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What are the Explanatory Factors Behind the Price Movements of Islamic Bonds?

One of the basic principles underlying the price movements of conventional financial instruments is that bond prices and interest rates hold an inverse relationship. When interest rates are pushed upwards (for any exogenously given reason; it could be due to the Central Bank’s decision as well as an increased risk of financial instruments), bond prices slump. In an efficient market such adjustments are immediate. Likewise, all information available to market participants and their expectations are fully reflected in bond and stock prices.

So, if interest rates play the central role in explaining what drives the prices of various debt instruments, what forces affect the Islamic bonds which, by definition, are not based on interest rates? Could it be that, ironically, the prices of Islamic bonds are indirectly affected by the prices of conventional bonds (and thus by their interest rates)?

According to the Financial Times, whilst conventional bondholders are entitled to receive interest and principal at specified dates from the issuer, the holders of Islamic bonds participate in the share of revenues generated over a particular period of time. Importantly, ‘under a sukuk structure the sukuk holders each hold an undivided beneficial ownership in the underlying assets.‘[1] The recognition that conventional and Islamic bonds are not substitutes lies at the core of understanding the structure of their pricing. In particular, ‘the aim is not simply to engineer financial products that mimic fixed-rate bills and bonds and floating-rate notes as understood in the West, but rather to develop innovative types of assets that comply with Shari’a Islamic law‘.[2] It is only once we allow for distinction between the two instruments that the conceptual difference is reflected in the real developments on the markets for these instruments respectively. Keeping this distinction in mind, what are the major factors behind sukuk pricing? This is not a straightforward question with a pre-defined answer. In fact, the November edition of the Journal of Asian Scientific Research clearly recognises that ‘pricing is a main concern for Sukuk since it is new to the market and has yet to develop any suitable mechanism to determine its price‘.[3] Since no such standardised mechanism for underwriting and defining the price of Islamic bonds exists, the prices can either be concluded to follow a random walk or are determined by a set of factors specific to each particular bond.

The former hypothesis is discharged on the premise that some non-random factors can be found. They could include bond-specific factors such as profitability of the asset associated with the bond, terms of participation in ownership of this asset or in the profit generated (for instance, a corporate sukuk will have very different terms from a sovereign sukuk), asset duration and investment risks, all considered while holding interest rate in the conventional system irrelevant. Amongst the more general factors there are liquidity concerns, premium for shariah-compliance and exogenous risks (some of these risks could be macroeconomic, political or expropriation). Importantly, only the bond-specific factors have the power to explain the price differential between different bonds. This is because the systematic risk is common for all the securities.

In theoretical terms ‘fixed annual interest rate payouts to investors over the life of the conventional bond are not used for Sukuk bonds. Instead, Sukuk returns are derived from leases, profit or sales of assets such as property, equipment or joint venture business‘.[4] In practice, the pricing is more complex and not limited to the value of underlying assets only. The challenges in price setting include the absence of a universal Islamic bechmark rate and a mechanism for price updating, the small number of participants, non-application of hedging methods and, more fundamentally, no consensus regarding the types of activities or investments that bonds can be underwritten on.

To highlight a recent example, in the case of sovereign sukuks of Qatar ‘returns to holders of the certificates are variable, and calculated on the basis of the London inter-bank offer rate (Libor) on dollar funds plus 0.4 per cent per annum, which makes the certificates competitive with, and similar to, conventional floating-rate notes. It should be noted that Libor is only used as a benchmark and the returns themselves do not represent interest payments, but rather rents related to a real underlying asset – the leased parcel of land supplied by the government of Qatar‘.[5] Yet benchmarking against Libor generates major criticism as the bond pricing structure is no longer interest-free. One could suggest an alternative reference point such as real GDP growth or non-oil GDP growth.

This leads to the conclusion that regardless of the conceptual difference between traditional and sukuk bonds, there is no other difference. Until the homogenisation of law for underwriting of Islamic securities is applied, they will remain interrelated and interest-rate based. In the context of Islamic bonds, this could follow either directly through reliance on the inter-bank rates or indirectly by reflection of the movement of interest-driven prices of conventional securities in the price of Islamic securities. Nevertheless, the bond-specific factors still prevail as the ultimate price-driving forces.

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[1] Financial Times Lexicon (section on Islamic bonds): www.lexicon.ft.com/

[2] Rodney Wilson, “Overview of the Sukuk Market,” in Islamic Bonds: Your Guide to Issuing, Structuring and Investing in Sukuk, J.A. Nathif and S.T Abdulkader (Euromoney Institutional Investor PLC, 2004): 3.

[3] Essia R.A., Aminul Islam and Tariq T.Y.A, “Islamic Sukuk: Pricing Mechanism and Rating,“ Journal of Asian Scientific Research 4(11) (2014): 640-648,644.

[4] Ibid., 645.

[5] Rodney Wilson, “Overview of the Sukuk Market,” in Islamic Bonds: Your Guide to Issuing, Structuring and Investing in Sukuk, Adam Nathif and Thomas Abdulkader (Euromoney Institutional Investor PLC, 2004): 13.

 

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