4 99.36 4.39 8.1

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Table 1.6 Fair Prices and Yield for Corporate AA2 Rated Active Sukuk

Bonds Profit rate issue date

Maturity date

Price 2010 (M2M)

Fair Price(2010)

Current yield (2010)

Fair YTM (2factor HJM )

5Y 4.65 28-Dec-06 28-Dec-11 101.89 99.95 3.56 4.66 7Y 5.35 28-Sep-06 30-Sep-13 103.75 99.75 4.21 5.42 5Y 6.1 30-Dec-08 30-Dec-13 106.29 99.68 4.3 6.27

Similarly 100 percent of the sample under the corporate AA2 rated active Sukuk has YTM relatively higher than mark-to-market yields, hence lower prices compared to the market prices (refer to Tables 1.6)6. Though there are few samples here but each of them revealed unfair yield allocated by the market and there prices deviated far from that of the market. All the above risk classes showed similar charasteristics to AAA rated active Sukuk. There were mispricing, unfair market yields and higher liquidity term premium inbuilt by investors. These was said based on the fair yields’ performance. Detail of the other categories namely: corporate AA3; A1; A2; and A3 Rated active Sukuk can be obtained in tables 1.7 to 2.0 below. Table 1.7 Fair Prices and Yield for Corporate AA3 Rated Active Sukuk

Bonds Profit rate issue date

Maturity date

Price 2010 (M2M)

Fair Price(2010)

Current yield[2010]

Fair YTM (2factor HJM )

8Y 5.2 12-Jun-07 12-Jun-15 94.58 99.66 6.41 5.32 10Y 5.6 12-Jun-07 12-Jun-17 92.48 99.51 6.92 5.78 11Y 5.85 12-Jun-07 12-Jun-18 91.68 99.42 7.19 6.03 12Y 2 12-Jun-07 12-Jun-19 63.7 99.91 7.46 2.03 13Y 2 12-Jun-07 12-Jun-20 59.72 99.9 7.72 2.03 11Y 6.63 23-Jun-08 23-Dec-19 101.51 99.15 6.42 7.01 12Y 6.83 23-Jun-08 24-Dec-20 101.37 99.05 6.65 7.25 13Y 7.03 23-Jun-08 23-Dec-21 101.27 98.95 6.87 7.5 14Y 7.23 23-Jun-08 23-Dec-22 101.16 97.18 7.09 8.51 16Y 7.95 23-Jun-08 23-Dec-24 103.62 98.57 7.54 8.6 17Y 8.35 23-Jun-08 23-Dec-25 105.32 98.41 7.76 9.08

Under the AA3 rated category, Sukuk yields showed similar characteristics to GII Sukuk. In Table 1.7, 54.55 percent of the sample Sukuk has higher yields. Their yields increase with maturity. While 45.45 percent that has lower fair yields compared to market yields also has higher market yield. Albeit, the fair yields in this category increases from 8-11 years but fell drastically at the 12th and 13th years maturities. These two Sukuk has the lowest market prices. Conversely, 63.64 percent has lower prices and 36.36 percent have higher prices than the market offered prices but their fair prices compare favourably with the prices of other samples in this credit class. The key parameter driving trading behavior of Sukuk investors which has it effect on the yield pattern may be the degree of risk aversion and the distribution of believe of investors about the future returns. Safety of timely payment of profit and principal under this class is

6Albeit, the number of these issues is a salient factor which may affect the credit curve curvature.

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another indication pointing to good performance of this credit class as regards fair yields on them.

Table 1.8 Fair Prices and Yield for Corporate A1 Rated Active Sukuk

Bonds Profit rate issue date

Maturity date

Price 2010 (M2M)

Fair Price(2010)

Current yield[2010]

Fair YTM (2factor HJM )

6Y 6.65 18-Oct-05 18-Oct-11 100.51 99.8 6.32 6.7 6Y 6.95 18-Oct-05 18-Oct-11 100.84 99.78 6.6 7 7Y 6.95 18-Oct-05 18-Oct-12 100.84 99.68 6.6 7.03 8Y 7.25 18-Oct-05 18-Oct-13 100.85 99.56 6.98 7.36 11Y 8.08 18-Oct-05 18-Oct-16 100.49 99.16 7.98 8.29 12Y 8.32 18-Oct-05 18-Oct-17 100.32 99.98 8.26 8.57 13Y 8.57 18-Oct-05 18-Oct-18 100.04 98.94 8.56 8.59 14Y 3.5 30-Apr-09 28-Apr-23 78.14 99.67 10.01 3.84 13Y 3.5 30-Apr-09 29-Apr-22 9.9 99.69 9.9 3.82 19Y 3.5 31-Oct-08 29-Oct-27 11.43 99.6 11.43 3.71

Under the A1 rated Sukuk, the yields also showed some similar characteristics to GII Sukuk. In Table 1.8, 70 percent of the Sukuk has higher yields and 30 percent has lower yield recorded for the A1 Sukuk. Some long term bonds under this credit class behave in line with the conventional believe that long term bonds became riskier as they move toward maturity because they usually earn lower returns with time. Though market allocated very high yield to them and lower prices; there is a wide disparity in the fair yields of long term Sukuk compare to market allocated yield; their yields were significantly small. The entire fair yields were higher; except for the long term Sukuk; that are with high deviation from the trend. 11-13 years Sukuk did not follow this convention; their yields were high and indeed higher than the market yields. By inference, there is the possibility to state that each Sukuk behave differently, this is a possible confirmation that investments in Sukuk market were in segmented maturities with different compartment. With this type of behavior of the yields, the yield curve is expected to be humped because joining the segmented maturity will determine the overall shape of the yield curve.

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Table 1.9 Fair Prices and Yield for Corporate A2 Rated Active Sukuk

Bonds Profit rate issue date

Maturity date

Price 2010 (M2M)

Fair Price(2010)

Current yield[2010]

Fair YTM (2factor HJM )

4Y 7.75 13-Apr-06 13-Apr-10 100.1 99.35 6.43 9.7 5Y 7.7 27-Jun-05 25-Jun-10 100.52 99.86 5.8 7.73 5Y 8.4 30-Aug-05 30-Aug-10 101.52 99.84 5.64 8.44 5Y 8 13-Apr-06 13-Apr-11 100.68 99.72 7.33 8.08 6Y 7.9 27-Jun-05 27-Jun-11 101.45 99.72 6.7 7.98 6y 8.7 30-Aug-05 30-Aug-11 103.31 99.94 6.44 8.72 6Y 8.25 13-Apr-06 13-Apr-12 101.09 99.84 7.67 8.28 18Y 10.2 23-Jun-08 23-Dec-26 97.4 99.96 10.53 2.28 19Y 10.4 23-Jun-08 23-Dec-27 95.7 99.95 10.95 10.43 50Y 9.25 28-Dec-07 28-Dec-57 95.48 97.77 10.09 10.13 50Y 9 30-Apr-07 30-Apr-57 94.58 97.83 10.08 9.85

Under A2 rated active Sukuk in Table 2.0, 81.82 percent of the bonds have higher yields while 27.27 percent were found to have lower yields in comparison to the market yields. Though the market yields on A2 Sukuk are relatively high, but the market yields on all long term bonds were fairly higher than yields on short term bonds. It is worth to know that the Sukuk with lower fair yields were all long term bonds that ranged from 18-50 years. The 18 year Sukuk has the lowest fair yield which is quite far from market yield on it. If other long term bonds were not having higher fair yields which are closer or higher than the market yields; it may lead us to conclude that there is likelihood that longer term A2 bonds behave as expected of them. That is long term bonds tend to have lower returns as they move towards maturity. Fortunately, the 19 and 50 years Sukuk behalf differently; their fair yields compete favourably with the market yields with just a little deviation. That is both market and fair yields on these credit classes do not conform with theory. Because both market and fair yields on these Sukuk tends to have higher returns as they move to long term maturities. Corporate A credit class were rated as best quality Sukuk with adequate safety of timely payment of profit and principal. With adequate safety on payment of profit and principal on time; the behavior of most long term A rated bonds in this sample is contrary to the convention and believe about long term bonds and bonds with this kind of rating. The fact that these Sukuk were rated by a recognized rating agency (i.e. RAM) may have reflected in their yield performances. When the prices were examined, 63.64 percent have lower prices than market price. These bonds were mostly medium term bonds therefore, 36.36 percent have higher prices. The Sukuk with higher prices were also mostly long term bonds. The pattern of changes in the prices is puzzling. The market prices for medium term bonds were above RM100 while the longer term bonds were below this price. Examining the fair prices, it was the opposite of what was obtainable under the market prices. There was a complete turnaround at the longer spectrum. In addition, the 18 years Sukuk has the lowest fair yield that is far below the market offered yield. It seems to have the largest price which is close to RM100. A possible curvature of the yield curve with this pattern may be predicted as non-monotonic. Sukuk of different maturities are likely non perfect substitute for each other.

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Table 2.0 Fair Prices and Yield for Corporate A3 Rated Active Sukuk

Bonds Profit rate issue date

Maturity date

Price 2010 (M2M)

Fair Price(2010)

Current yield[2010]

Fair YTM (2factor HJM )

7y 6.7 4-Jul-03 2-Jul-10 99.52 99.89 8.17 6.72 7Y 7 31-Oct-03 29-Oct-10 99.14 99.89 8.39 7.02 5y 8.2 19-Sep-05 17-Sep-10 100.23 99.84 7.74 8.24 23Y 15.4 30-Oct-09 29-Oct-32 3.43 99.89 15.4 15.52

Lastly under A3 rated Sukuk in Table 5.2.1.8, 50 percent was recorded for higher and lower yields respectively. Despite this fact, 100 percent of the bonds have lower prices compare to market prices. This is against expectation as higher YTM is expected to translate to lower prices and vice versa. Because 50 percent has higher fair yields, despite this fact their market prices were lower than the mark-to-market prices. 50 percent has lower fair yields than the alllocated market yields. Investors in medium and long term bonds with comparative default risk and different investment horizon received different returns as a result of differences in their bond’s liquidity. Cedit worthiness of the issuer may be a responsible factor for this kind of performance.

Table 2.1 Credit Risk Classes and their Percentage of Higher and Lower YTM and Price

Class Credit Higher YTM(%) Lower YTM(%) Higher Price(%)

Lower Price(%)

GII 83.30% 16.70% 88.89% 11.11% Corporate AAA 100% 0 0 100% Corporate guranteed A1 100% 0 0 100% Corporate AA1 100% 0 0 100% Corporate AA2 100% 0 0 100% Corporate AA3 54.55% 45.45% 36.36% 63.64% Corporate A1 70% 30% 10% 90% Corporate A2 81.82% 27.27% 36.36% 63.64% Corporate A3 50% 50% 0 100%

Overall result (in table 2.1) shows that 88.89 or approximately 89% of the Malaysian Sukuk can be seen as having higher yield-to maturity than what the market assigned to them while almost 90% of Malaysia active Sukuk were overrpriced. For the profit rate term structure and the credit curves for corporate Sukuk, refer to figires 1-16 in the appendix.

However, Spot and Forward rates generated for GII Sukuk were ploted using MATLAB. GII Spot and forward rates based on Settlement date from 30th August 2004-31st December 2008 (beginning and end curves only were shown in the appendix-Figure 17-20). It was observed that all the spot and forward rates obtained presented a humped shape curve which was explained in the literature by the Market Segmentation Hypothesis. An indication of a segmented maturity in the Malaysian Sukuk market with joined intersection of the compatimentalized curve determining the aggregate market curve. It shows that Sukukholders preferred their investment habitat and

19

hold on to their maturity spectum where they are safe while holding different bonds with differing maturity spetrums. A behaviour governed by their asset and liability match. Studying the spread between the spot and the forward rates generated appears that the long term profit rates are not an average of future short term rates. This we have stated a priori that there is the likelihood that profit rates may have weak predictability power. It is expected that profit rates which changes with the economic uncertainty and therefore not fixed, may not be easily predictable. The spot and forward rates figures obtained were used to run Ordinary lease square regression to observe staistical evident on forward rates predictability which may support the outcome of the curvatures and slopes obtained from the yield and credit curves. Issue dates of these Sukuk were from 2001-2009 while maturity date ranges from 2009-2057. To predict the ability of the forward rates to forecast the spot rates employing simple linear regression to regress the forward rate on the actual spot profit rates at time t with n years to maturity using the following equation:

tsrn = α + βt fr +εt …………………………………………………….

Where tsrn is the actual spot profit rate of an n year bond at time t, βt is the slope coefficient of the forward rate; fr is the implied forward rate of 1 year bond at time t; while εt is the disturbance error term. Table 11 below presented the regression result.

Table 2.1 Simple Variable Correlation Output Result

Single Variable Correlation Output Report

Correlation Analysis

spot rates and forward rates

Correlation Coefficient R

0.559

Coefficient of Determination R-Square

31.25%

Adjusted R Square 31.16% Observations 757 Level of Significance 0.05 Value of "r" (if known) 0.559 Sample Size (if known) 757 t-score 18.524 two-tail upper critical t-score 1.96 two-tail upper critical t-score -1.96 P(value) two-tail 0.000 Decision: Reject Null

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Table 2.3 Spot and Forward Rates Regression Output Result Variable α βt fr Standard Error t-statistic P-value decision Spot rates 0.034 0.001 66.974 0.000 Reject Null Forward rates 0.018 0.007 2.610 0.000 Reject Null R-square= 89% Adjusted R-square=76%

tsrn = 0.03411 + 0.018021 fr + 0.0098………………………………………..(3.0) se =(0.001) (0.0069) t = (66.974) (2.610)

In equation (3.0), 0.03411 is the α, it is statistically different from zero and significant at 5% significant level. 0.018021 is the co-efficient of the forward rates. It is statistically different from 1, while 0.0098 is the error term εt. Standard deviation of α is 0.001 and 0.0069 stardand deviation for the co-efficient of forward rates. The t-statistic for α and βt fr is 66.974 and 2.610 significant at 5%. Given the 56% correlation coefficient, there was an indication of high degree of linear relationship between the two variable i.e. spot and forward rates. Based on the assumptions of classical linear regression model estimation that Ordinary Lease Square (OLS) estimators are BLUE- Best Linear Unbiase Estimator and based on asymptotic consideration of the samples; the spot rate is a linear function of a random variable and has minimum variance in the class of such unbiased estimators. The Durbin Watson statistics of 0.441 showed that there is no likelihood that the model neither suffered from pure autocorrelation nor specification error. Based on these result, there is the likelihood to conclude that forward profit rates has weak predictability power to forecast future spot rate. Hence, Pure form of expectation hypothesis may not be supported. Future spot rates predictability can be used by economist, economic policy makers, the Central Bank, investors, long term investment managers as well as other market players in the capital market.

Comparing Malaysian Government Sukuk Yield Curves with Corporate Credit Curves

Different types of yield curve comparison can assist investors in determining the relative value of their bonds, extra yield accruable to them for investing in non-governmental bonds. These can assist in formulating good strategies to increase their portfolio. An attempt is made here to compare the GII curves of 5 different maturities with two high investment grades and one low investment grade Sukuk. From table 2.5, 4 years lower quality Sukuk A2 proof to be a high yield bond with 5.9725% spread over yield offer by GII. 5 years corporate A2 also outperformed 5 years AAA by offering extra 2.8647% extra yield over extra yield AAA investor earn as additional yields for taken additional risk. For 6 years maturity class, AA1 risk class outperformed AAA risk class why A2 investors are worse-off with a negative spread of 1.8553. Lastly, in the 10 and 11 years maturity class, AA1 outperformed AAA Sukuk. The performance seems to improve as A2 Sukuk moves towards longer spectrum.

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Table 2.5 Malaysian Government Sukuk (GII) versus Corporate AAA, AA1 and A2

Maturity GII (%) Corporate AAA(%) AA1(%) A2(%)

Corporate Spread AAA(%)

Spread AA1(%)

Spread A2(%)

4y 3.33 - - 9.29 - - 5.97 5Y 3.33 5.41 - 8.29 2.09 - 4.96 6y 4.39 5.73 6.84 2.54 1.34 2.44 -1.85 10Y 4.33 6.69 7.63 - 2.37 3.31 - 11Y 4.57 5.39 7.81 - 0.83 3.24 -

Comparing the Relationship between Maturities within Malaysian Sukuk

A. An attempt was made to compare yields on 3 years Sukuk with 10 and 11 years government Sukuk. Comparison of this nature is usually done to see the relationship between yields on the same type of securities. Mean YTM on 3 years Malaysian Government Sukuk was 3.625% while 10 and 11 years Sukuk has 4.325% and 5.43% respectively (refer to Table 2.6). It implies that 10 years government Sukuk offer compensation for extra risk taken for investing for additional 7 years with 0.7% extra returns. Meanwhile, additional return on 11 years Sukuk for taken extra risk was 1.805%. One can infer that there is probability of increasing extra returns (liquidity or risk premium) towards the longer maturity spectrum as depicted in the Figure 21.

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Table 2.6 Fair Yield for Malaysian Government Sukuk-Different maturity Comparison

Bonds Profit rate Fair YTM (2factor HJM ) Mean YTM

3Y 3Y 3Y 3Y 10Y 10Y 10Y 10Y 10Y 11y

3.57 4.363 3.077 3.288 4.419

3.82 3.941 4.295

3.91 4.492

3.58 4.41 3.15

3.4 4.48 3.88 4.03

3.625

4.325 4.47 4.16 5.43 5.43

Figure 21 YTM Comparison within Malaysian Government Sukuk

B. Comparison between 5, 10 and 12 years AAA corporate active Sukuk showed an upward slope curve. This curvature is an indication of inbuilt liquidity premium to compensate investors on long term basis for taking extra risk (refer to table 2.7 and figure 22). This was ditto for AA1 rated sukuk as could be seen in table 2.8 and figure 23.

Table 2.7 Fair Yield for Corporate AAA Rated Active Sukuk

Bonds Profit rate Fair YTM (2factor HJM ) YTM

5y 10y 10y 12Y

6.3 5.85

6.5 6.3

5.32 5.864

6.62 6.326

5.32

6.242 6.326

23

Figure 22 YTM Comparison within AAA Sukuk

The shape of the yield curve obtained under AA1 rated Sukuk was the similar to the curve under the Malaysia Government Sukuk as could be seen in Table 2.8 and figure 23. There are also extra returns to investors on long term basis. In fact, there is a glaring 1.39 percent risk premium to 12 year’s investor for investing for another 6 years over the 6 years investors. While 1.41 percent extra returns was earned for investing on another 7 years when 6 years Sukuk return was compared with 13 years AA1 Sukuk. As far as extra returns to an investor on 13 years spectrum is concerned when compare with 12 years investment horizon, 13 years investor earn just 0.02 percent extra return for extra 1 year risk taken.

Table 2.8 Fair Yield for Corporate AA1 Rated Active Sukuk

Bonds Profit rate Fair YTM (2factor HJM ) YTM

6y 6y 12Y 13Y

5.85 7.45

8 8

5.87 7.51 8.08

8.1

6.69 8.08

8.1

Figure 23 YTM Comparisons within AA1 Sukuk

C. The curvature for AA3 corporate Sukuk is akin to the GII and AA1. As the security moves toward maturity, liquidity premium is built into the return to Sukukholders to compensate them for holding longer term bonds and for the additional risk of credit default as applied to rated corporate bonds. A relatively big extra return to investors on 16 and 17 years Sukuk was observed. 3.28 percent and 3.76 percent risk premium were earn for investing for 16 and 17 years respectively when compared with the return on 8 years investment horizon. This credit class showed a better liquidity premium than the

24

Malaysia Government Sukuk and other credit classes examined. Though, despite this fact, its yield curve is similar to GII. By implication, corporate AA3 Sukuk’s behavior conforms to the bond market convention. There is the likelihood of higher extra returns aside the risk-free rates on these Sukuk.

Table 2.9 Fair Yield for Corporate AA3 Rated Active Sukuk

Bonds Profit rate Fair YTM (2factor HJM )

8Y 16Y 17Y

5.2 7.95 8.35

5.32 8.6

9.08

Figure 24 YTM Comparisons within AA3 Sukuk

Conclusion and Recommendations

The output from the above OLS estimate led us to conclude that the predictor that is the forward rate has a very weak predictive power to forecast the spot profit rate. This indicates that the long term rates are not the average of future spot rates on long term bonds. Hence, on the term structure of profit rates of Sukuk; expectation hypothesis may not be supported based on the statistical evidence. Similar result was found by Shiller, Campbell and Schoenholtz (1983), Markiw and Summer (1984), Markiw and Miron (1986), Hardouvelis (1994), Campbell and Shiller (1991) inter alia. Furthermore, Fama and Bliss (1987) find little evidence that forward rates can forecast near term changes in interest.

Humped shape yield curves were explained in the term structure of interest rates theory by one of the forms of Expectation hypothesis that is the Market Segmentation Theory. This shape implies that there is uncertainty in the Sukuk market as regards the investors’ expectation about the future spot profit rates. It also implies that there is segmentation of maturities and each maturity are not good substitute for one another. Hence, each segment will have its own shape of the yield curve while joining together the shape in each segment may cause the overall yield curve to be humped after joining the segmented shapes.

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The curvature of the spot and forward slopes and array of statistical evidences in the two regressions analysis founds that market may not be building-in investors’ expectations into the profit rates on Sukuk. The predictive power of forward profit rate to forecast future spot profit rates is weak. Non-existence of good market valuation, few experts on Islamic financial instrument in the market and few trading on Sukuk may be attributed to these. Improvement on the weaknesses; observed in the Sukuk market; in the nearest future may yield better results than these in future researches of term structure of profit rate on this nascent Islamic financial instrument and market. Benchmarking IFIs profit rate to available interest rate for better competition practice which Muhammad Al-Bashir (2008) submitted that it can be seen as a distortion to true market value of underlying assets and hence, their returns is buttressed by the pricing pattern observed between the market allocated prices and the fair prices calculated in the study.

Corporate Sukukholders are possibly compensated through additional yields; when GII is use as benchmark; for holding risky bonds and for investing on long term basis as revealed by the performance of different classes of credit risk examined in the study. Comparison between same security and different credit class, revealed an upward sloping YTM and indication of liquidity or risk premium inbuilt in the investor’s return for taking extra risk. This finding showed support for Liquidity Preference Theory form of Expectation Hypothesis. By implication, future spot profit rates are biased estimator of long profit rates.

References

Accounting and Auditing Organization For Islamic Finance and Institutions, Exposure Draft, Shari’ah Standard No. (18) on Investment Sukuk, Novemeber 2002.

A Guide to Malaysian Government Securities. (2007). Second Edition, prepared by Monetary Policy implementation Section, Investment Operations and financial Market Department, Bank Negara Malaysia.

Ariff, M., Cheng, F.F., and Neoh, V.H., "Bond Market in Malaysia and Singapore", Penerbit University Putra Malaysia Press, 2009.

Bali, T.G., “Modeling the Stochastic Behaviour of Short Term Interest Rates: Princing Implication for Discount Bonds”, Journal of banking and Finance, Vol. 27, issue 2, 2003.

Campbell John Y and Shiller Robert J., “Yield Spread and Interest Rate Movement: A Bird’s eye View”, Review of Economic Studies, Vol. 58, 1991, pp. 495-514.

Choudhry, M., “Fixed Income Securities and Derivatives Handbook”, Bloomberg Press, U.S.A., First Edition 2005.

Fabozzi, J. F. and Mann S. V., “The Handbook of Fixed Income Securities”, Seventh Edition, McGraaw-Hill Companies Inc, 2005.

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Fama, E. F, and Bliss, R. R., “The Information in Long-Maturity Forward Rates”, American Economic Review, Vol. 77, September, 1987, pp. 680-92.

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Appendix

1. Malaysian Government Sukuk Yield Curves by years from SukukTwo-factor HJM Model Data

Figure 1. Mean YTM for all 5 and 6 years GII Sukuk Figure 2. Mean YTM for all 3 and 4 years GII Sukuk [3-D Area]

Figure 3. Mean YTM for all 5 and 6 years Figure 4. Mean YTM for all 5 and 6 years [3-D Area]

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Figure 5. Mean YTM for all 10 and 11 years Figure 6. Mean YTM for all 10 and 11 years GII Sukuk GII Sukuk [3-D Area]

Figure 7. Term Structure of GII Sukuk Profit rates Figure 8. Term Structure of GII Profit rates Using Mean YTM Sukuk [3-D Area]

Corporate Sukuk Credit curves from Data Generated from SukukTwo-factor HJM

Figure 9. Credit Curve for Corporate AAA Figure 10. Credit Curve for Corporate guranteed A 1 Risk Class

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Figure 11. Credit Curve for Corporate AA3 Figure 12. Credit Curve for Corporate AA1 Risk Class Risk Class

Figure 13. Credit Curve for Corporate AA2 risk Figure 14. Credit Curve for Corporate A1 Risk Class Risk Class

Figure 15. Credit Curve for Corporate A3 Figure 16. Credit Curve for Corporate A2 Risk Class

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2. GII Spot and Forward Curves Based on Different Settlement date from 30th August 2004-31st December 2008

0 5 10 15 20 25-0.02

0

0.02

0.04

0.06

0.08

0.1

0.12

Maturity (Yrs)

YTM (%)

Figure 17 GII Forward Curvess based on Settle date of August 30th 2004

Cubic spline interpolant

ForwardRates spline

31

0 5 10 15 20 25-0.02

0

0.02

0.04

0.06

0.08

0.1

0.12

Maturity (Yrs)

YTM (%)

Figure 18 GII Forward Curvess based on Settle date of August 30th 2004

Cubic spline interpolant

ForwardRates spline

32

0 5 10 15 20 250.015

0.02

0.025

0.03

0.035

0.04

0.045

0.05Figure 19 GII Spot Curves based on Settle date of December 31th 2008

Maturity (Yrs)

YTM (%)

Shape-preserving interpolant

ZeroRates shape-preserving

33

0 5 10 15 20 250

0.01

0.02

0.03

0.04

0.05

0.06

0.07Figure 20 GII Forward Curvess based on Settle date of December 31th 2008

Maturity (Yrs)

YTM (%)

Cubic spline interpolant

ForwardRates spline