DYNAMIC INTERACTIONS AND DIVERSIFICATION

BENEFITS BETWEEN SUKUK AND BOND MARKETS:

INTERNATIONAL EVIDENCE

BY

RUBAIYAT AHSAN BHUIYAN

A dissertation submitted in fulfilment of the requirement for

the degree of Doctor of Philosophy (Economics)

Kulliyyah of Economics and Management Sciences

International Islamic University Malaysia

NOVEMBER 2017

ii

ABSTRACT

There is an enormous impact of the financial subprime crisis on returns of many asset

classes, questioning on the effectiveness of the portfolio theory. Post the global financial

crisis, one of the major challenges for regulators and investors is to search for level of

integration of financial markets in consideration that globalization and technological

advancement have enhanced cross-class correlations and complicate diversification

opportunities. This study attempts to examine empirically whether fixed income

investors of developed and emerging countries can diversify their portfolio through

investing in the global sukuk market. The first phase of the study which saw the

reduction of the Value-at-Risk of hypothetical portfolios constructed with bond and

sukuk indices, had motivated for further analysis be undertaken on the dynamic

interaction between these two investment assets. In the second phase, this research

investigates the co-movement and causality between sukuk and bond markets while in

the last phase, it examines the diversification opportunities for global conventional fixed

income investors through inclusion of sukuk in their portfolios. This study applies

several approaches including wavelet analysis and DCC GARCH in examining the

dynamic relations and diversification benefits of these two assets. In terms of data, the

daily return of 14 bonds and sukuk indices covering the period from January 2010 to

December 2015 are used. The findings suggest that Malaysian and global sukuk markets

provide better diversification benefits for the developed and emerging market for fixed

income investors. In addition to that, fixed income investors from developed countries

could also gain higher diversification benefits compared to emerging market investors

by considering both bond and sukuk in their portfolios. This research has demonstrated

a deeper understanding of the characteristics of international sovereign bond markets

from portfolio diversification perspective. Wavelet approach enriches the

understanding of this dynamic behavior between sukuk and bond indices and it has

significant implications for investors, regulators and portfolio managers. Information

on cointegration and lead-lag relationship between sukuk and bond indices may also be

useful for the regulators in terms of formulating macro stabilization policies for the

countries as well as for fund managers in articulating their trading and investment

activities.

iii

ملخص

هناك أثر هائل للأزمة المالية على عوائد العديد من فئات الأصول، مما يشكك في فعالية نظرية الحافظة. وباعتبار الأزمة المالية العالمية، فإن أحد التحديات الرئيسة التي يواجهها المنظمون والمستثمرون هو البحث

والتقدم التكنولوجي قد عززتا العلاقات عن مستوى التكامل بين الأسواق المالية بالنظر إلى أن العولمةدراسة تجريبية ما إذا كان بإمكان إجراء المتبادلة بين الطبقات ويعقدان فرص التنويع. تحاول هذه الدراسة

مستثمري الدخل الثابت في البلدان المتقدمة والناشئة تنويع محفظتهم من خلال الاستثمار في سوق الصكوك المرحلة الأولى من الدراسة التي شهدت تخفيض القيمة الافتراضية للمخاطر التي تم العالمية. وقد دفعت

باستخدام مؤشرات السندات والصکوك إلی إجراء المزيد من التحليل علی التفاعل الديناميکي هاإنشاؤسببية بين الأصلين الاستثماريين. وفي المرحلة الثانية، يبحث هذا البحث في الحركة المشتركة وال ذينهبين

الصكوك وأسواق السندات، بينما يدرس في المرحلة الأخيرة فرص التنويع لمستثمري الدخل الثابت التقليدي العالمي من خلال إدراج الصكوك في محافظهم. وتطبق هذه الدراسة عدة مقاربات منها تحليل المويجات

الأصلين. من حيث في دراسة العلاقات الديناميكية وتنويع فوائد هذين DCC GARCHوسندا ومؤشر الصكوك التي تغطي الفترة من يناير ( 14ربعة عشر )البيانات، تم استخدام العائد اليومي لأ

. وتشير النتائج إلى أن أسواق الصكوك الماليزية والعالمية توفر منافع تنويع 2015إلى ديسمبر 2010الثابت. وباإلضافة إلى ذلك، يمكن للمستثمرين أفضل للأسواق المتقدمة والناشئة للمستثمرين ذوي الدخل

سواق لأذوي الدخل الثابت من البلدان المتقدمة أيضا الحصول على فوائد تنويع أعلى مقارنة بمستثمري االنظر في السندات والصكوك في محافظهم. وقد أظهر هذا البحث فهما أعمق لخصائص لالالناشئة من خ

من منظور تنويع الحافظة. ويثري نهج المويجات فهم هذا السلوك أسواق السندات السيادية الدوليةالديناميكي بين الصكوك ومؤشرات السندات، وله آثار كبيرة على المستثمرين والهيئات التنظيمية ومديري المحافظ. ويمكن أيضا أن تكون المعلومات المتعلقة بالتكامل المشترك والعلاقة بين الصكوك ومؤشرات

يدة للمنظمين فيما يتعلق بصياغة سياسات تثبيت الاقتصاد الكلي للبلدان وكذلك لمديري السندات مف .الصناديق في توضيح أنشطتهم التجارية والاستثمارية

iv

APPROVAL PAGE

The thesis of Rubaiyat Ahsan Bhuiyan has been approved by the following:

_____________________________

Maya Puspa Rahman

Supervisor

_____________________________

Gairizazmi Mat Gani

Co-Supervisor

_____________________________

Buerhan Saiti

Co-Supervisor

_____________________________

Nazrol Kamil Bin Mustaffa Kamil

Internal Examiner

_____________________________

Abul Monsur Mohammed Masih

External Examiner

_____________________________

Wan Mansor Wan Mahmud

External Examiner

_____________________________

Noor Mohamad Osmani

Chairman

v

TO

My beloved parents, Serajul Islam Bhuiyan, Dulari Ferdousi and my wife; Mousumi

Ahsan

My dearest brother and sister, Safaiyat Ferdous, Sanjida Fardousi

vi

DECLARATION

I hereby declare that this thesis is the result of my own investigations, except where

otherwise stated. I also declare that it has not been previously or concurrently submitted

as a whole for any other degrees at IIUM or other institutions.

(Rubaiyat Ahsan Bhuiyan)

Signature ........................................................... Date .........................................

vii

COPYRIGHT PAGE

INTERNATIONAL ISLAMIC UNIVERSITY MALAYSIA

DECLARATION OF COPYRIGHT AND AFFIRMATION OF

FAIR USE OF UNPUBLISHED RESEARCH

DYNAMIC INTERACTIONS AND DIVERSIFICATION

BENEFITS BETWEEN SUKUK AND BOND MARKETS:

INTERNATIONAL EVIDENCE

I declare that the copyright holders of this dissertation are jointly owned by

Rubaiyat Ahsan Bhuiyan and IIUM.

Copyright © 2017 (Rubaiyat Ahsan Bhuiyan) and International Islamic University Malaysia. All

rights reserved.

No part of this unpublished research may be reproduced, stored in a retrieval system,

or transmitted, in any form or by any means, electronic, mechanical, photocopying,

recording or otherwise without prior written permission of the copyright holder

except as provided below

1. Any material contained in or derived from this unpublished research

may be used by others in their writing with due acknowledgement.

2. IIUM or its library will have the right to make and transmit copies (print

or electronic) for institutional and academic purposes.

3. The IIUM library will have the right to make, store in a retrieved system

and supply copies of this unpublished research if requested by other

universities and research libraries.

By signing this form, I acknowledged that I have read and understand the IIUM

Intellectual Property Right and Commercialization policy.

Affirmed by (Rubaiyat Ahsan Bhuiyan)

……..…………………….. ………………………..

Signature Date

viii

ACKNOWLEDGEMENTS

In the name of Allah, the most gracious and the most merciful.

“By time. Indeed, mankind is in loss. Except for those who have believed and done

righteous deeds and advised each other to truth and advised each other to practice”

Surah Al-Asr

Alhamdulillah rabbil ‘alamin, all praise be to Allah, the loving one (Al-wadud), the

responder to prayers (Al-Mujib), the knower of all (Al-‘Alim); for the guidance of

blessings bestowed upon me in completing this research. Peace be upon our beloved

prophet Muhammad, his family and all his companions.

I would like to take this opportunity to express a special gratitude to my main supervisor,

Assistant Professor Dr Maya Puspa Rahman who has allowed me to explore my area of

interests, and provided me her full support and motivation, throughout this journey. My

appreciation also goes to my co-supervisor, Associate Professor Dr. Gairuzazmi mat

Ghani and Associate Professor Dr. Buerhan Saiti. They provided generously of their

time in expanding the ideas, improving the dissertation through their innumerable and

valuable comments. I also owe the greatest intellectual debt that cannot be repaid to

Assistant Professor Nazrol Kamil Bin Mustaffa Kamil, Professor Abul Mansur

Mohammed Masih, Professor Dr Wan Mansor Wan Mahmud, Assistant Professor Dr

Fardous Alam and Associate Professor Dr Razali Haron.

To all my colleagues and friends, who were together in this field of knowledge, my

sincere thanks for being with me through thick and thin. To my brothers and good

friends, Dr Kazi Md Tareq, Dr Abdul Momen, Dr Dawan Mahabub, Dr Faruq Ahmed,

Dr Sazzadul Karim, Dr Aftab Anwar and Dr Ferdous Azam. I am also thankful for the

kind advice and moral supports from Brother Mazba, Brother Faisal, Brother Hakim,

Brother Rubaiyat, Brother Sawkot, Brother Noman, Brother Muhibullah and to all my

friends whose names are not mentioned here.

Last but not least, I am grateful to my parents, who have always been my pillar of

strength. It was his unconditional love, emotions, as well as moral support that enabled

me to go through the best and worst years of graduate study and the completion of this

work. Thank you for believing in what I am capable of.

And to my beloved wife, younger brother and sister, I am thankful for the showers of

love.

May all of us reunite in Jannah, amiin.

ix

TABLE OF CONTENTS

Abstract……………………………………………………………………………..ii

Abstract in Arabic…………………………………………………………………..iii

Approval Page…………………………………………………………….......…….iv

Declaration……………………………………………………………………...…. v

Copyright Page…………………………………………………………………..…vi

Acknowledgements ………………………………………………………………..vii

List of Tables……………………………………………………………………….xii

List of Figures……………………………………………………………………,,,xiv

List of Abbreviations………………………………………………………………xviii

CHAPTER ONE: INTRODUCTION .................................................................... 1

1.1 Background ............................................................................................... 1

1.2 Problem Statement .................................................................................... 10

1.3 Objectives ................................................................................................. 13

1.4 Research Questions ................................................................................... 14

1.5 Significance of the Study .......................................................................... 14

1.6 Contribution of the Study ......................................................................... 16

1.7 Organization of the Study ......................................................................... 17

CHAPTER TWO: BRIEF OVERVIEW OF THE SUKUK MARKET ............. 20

2.1 Introduction............................................................................................... 20

2.2 Key Landmarks of the Global Sukuk Market ........................................... 21

2.3 Definition of Sukuk .................................................................................. 24

2.4 Origin of Sukuk ........................................................................................ 25

2.5 Sukuk vs Bond: A Comparative Analysis ................................................ 25

2.6 Sukuk Structure ........................................................................................ 27

2.7 Sukuk Issuance Based on AAOIFI’s Recommendations ......................... 32

2.8 The impact of Global Financial Crisis 2007/2008 on the

Conventional Bond and Sukuk Market .................................................... 34

2.9 Conclusion ................................................................................................ 36

CHAPTERTHREE: REVIEW OF LITERATURE …...………………………..38

3.1 Introduction............................................................................................... 38

3.2 Theoretical Underpinning ......................................................................... 39

3.2.1 Theoretical Underpinning of Co-movement …………………….39

3.2.2 Theoretical Underpinnings of Lead-Lag Relationship .................. 42

3.2.3 Theoretical Underpinnings of Diversification……………………43

3.3 Literature on Co-movements and Bond Market Integration..................... 48

3.3.1 Co-movement ……………………………………………………48

3.3.2 Co-movements and Capital Flaws ................................................. 49

3.3.3 Co-movement and Correlation……………. …………………….51

3.3.4 Portfolio Diversification Advantage and Pitfalls ……………......51

3.4 Literature on Lead-Lag Relationship ........................................................ 53

3.5 Literature on Portfolio Diversification Benefit of Bond Market .............. 56

x

3.6 Literature Review on Empirical Studies on Sukuk................................... 60

3.6.1 The Value-at-Risk of Sukuk Market……………………………. 60

3.6.2 Risk and Return Profile of Sukuk Market ……………………….61

3.6.3 Information Efficiency & Volatility of Sukuk Market .................. 62

3.6.4 Securitization Issues in Sukuk Market …………………………. 64

3.6.5 Development and Sustainability of Sukuk Market ……………...65

3.6.6 Co-movements and Diversification Opportunities in Sukuk

Market………………………………………………………… 66

3.7 Research Gap……. ................................................................................ 68

3.8 Research Framework of Analysis ............................................................. 71

3.9 Conclusion ................................................................................................ 72

CHAPTER FOUR: RESEARCH METHODOLOGY ..................................... 73

4.1 Introduction............................................................................................... 73

4.2 Methodology ............................................................................................. 73

4.2.1 Value-at-Risk……………………………………………………. 73

4.2.2 Co-integration Test ........................................................................ 76

4.2.3 Lead –Lag relationship Analysis ................................................... 80

4.2.3.1 Wavelet Cross- correlation………………………………..81

4.2.3.2 Wavelet Phase Difference………………………………...84

4.2.4 Method for analyzing Diversification Opportunities ..................... 86

4.2.4.1 Continuous Wavelet transform…………………………....86

4.2.4.2 DCC-MGARCH…………………………………………..87

4.2.4.3 Test of mean reversion……………………………………95

4.3 Conclusion ................................................................................................ 96

CHAPTER FIVE: FINDINGS AND DISCUSSIONS .......................................... 98

5.1 Introduction............................................................................................... 98

5.2 Data……………………………………………………………………...99

5.3 VAR analysis…………………………………………………………....100

5.4 Co-integration Test ……………………………………………………..105

5.4.1 Unit Root Tests…………………………………………………...105

5.4.2 Selection of Optimal Order……………………………………....106

5.4.3 Cointegration Test between Bond and Sukuk Index………….... .108

5.4.4 Bivariate Johansen Cointegration test between bond and sukuk index

………………………………………………………………….. 109

5.4.5 Multivariate Johansen Cointegration Test between sukuk and bond

indices ..................................................................................................... 111

5.4.6 VECM Results of Sukuk and Emerging market bond indices ....... 112

5.5 Wavelet Cross-Correlation ....................................................................... 114

5.5.1 The Wavelet Cross-Correlations between Developed Market Bond

and Sukuk Indices ................................................................................... 115

5.5.2 The Wavelet Cross-Correlations between Emerging Market Bond

with Sukuk Indices .................................................................................. 126

5.5.3 Tables provided a summary on the lead-lag relationship between

the sukuk and bond indices ..................................................................... 138

5.6 Wavelet Coherency .................................................................................. 143

5.6.1 The Outcome of the Wavelet Coherency Approach of Developed

Market Indices ......................................................................................... 143

xi

5.6.2 The Outcome of the Wavelet Coherence Analysis of Emerging

Market Indices ......................................................................................... 157

5.6.3 Salient points of the wavelet coherence between sukuk and the

selected bond indices............................................................................... 170

5.7 MGARCH- DCC Approach ..................................................................... 175

5.7.1 Testing for Mean Reversion of Volatility ....................................... 178

5.7.2 Plotting the estimated conditional volatilities of developed market

bond and sukuk indices ........................................................................... 179

5.7.3 Plotting the estimated conditional correlations of developed market

bond and sukuk indices ........................................................................... 180

5.7.4 Estimation of MGARCH-DCC Model for Emerging Market ......... 184

5.7.5 Testing for Mean Reversion of Volatility ....................................... 186

5.7.6 Plotting the estimated conditional volatilities of emerging market

bond and sukuk indices ........................................................................... 187

5.7.8 Plotting the estimated conditional correlations of emerging market

bond and sukuk indices ........................................................................... 189

5.8 Summary of this Section ........................................................................... 192

CHAPTER SIX: CONCLUSION AND POLICY IMPLICATION .................... 195

6.1 Summary ................................................................................................... 195

6.2 Policy Implication of the Study ................................................................ 206

6.3 Limitation of the study and recommendations for future research ........... 208

REFERENCES…………………………………………….....................................210

LIST OF PUBLICTIONS………………………………………………………....224

APPENDIX …………………………………………………………………….......225

xii

LIST OF TABLES

Table No

Page No.

1.1 Sharpe Ratio of DJSI and WBIG 7

1.2 Returns volatilities of DJSI and WBIG 8

2.1 Comparison between bond and sukuk 26

2.2 Summary of the noticeable features of Shariah contracts

for sukuk structure

30

5.1 List of Indices 99

5.2 VaR Estimation (5 Days) 101

5.3 List of Portfolio 102

5.4 VaR Estimates (5 Days) 103

5.5 Test of the unit root hypothesis of bond and sukuk indices 105

5.6 Optimal lag selection for Bivariate Cointegration test 107

5.7 Optimal lag selection for Multivariate Cointegration test 108

5.8 Bivariate Johansen Cointegration test between Developed

market bond and Malaysian sukuk index

109

5.9 Bivariate Johansen Cointegration test between Developed

market bond and Malaysian sukuk index

109

5.10 Bivariate Johansen Cointegration test between Emerging

market bond and Dow Jones sukuk index

110

5.11 Bivariate Johansen Cointegration test between Emerging

market and Dow Jones sukuk market

110

5.12 Multivariate Cointegration test results between sukuk and

different bond indices

111

5.13 VECM equation results: Malaysia sukuk with Emerging

market bond indices

113

5.14 VECM equation results: Dow Jones Global sukuk with

Emerging market bond indices

113

xiii

5.15 Summary of the lead-lag relationship between Malaysia

sukuk and Developed market bond indices

138

5.16 Summary of the lead-lag relationship between Dow Jones

sukuk and Developed market bond indices

139

5.17 Summary of the lead-lag relationship between Malaysia

sukuk and Emerging market bond indices

141

5.18 Summary of the lead-lag relationship between Dow Jones

sukuk and Emerging market bond indices

142

5.19 Summary of Wavelet Coherence analysis on Developed

Bond and Sukuk Markets

171

5.20 Summary of Wavelet Coherence analysis on Emerging

Bond and Sukuk Markets

172

5.21 Ranks of the unconditional volatilities of the developed

market bond and sukuk indices

176

5.22 Unconditional correlations between Developed market

bond with Malaysia sukuk index

177

5.23 Unconditional correlations between Developed market

bond with Global sukuk index

177

5.24 Mean Reversion of Volatility 178

5.25 Ranks of the unconditional volatilities of the emerging

market bond and sukuk Indices

185

5.26 Unconditional correlations between Emerging market

bond with Malaysia sukuk indices

186

5.27 Unconditional correlations between Emerging market

bond with Global sukuk indices

186

5.28 Mean Reversion of Volatility 186

xiv

LIST OF FIGURES

Figure No Page No.

1.1 Sukuk Resilient to US Fed Tapering Fears As at 29 August

2014

9

2.1 Annual Sukuk Issuances 21

2.2 Sukuk Issuances by Country (1Q2015) 22

2.3 Sukuk Issuances by Issuer Type (1Q2015) 23

2.4 Classification of sukuk based on Shariah contracts 29

3.1 Research Framework for Examining Diversification

Opportunity in sukuk Market

71

4.1 Phase-difference circle 85

5.1 Wavelet cross-correlation between BUSG and

TRBPAMGOVI

115

5.2 Wavelet cross-correlation between BUSG and DJSUKUK 117

5.3 Wavelet cross-correlation between BCAN and

TRBPAMGOVI

118

5.4 Wavelet cross-correlation between BCAN and DJSUKUK 118

5.5 Wavelet cross-correlation between BGER and

TRBPAMGOVI

120

5.6 Wavelet cross correlation between BGER and DJSUKUK 120

5.7 Wavelet cross-correlation between BRIT and

TRBPAMGOVI

122

5.8 Wavelet cross-correlation between BRIT and DJSUKUK 122

5.9 Wavelet cross-correlation between BAUS and

TRBPAMGOVI

123

5.10 Wavelet cross-correlation between BAUS and DJSUKUK 124

5.11 Wavelet cross-correlation between BJPN and

TRBPAMGOVI

125

xv

5.12 Wavelet cross correlation between BJPN and DJSUKUK 125

5.13 Wavelet cross-correlation between BSIN and

TRBPAMGOVI

127

5.14 Wavelet cross-correlation between BSIN and DJSUKUK 127

5.15 Wavelet cross-correlation between BINDO and

TRBPAMGOVI

128

5.16 Wavelet cross-correlation between BINDO and

DJSUKUK

129

5.17 Wavelet cross-correlation between BMYR and

TRBPAMGOVI

130

5.18 Wavelet cross-correlation between BMYR and DJSUKUK 132

5.19 Wavelet cross-correlation between BCGB and

TRBPAMGOVI

133

5.20 Wavelet cross-correlation between BCGB and DJSUKUK 133

5.21 Wavelet cross-correlation between BINDI and

TRBPAMGOVI

134

5.22 Wavelet cross-correlation between BINDI and DJSUKUK 135

5.23 Wavelet cross-correlation between BKRW and

TRBPAMGOVI

136

5.24 Wavelet cross-correlation between BKRW and DJSUKUK 136

5.25 Continuous wavelet transforms: BUSG and

TRBPAMGOVI

143

5.26 Continuous wavelet transforms: BUSG and DJSUKUK 145

5.27 Continuous wavelet transforms: BCAN and

TRBPAMGOVI

147

5.28 Continuous wavelet transforms: BCAN and DJSUKUK 148

5.29 Continuous wavelet transforms: BGER and

TRBAPAMGOVI

149

5.30 Continuous wavelet transforms: BGER and DJSUKUK 150

5.31 Continuous wavelet transforms: BRIT and

TRBAPAMGOVI

151

xvi

5.32 Continuous wavelet transforms: BRIT and DJSUKUK 152

5.33 Continuous wavelet transforms: BAUS and

TRBAPAMGOVI

153

5.34 Continuous wavelet transforms: BAUS and DJSUKUK 154

5.35 Continuous wavelet transforms: BJPN and

TRBAPAMGOVI

155

5.36 Continuous wavelet transforms: BJPN and DJSUKUK 156

5.37 Continuous wavelet transforms: BSIN and

TRBAPAMGOVI

157

5.38 Continuous wavelet transforms: BSIN and DJSUKUK 158

5.39 Continuous wavelet transforms: BINDO and

TRBAPAMGOVI

160

5.40 Continues wavelet transform: BINDO and DJSUKUK 160

5.41 Continuous wavelet transforms: BMYR and

TRBAPAMGOVI

162

5.42 Continuous wavelet transforms: BMYR and DJSUKUK 164

5.43 Continuous wavelet transforms: BCGB and

TRBAPAMGOVI

165

5.44 Continuous wavelet transforms: BCGB and DJSUKUK 165

5.45 Continuous wavelet transforms: BINDI and

TRBAPAMGOVI

166

5.46 Continuous wavelet transforms: BINDI and DJSUKUK 167

5.47 Continuous wavelet transforms: BKRW and

TRBAPAMGOVI

168

5.48 Continuous wavelet transforms: BKRW and DJSUKUK 170

5.49 Conditional volatilities of sukuk and developed market

bond indices returns

179

5.50 Conditional volatilities of sukuk and developed market

bond indices returns

180

5.51 Conditional correlations of Malaysian sukuk index returns

with developed market bond indices

181

xvii

5.52 Conditional correlations of Malaysian sukuk index returns

with developed market bond indices

181

5.53 Conditional correlations of Global sukuk index returns

with developed market bond indices

182

5.54 Conditional correlations of Global sukuk index returns

with developed market bond indices

183

5.55 Conditional volatilities of sukuk and emerging market

bond indices returns

187

5.56 Conditional volatilities of sukuk and emerging market

bond indices returns

188

5.57 Conditional correlations of Malaysia sukuk index returns

with emerging market bond indices

189

5.58 Conditional correlations of Malaysia sukuk index returns

with emerging market bond indices

190

5.59 Conditional correlations of global sukuk index returns with

emerging market bond indices

190

5.60 Conditional correlations of global sukuk index returns with

emerging market bond indices

191

xviii

LIST OF ABBREVIATION

ADF Augmented Dickey-Fuller

BPAM Bond Pricing Agency Malaysia

BNM Bank Negara Malaysia

CWT Continuous Wavelet Transform

DCC Dynamic Conditional Correlation

DWT Discrete Wavelet Transform

e.g. exempligratia (for example)

et al. et alia (and others)

GCC Gulf Cooperation Council

ISRA International Shari’ah Research Academy

MGARCH Multivariate Generalized Autoregressive Conditional

Heteroscedasticity

MODWT Maximal Overlap Discrete Wavelet Transform

MPT Modern Portfolio Theory

OLS Ordinary Least Squares

SAC Shari’ah Advisory Committee

VAR Vector Auto Regression

VECM Vector Error Correction Modelling

YTM Yield to Maturity

1

CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND

Understanding the co-movement among asset returns is always a critical issue in finance,

as investors can minimize the risk through diversification. Co-movement has not only

theoretical implications to understand the formation of asset prices but also practical

implications for asset allocation and risk management (Connolly, Stivers and Sun; 2007).

Due to the dynamic nature of the markets, the significance of the correlation estimation has

increased in the recent situation, especially during the highly volatile period. Therefore,

investors search for diversification opportunities through investing in that sort of portfolio

which has negative or lower correlation among assets’ return.

Some investors strive for capital appreciation while others may follow capital

preservation strategy in terms of investment. Capital preservation helps investors to

safeguard the capital, rather than considering the return on investments. Diversification

helps investors to safeguard their capital through allotting money in different

investments. Diversification can support a portfolio to boost not only when markets are

prosperous but also when the returns go down in a particular sector. Investors who held

100% equity portfolios over the last few years had experienced getting very poor

returns. On the other hand, the investors who diversified their portfolio through

investing in bonds, property, infrastructure and hedge funds, were more likely to gain

higher returns (Goldman Sachs, 2011).

Economists and financial analyst emphasize on “Market Portfolio” as the

combination of all asset classes that provides the highest risk-adjusted returns. The

2

market portfolio gives a beneficial guideline which helps to reduce risks and diversify

investments in the best feasible way amongst uncorrelated assets. This diversification

should not be restricted within a country while it should combine all asset classes

globally.

There is an enormous impact of the recent financial subprime crisis on the returns

of many asset classes, questioning on their contribution to the portfolio maximization,

following the classic portfolio theory. Moreover, globalization and technological

advancement enhance cross-class correlations, complicating the diversification

opportunity. After the financial crisis, a major challenge for the policy makers and

investors was to search the level of integration of financial markets with a perspective

of gaining the benefit of diversification opportunity. As the global economy grows and

developing markets enlarge their economies, both individual and institutional investors

search for prospects to diversify their portfolios. As co-movements become stronger,

diversification benefits become lower (Ilano and Bruneau, 2009). To avail global

portfolio diversification benefit, individual and institutional investors are more

interested in co-movements. A large portion of international asset markets is

represented by bond markets and it is also important to understand the association

between them.

Usually, investors seek diversification opportunity combining bonds and stocks

in the portfolio, where stocks are a riskier investment compared to bonds, but provides

a higher return than a bond. Barsky (1989) stated that the bond and stock co-movement

is independent. However, a positive stock-bond correlation also observed in the

financial markets is considered as a “spillover” effect which means shocks in the stock

market have an impact on volatility and returns in a bond market that causes prices to

fall for both assets. Another strong reason behind the positive stock-bond correlation is

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the “contagion” effect, which means these two assets may be affected by the

macroeconomic variables in a comparable way that may cause positive correlation in

bond and stock returns. Based on previous studies, it can be argued that there is negative

correlation observed between these two assets. Ideally, correlation needs to shift from

a positive to a negative sign to diversify a portfolio, thus enabling investors to gain

decoupling benefits. Decoupling is defined as when the returns to asset shift towards

opposite direction which leads to maximizing the diversification benefits for the period

of market crisis because of flight-to-safety phenomena (Gulko 2002). Flight-to-safety

can be defined as when the stock market plummets sharply, hence, there is a tendency

among investors to shift their investments from risky to non-risky assets for example,

treasury bills and bonds (Masloy & Roehner 2004).

Bonds have a significant role in an investor’s portfolio as they assist in

preserving capital and offer diversification in many different market environments.

After removing government barriers to the international flow of capital in major

developed countries during the early 1980s, the integration of global bond markets has

increased intensely in the previous two decades. The degree and the nature of

association in the global bond market have significant implications on bond

diversification opportunity (e.g., Clare et al., 1995). To diversify investment risk or

enhance portfolio performance, investors eventually seek opportunities in the emerging

global bond markets. However, there is a significant variation found in international

bond market return co-movements (Clare and Lekkos, 2000). Therefore, the degree of

global bond market association is importantly an issue of empirical analysis.

In relation to that, Islamic finance receives a lot of attention from the

academicians, institutional investors and asset managers in the search for higher returns,

lower correlation and growth potentiality. The global Islamic finance industry was

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valued at approximately USD1.9 trillion as of 2014 (KFH, 2015). Significant growth

was observed in the Islamic finance industry at nearly 16.94% between 2009 and 2013

(KFH, 2015) and the number of investors interested in Shariah-compliant securities is

expected to grow along with the industry. The Islamic financial industries are found to

be insulated from crisis due to the fundamental restriction of the Shariah against Riba

(Interest) and Gharar (needless uncertainty), and the impermissibility and

inaccessibility of financial derivatives which may have been a vital contributor to

protecting the Islamic financial system from encountering the vast effects of the crisis

(Smolo and Mirakhor, 2010).

In this context, Islamic finance, specifically fixed income instruments

recognized as sukuk, is now an essential part of the mainstream global financial system.

The market topped US$300 billion at the end of 2014, with a remarkable growth and

increasing diversification of issuers (MIFC, 2014). Sukuk complies with the Islamic

law which prohibits charging or paying interest, rather payments are made based on

profit or loss sharing, as well as rental or lease income. Although Muslim investors are

the key buyers of sukuk instruments, however, the demand for sukuk now spread out

far beyond the Islamic world. Statistics show that conventional investors may account

for approximately 40% to 60% of any sukuk subscription.1, 2 Financial engineering has

designed sukuk structure in such a way which support the private and public

organization to fund (Oakley, 2011). Hence, sukuk can be a lucrative option for both

Islamic and non-Islamic fund managers who are looking for diversified investment

portfolio.

1 Source: Financial News, “Western Investors Warm to Sukuk,” 17 July 2012. 2 Source: FinanceAsia, “Malaysia's Islamic Bonds Lure ‘Agnostic’ Investors,” 21 May 2014.

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The global sukuk market had observed sharp growth in the previous few years

as annual issuances were just about USD1172 million in 2001 to USD138 billion in

2013 (IIFM, 2014). The recent growth of the global sukuk market has been very

impressive driven by key markets such as Malaysia, the United Arab Emirates (UAE)

and Saudi Arabia as well as emerging frontiers such as Indonesia and Turkey. The

global sukuk outstanding topped USD300 billion as of November 2014, an 11.4%

increase from USD269.4 billion at the end- 2013 (MIFC, 2014). There is an increasing

trend observed in Malaysia’s secondary sukuk market which is fairly sizeable at

approximately USD173.4 billion at the end of November 2014, 9.6% increase year-on-

year. At the same time, the total GCC sukuk outstanding portfolio rise by 6.4% to

USD90.8 billion compared to USD85.3 billion outstanding at the end of 2013 (MIFC,

2014). Ernst & Young a well-known global consultant, forecast that there would be a

high global demand for sukuk and it may reach US$900 billion by 20173 . In recent

times in 2014, revolutionary issuances were documented from the UK, Hong Kong,

Senegal, South Africa and Luxembourg – strengthening the sukuk market’s position as

a sustainable and competitive source of funding. Moreover, sukuk listings have also

moved to cross-border activity as sukuk is listed on many key stock exchanges

specifically in Europe – such as London Stock Exchange, Irish Stock exchange, and

Luxembourg Stock Exchange (MIFC, 2015). In the corporate sector, national oil and

gas producer Petronas issued USD1.25 billion sukuk to raise working capital4.

Mitsubishi UFJ, Bank of Tokyo and Goldman Sachs debuted in the global sukuk market

in September 2015.

3 Ernst & Young MENA, “Global Demand for Sukuk to Reach US$900bn by 2017,” 9 September 2012. 4 “PETRONAS begins USD 17bln bond and sukuk drive” The Star (March 2015)

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It is essential to discuss the risk-return profile and relative strengths of sukuk

markets compared to bond markets before discussing the diversification benefits of

sukuk. Although there are many similarities between bonds and sukuk; nonetheless,

these two financial instruments are different and are not duplicate tools of financing.

Sukuk has a coupon, fixed term maturity and is tradable at yield price which is similar

to conventional bonds (Zakaria, Isa, and Abidin, 2012). However, sukuk is issued based

on shariah principals that differ from bonds, since bonds are based on ancient structure

of a loan imposed with interest (RAM, 2008) while sukuk as a certificate that ensures

the holder’s ownership right of an underlying asset which is undivided in nature and it

also claims to all rights and obligation of a tangible assets (IFSB). In line with Bey

(2007) and Wahdy (2007), sukuk are more competitive in comparison with bonds. This

is due to: (1) the possibility of gaining higher profit sharing than bonds, (2) secured to

fund potential projects, (3) in the event of a loss, investors would still retain their assets,

and (4) they are not perceived as a debt but investment letters.

Moreover, according to the empirical studies conducted by researchers claimed

that the average yield to maturity and the returns of sukuk certificates are higher than

conventional bonds in major sukuk issuing countries (Fathurahman and Fitriati, 2013;

and Mosaid and Boutti, 2014). For instance, according to Safari el. al (2013), there is a

significant difference between the mean yield of sukuk and bonds for all securities

issued by Bank Negara Malaysia (BNM). The difference between means showed a

positive figure which represents the yield of sukuk certificates is higher compared to

the yield of bond issued by the BNM, ceteris paribus. In term of securities issued by a

government agency such as Cagamas Berhad, there is a significant difference have

found between mean yields of sukuk securities and bonds except for securities with 1

or 2 years maturity. The mean difference showed a positive figure which also highlights