Analysis of the Sukuk in an Investment Bond Portfolio

So far we have only considered sukuks and their impact on an economy. For an investor, their concern will be more on generating a healthy return and minimising risk. Sukuk achieves both. In her research, Farah Daghestani finds that sukuk when added to an investor’s portfolio helps reduce risk but does not result in stronger returns. Here we partially reprint her research.

Objectives

It is not an easy process for portfolio managers to meet specified investment goals for the benefit of investors. Fixed-income securities have several features that many investors ignore as most investors think that investing in fixed-income securities such as bonds is safe. They do not grant sufficient attention to the risk involved, content with receiving a regular coupon payment.

The aim and objective of the research is to estimate the risk of sukuk through estimating the risk of a portfolio consisting of both sukuks and conventional bonds and comparing it to the risk estimation of a portfolio consist of conventional bonds only. The focus of the investigation is the introduction of sukuk to a bond portfolio and whether it creates any diversification benefits to investors by minimising the risk. To ascertain this, I compare a mixed portfolio (with sukuk) to an investment portfolio of conventional bonds only during and after the 2007 financial crisis using Value at Rrisk method (VaR). VaR measures the expected maximum loss which can occur over a specified time period for a set level of probability and a given statistical confidence level.

Methodology

The chosen VaR for evaluating risk is widely applied in this area to identify the benefit from diversification. VaR measures the worst expected loss of a portfolio over a certain holding period at a defined confidence level under normal market conditions within a limited time horizon. VaR became a standard measure of portfolio risk over the last decade and is now heavily used in risk management. It is a vital method for setting capital requirements for banks. Its’ success can be attributed to three reasons. First, this risk measure is highly intuitive and closely related to investor’s goals. Second, VaR does not depend on any specific assumptions about return distributions or risk aversion.

The third and most crucial reason VaR is that Basel II accord on banks’ equity requirements suggests the usage of VaR. Consequently, VAR can be considered as a standard instrument in assessing portfolios and credit risk. Moreover, the VaR method works across different asset classes such as stocks and bonds. With this method, it is possible to measure the aggregated risk of a diversified portfolio.

To calculate VaR, there are many different approaches. The Asset Normal Approach is the basic approach in calculating VaR and is based on historical bond prices. It assumes that the respective values of the position in the portfolio are normally distributed. I have chosen this approach as the percentage change in the bond/ sukuk price would reflect the change in the value of the entire portfolio position and therefore in possible future losses.

The sample of the study comprise of UK conventional bonds and global sukuk issues. UK bonds were selected as a benchmark in the study due to the stability of the economy. For sukuk; the publicly traded issues only were selected from different countries as most of the trades is restricted to primary market and only in a few cases is secondary market data is available.

The database sample used in this study comprises of three sets of portfolios. The first portfolio is a Conventional Bond Portfolio, which consists of United Kingdom corporate bonds issues collected from 2002-2012. The Second Portfolio consists of a mix of UK conventional bonds and global sukuks. The sukuk issues collected are corporate sukuks. The sukuk issues are collected for the same period from Muslim courtiers such as Bahrain, Qatar, UAE, Kuwait, Saudi Arabia, Pakistan, Indonesia and Malaysia. Three sets of portfolios were created from the sample. The first set consists of two portfolios. The first portfolio consists of four bonds and the second portfolio consists of the same four bonds of the first portfolio plus two sukuks. The second and third sets each consist of two portfolios. The first portfolio has five bonds and the second portfolio includes the first portfolio plus two sukuks. (table 7).

Analysis

VaR was computed for a portfolio value of £50 million. The results show a VaR of £9.6 million for the second set of bond and sukuk portfolio. One can expect the loss on the market value of the portfolio will not be larger than £9.6 million or 9.6% of its value 99% of the time (as of end-June 2012). It also means that there is a 9.6% chance that the loss could be larger than £ 9.6 million for a period of 35 months. The corresponding figure for the non-Sukuk or conventional bond portfolio stands at £ 12.7 million VaR. Therefore, the introduction of sukuk amounts to a 4.1% reduction in VaR in the conventional bond portfolio. To compare the estimation, the third set shows that sukuk reduces VaR by £3.2 million giving VaR of £13 million for the mix conventional bond and sukuk portfolio and a VAR of £16.2 million for the conventional bond portfolio.

The same results can be seen for sets two and three. The sukuk and conventional bond portfolio shows a VaR of £28.7 million losses compared to £18.4 million for the conventional bonds portfolio, which means that adding sukuk to this portfolio increased VaR by more than 10% (Table 8)

The principal findings of this empirical research are the following:

1. Sukuk are different to conventional bonds according to their price behaviour although international issues of sukuk are similar to conventional bonds when it comes to such features as issuance, redemption procedures, coupon payments, and default clauses.

2. Inclusion of sukuk in a bond portfolio minimises the risk compared to a portfolio consist of bonds only.

3. The correlation of sukuk returns with returns of conventional bonds is much smaller than the correlations of returns on conventional bonds with each other. Therefore if bonds are not perfectly correlated with sukuk in the portfolio, VaR is expected to be lower by the definition of correlation.

4. Possible gains from diversification should be evaluated against the lower return and liquidity risk of sukuk. Most of the time, possibly because of the segmented market structure and modern portfolio theory of risk versus returns, sukuk offer lower returns compared to conventional bonds.