Do Sukuk Attract Riskier Borrowers?

After reading the paper "Are Islamic Investment Certificates Special? Evidence on Post-Announcement Performance of Sukuk Issues", I was left with significant questions about what information the study provided.  Given the lack of data on sukuk and the limited universe of sukuk issues, it was unlikely to reach a significant conclusion that would illuminate the costs and benefits for sukuk issuers, but the report is a good data point to have, even if I have questions for me about the statistical tests used in the study.

The paper, written by Christophe Godlewski and Laurent Wiell of the EM Strasbourg Business School at the University of Strasbourg and Rima Turk-Aris of Lebanese American University, attempts to determine whether sukuk are beneficial for issuers (and their shareholders).  They use a test to determine whether there is a significant impact on the share price of companies (compared to the market) when they announce sukuk versus conventional bonds.  The test focuses upon the period plus and minus two days from the issuance.  They limit the analysis to Malaysian corporate sukuk because the data (and secondary market activity) in sukuk in other regions is lacking.

The general finding is that conventional bond issuance has no statistically significant impact on a company's share price, while sukuk issuance has a negative impact on a company's share price.  The significance is relatively weak (10% significance level), but that is to be expected for the relatively limited data set they are working with.

The authors' conclusion, despite their earlier point that most sukuk are structured to be nearly identical to conventional bonds in economic outcome, is that the profit-sharing structure creates adverse selection problems (companies with worse prospects are more likely to issue a profit-sharing debt instrument than companies with better prospects).  They did find that the companies issuing sukuk were generally worse performing than conventional issuers, had higher debt levels and they conclude that the adverse selection problem is the main reason for their results.

With due credit for creating an interesting analysis based on limited data, there are many questions that arise from their analysis.  First is why they did not try to account for the performance metrics of the company (based on its underlying fundamentals) to reduce the likelihood that their result of significant adverse market reaction to sukuk issuance was due to the companies fundamentals rather than just the issuance of a sukuk.  The specification of their models is not explicitly provided, which makes it difficult to know what control variables they included in the model.  For example, they could have used total debt to assets as a way to control for the riskiness of the company (or another metric).

A more fundamental problem is that their conclusion does not fit the actual makeup of the sukuk market.  The authors' explanation of the preferability of sukuk over conventional bonds for companies with poor business prospects (or even just more risky prospects) would be justified if sukuk were actually structured as profit-sharing investments (a quasi-debt security).  However, this is not how sukuk are structured.

Sukuk are structured (whether they are ijara-based or pre-AAOIFI mudaraba/musharaka or another structure) to replicate the economic outcome of a conventional bond.  That means that they are structured so that the company issuing the sukuk is essentially signing up for a periodic payment over several years and then a balloon payment at maturity to redeem the sukuk.  The periodic payment is most commonly set based on the prevailing interest rates.  From an economic perspective (the perspective of the company's shareholders), the company does not create any different situation whether they use a sukuk or conventional bond.

The interesting test of this hypothesis would be to take the same or a similar data set and re-run the analysis and see whether the outcome is identical with additional control variables included.  Specifically, does the finding that companies that issue sukuk have worse stock market performance (and conventional bond issuers have no significant change in performance) remain robust if the specification includes firm-specific control variables to pick up the poorer performance of sukuk issuers? Unless the sukuk involved are structured to actually expose the investors to greater risk than a conventional bond, the reported results will come into question.

The adverse selection problem that is possible with Islamic finance is a serious problem and has led to the industry adopting products that closely replicate conventional debt.  However, with the product mix being as it is, it is difficult to argue that there remains  an adverse selection problem for Islamic finance and this paper essentially tries to do just that.  If the data set allows it, one way to test for the effect would be to try to find whether the effect depends on whether a sukuk is a mudaraba or musharaka versus an ijara (or other debt-based sukuk).  The data limitations for sukuk remain difficult within the context of statistical study, but it still leads me to have questions about whether the methodology used in this report is adequate for providing a result that is meaningful for the industry.