ANALYSIS OF ISLAMIC BOND (SUKUK) MARKET OF DUBAI AND MALAYSIA
Analysis of Islamic Bond (Sukuk) Market of Dubai and Malaysia
Introduction
As the business has expanded all across the world due to rise of internalisation or globalisation, it has become necessary that both the sources of equity and debt capital must be obtained for financing operational activities. In this regard, experts in financial management designed different modes of finance in which issuance of bonds, in case of debt management, forms an integral position. However, these conventional form of bond issuance require trading based on interest rates and are not backed by any security.
Therefore, based on Islamic principles, a religious form of bond securities are being introduced in many Muslim countries. These securities, known as Sukuk, prohibit the trading based on interest rate (riba) and make investors the owners of underlying asset, security or cash flow from the project. To address this concern, the research paper is written to make analysis of Islamic Bond market in Dubai (UAE) and Malaysia. This analysis is performed based on examination of structure and dynamics of Islamic Bonds in these two countries.
In its nature, the bond market in Dubai is the largest centre in the global economy to trade numerous bond issues with Sukuk listings of around USD 36.71 billion. This market has outperformed Malaysian bond market for Sukuk that has touched the level of USD 26.6 billion as of 2015 .
In contrast to conventional bond issues, the Islamic Bonds (Sukuk) in Dubai and Malaysia are structured to comply with Shari’ah principles. In conventional bonds, investors receive certificate which makes them eligible to receive principal as well as interest payments. Comparatively, bonds or Sukuk issued in Dubai and Malaysia are structured to reward investors with ownership rights of the underlying securities and assets. With their exact nature, Sukuk issues in Dubai and Malaysia contain yield-to-maturity that is linked to rentals of the lease agreement (Ijarah) of the project. The bond issues are backed by any security, asset or cash flow generated from the project. This is in contrast with conventional bonds that make principal as well as interest payments to all investors.
Sukuk (Islamic Bonds) issued in these two markets prohibit the payment and receipt of Riba (interest). In fact, investors are entitled to receive fees and profit distributions generated by underlying assets and transactions. Regarding the actual structure, Sukuk issues in Dubai and Malaysia provide investors with an ownership share in an underlying security, asset or business project. The cash flow generated by any of them is paid as a return on investment to Sukuk holders. On maturity or at end of lease agreement, principal is paid to issue holders either by selling back the asset to any third party or to a fund raiser (originator).
Islamic Modes of Finance Underpin the Dubai Sukuk and Malaysian Sukuk
In Dubai and Malaysian bond market, there are similar modes of finance followed by business entities and government organisations. These economies may use different instruments as a model for financing capital intensive projects or operations. But there are certain Sukuk instruments that are used extensively with large volume of business transactions.
Specific to Middle Eastern boundaries, Ijarah Sukuk are considered to be the most basic mode of Wakala Sukuk. These kinds of Islamic Bonds can not only be backed by certain real assets but with numerous investment securities as well. Compared to the Bond market in Dubai, Malaysian business entities and government organisations enter into Murhaba Sukuk as a basic mode of Islamic Finance. This is particularly true because the structure of Murabahah Sukuk is simple that supports investors to raise Islamic Finance even if they do not own any real or investment asset.
Modes of Finance and their Relationship with the Dubai and the Malaysian Sukuk
As highlighted in the previous section that, in Dubai, Sukuk-al-Ijarah mode of Islamic finance is used concerning Islamic Bonds (Sukuk), this particular mode is largely based on a lease agreement. It has relationship with Sukuk management in Dubai in a manner that owners of the project and tangible assets transfer their rights to usufruct (rights to use and benefit) to the lessee in exchange for a rental payment in return. The rental payments are agreed upon at a certain rate and for a pre-specified period.
In Islamic Finance structure of Malaysian bond market, Murhabah represents a contractual agreement between the customers (purchasers) and financiers (sellers) concerning spot delivery of any underlying or agreed upon commodity/asset. Once the asset is sold to the customer, the ownership rights are transferred to the purchaser (client) from the financier (seller) and it represents a debt owed to him .
Investment Considerations Relevant to an Investor
When any investor is willing to make investments in the conventional and Islamic Bonds, there are certain considerations that need to be made regardless of whether such investments are made in Dubai or Malaysia. Though there are different modes of Islamic Finance followed in Dubai and Malaysian markets in case of Islamic Bonds (Sukuk), yet all of the investment considerations remain the same to highlight certain risks or uncertainties. Investors, in Dubai and Malaysian Sukuk, must consider them depending upon their cash flow requirements, risk appetite as well as the amount of investment.
Coupon Payments
In both the Dubai and Malaysian Sukuk (Islamic Bonds), coupon payments are either fixed, variable (floating) or even zero . Those Islamic Bonds (Sukuk) that pay fixed coupon payments generally pay interest on a monthly, quarterly or sometimes, semi-annual basis. Floating or variable coupon payments keep changing from period to period to match bond market rate and absorb any underlying risk of loss. In zero coupon Islamic Bonds (Sukuk), no coupon payment is made during the life but investors receive payments at maturity or due date .
Price of the Islamic Bond (Sukuk)
Another investment consideration for investors in Dubai and Malaysian markets is the current price of the Sukuk. If the bond is sold at market price higher than its face value, it is said to be traded with premium and lower yield (interest rate) whose interest rate risk is low. In contrast, if the current market price is less than the face value of an Islamic Bond (Sukuk), it is said to be traded at discount and increased yield (interest rate) for which the interest rate risk is higher .
Maturity Redemption of the Sukuk Issue
Investors must also consider bond’s (Sukuk’s) maturity when dealing in Dubai and Malaysian bond market. The issues can be either for short tenure (probably up to one year or less) or they may have longer maturities (beyond one year). In the same manner, investors must give special attention to redemption if they plan to leave or withdraw from their Sukuk investments at any point of time. In Callable Sukuk issues, investors can be paid principal and profit amounts before maturity. However, if an investor has considered put position, then, he can receive principal and profit only at maturity or due date, not earlier than this specified date .
Credit Quality of Islamic Bonds (Sukuk)
The last consideration which investors should be concerned about is the credibility or credit quality of the issue since it reflects any possibility of risk of default. If Islamic Bonds are issued by Dubai or Malaysian Government, the only risk involved concerns the country’s sovereignty (sovereign risk). In case of private sukuk, the rating by credit rating agencies must be considered. Comparative to low quality bonds, high quality bonds with greater credit rating are expensive.
Overview of the UAE and Malaysian Economy to enable Investors to Gauge the Investment Climate
A credit rating of AA is assigned to UAE market by Standard & Poor's (S&P) which dictates that issuers have strong capacity to repay their investors and have higher liquidity strength. After 2008, the central bank of United Arab Emirates decided to increase its interest rate level by 25 basis points to a level of 1.25%. From 2007 to 2015, the average interest rate is 1.26%. Since 2009, the interest rate level has become stable at 1.06 to 1.25 percent. This serves as an investment cushion to all investors since their fear about interest rate volatility is greatly relaxed. This is because officials of United Arab Emirates (UAE) market have resisted the need to change interest rate level .
As far as Malaysian Islamic Bond (Sukuk) market is concerned, the rating agency named Standard & Poor's (S&P) has awarded a credit rating of A- (since 2007) to its sovereignty. It shows that the economy is stable enough and will never default on Sukuk issued by the Government entities. In Malaysia, to mitigate the negative effects of global financial and economic environment, the average interest rate from 2004 to 2015 has been 2.96%. Though the interest rate is increasing since 2010, yet it has become stable at the level of 3.25%. It shows that there is less uncertainty for both the local and foreign investors.
Are Malaysian Islamic capital markets different from those in the Gulf States?
Though these Islamic capital markets are located in different geographical locations yet the rise of globalisation has caused all marketplaces and economies to synchronise with one another. Both of these markets are different in size and business transactions but their structure and dynamics are still the same. Both of these Islamic capital markets prohibit the trade activity based on riba (interest) and comply strictly with Shari’ah principles. The only difference between these markets is that the UAE market is concentrated on Sukuk-al-Ijarah whereas the Malaysian bond market enters into majority of its trade based on Murabahah Sukuk . Both the capital markets of UAE and Malaysia are structured in a manner that never conflicts with Islamic principles and consciences of all Muslims. Moreover, the trade activity in these capital markets is certainly prohibited in all such items that involve ambiguity (gharar), gambling (maisir) and usury (riba).
Shari’ah Board Requirements in Place
In the UAE, it is the Securities and Commodity Authority (SCA) which has sole responsibility to approve listing Islamic Bond (Sukuk) issuance in the money market issued by the PJSC. Sukuk issues must be approved by this body. The issuer must have Shari’ah Board and the amount of issue should not be less than fifty million Dirhams or its equivalent in any of the international foreign currencies convertible into the UAE and acceptable to SCA. The issue must be rated by a credit rating agency that must be further approved by SCA. The issuer must have adequate solvency, a license as well as representation by any underwriting agent .
In Malaysia, Islamic Bonds (Sukuk) are covered under the influence of the Securities Commission (SC) of Malaysia. They are regulated under section 212 of the Capital Markets and Services Act, 2007. Just as in UAE market, Sukuk issued in Malaysia must be rated by a credit rating agency to inform investors of underlying risk. The issuer must have enough liquidity to support fee, profit and principal payments.
Issues of Corporate Governance Relevant to Sukuk in Dubai and Malaysia
When any of the Islamic Bond or Sukuk is issued in the UAE and Malaysian capital market, the only corporate governance issue that arises from this transaction concerns the strict compliance to Shari’ah principles. The first issue that needs to be considered in Sukuk issuance relates to the prohibition of certain illegal and immoral activities to make profit. Certainly, poor governance system would prevail if issue related to trade activity between buyers and sellers of Sukuk is not well taken care of. The trade activity must not be based on unlawful and illegal code of conduct.
How is the issuance of Sukuk Rated and by whom?
The process for having any credit rating assigned to any Sukuk is simple. The issuer and Sukuk’s underwriter apply to a rating agency to assign any credit rating depending on historical financial performance and solvency. The rating agency, then, evaluates the liquidity strength and debt management capacity of the issuer in favour of all investors.
In UAE market, the largest credit rating agency concerning the issuance of Islamic Bonds (Sukuk) is Standard & Poor's (S&P) . Malaysian Rating Corporation Berhad is one of the recognised rating agencies in Malaysia in case of Islamic Bonds (Sukuk). Moody’s also have some involvement in this regard for supporting investors from foreign countries.
Risks for Investors Associated with Investing in Sukuk
For every investor in Sukuk, there is a risk that is always adjusted against its return. This is because high risk Sukuk issues pay its investors higher investment returns for assuming greater uncertainties and vice versa . In such a case, there is an uncertainty that the issuer may go bankrupt or insolvent at any point time, before maturity, due to liquidity management issues or financial distress.
However, high quality Sukuk issues also contain some risks which investors must be aware about. The calculation of current and market price depends upon the discounting factor in the denominator of bond calculation, that is, yield-to-maturity. As interest rates increase, the risk of Sukuk issue increases that reduces its current price in the market. Because of this, the bond could be traded only at discount . In the same manner, if the credit rating agency downgrades the overall rating of the issue, there is a risk that investors may find it difficult to liquidate or sell their Sukuk issue which is already traded at discount .
Lessons Learned
After a detailed and theoretical analysis of Islamic Bond (Sukuk) market in Dubai and Malaysia, it is leant that both of these markets are similar with one another when it comes to Shari’ah compliance, market dynamics and overall structure. However, the modes of Islamic finance differ among Dubai and Malaysian market. One is concentrated on Ijarah Sukuk whereas the other one focuses more on lease agreements and Murabahah Sukuk. In all Sukuk issues, the illegal trade activities and riba (interest) are prohibited strictly based on Islamic principles.
Different investment considerations that must be taken care of include coupon payment, maturity, yield-to-maturity and credit quality which is the same for Dubai and Malaysian Sukuk. Low quality bonds offer high risk premium compared to Sukuk with lower credit rating. As per ratings assigned by Standard and Poor’s (S&P), the bond issuances of these two economies have secured similar positions and liquidity strength to pay off investors. Both the UAE and Malaysian official have kept the interest rate consistent since 2012 which is a good sign for all investors as this policy action reduces or minimises interest rate volatility.
As far as investment considerations are concerned, investors in the Islamic Bonds or Sukuk issues of Dubai and Malaysian markets can be sure of investment returns. This is so because the level of interest rate is kept consistent since 2012 in case of both the economies. Due to highly stable interest rates and yield to maturity, investors can accurately calculate and account for underlying risks and returns.
Although there are certain regulatory requirements and Shari’ah principles, yet there are some corporate governance issues associated with Sukuk issues of Dubai and Malaysian capital markets. They are related to the legality of trade activities and underlying assets. Overall, if the Dubai and Malaysian markets are compared, both of these marketplaces only differ according to volume of business transactions as well as modes of Islamic finance. However, the exact nature and structure of these markets is still the same due to universality of Islamic principles.
References
Arnold, W., 2008. UAE resists global trend to trim interest rates. [Online] Available at: http://www.thenational.ae/business/economy/uae-resists-global-trend-to-trim-interest-rates [Accessed 16 January 2016].
D'Souza, E., 2009. Macroeconomics. Pearson Education India.
French, D. & Potter), M., 2016. UPDATE 1-UAE emirate Sharjah plans sukuk issue in Q1 - sources. [Online] Available at: http://www.cnbc.com/2016/01/05/reuters-america-update-1-uae-emirate-sharjah-plans-sukuk-issue-in-q1--sources.html [Accessed 16 January 2016].
Gough, L., 2013. Financial Times Guide to how the stock market really works. Pearson UK.
Hassan, K. & Lewis, M., 2009. Handbook of Islamic Banking. Edward Elgar Publishing.
Kane, F., 2015. Dubai now leading hub for sukuk trading. [Online] Available at: http://www.thenational.ae/business/economy/dubai-now-leading-hub-for-sukuk-trading [Accessed 13 January 2016].
Khan, M.F. & Porzio, M., 2010. Islamic Banking and Finance in the European Union: A Challenge. Edward Elgar Publishing.
McMillen, M., 2013. Islamic Capital Markets: A Selective Introduction. [Online] Available at: http://whoswholegal.com/news/features/article/30640/islamic-capital-markets-selective-introduction [Accessed 16 January 2016].
Peng, J., 2008. State and Local Pension Fund Management. CRC Press.
Reilly, F. & Brown, K., 2011. Investment Analysis and Portfolio Management. Cengage Learning.
SCA, 2013. Islamic Sukuk. [Online] Available at: http://www.sca.gov.ae/english/pjsc/lddprocedures/listingpjsc/pages/registersoukok.aspx [Accessed 16 January 2016].
Tyson, E., 2011. Investing For Dummies. John Wiley & Sons.
Vardi, N., 2010. The Integration of European Financial Markets: The Regulation of Monetary Obligations. Routledge.
