The mechanics of Sukuk investment are a mysterious and complicated subject for many investors. From the Sukuk structure and the pricing methodology, to its risks and trading strategy, weoften leave it to the experts to handle. However with its position as an essential asset class in the mandate of Shariah funds, understanding Sukuk structure is important for all participants. DR SUTAN EMIR HIDAYAT, PROF DR MOHD AZMI OMAR, DR SALINA H KASSIM and MAYA PUSPA ABDUL RAHMAN attempt to unravel the management of a Sukuk portfolio and how investor behavior can be assessed based on the variation of the Sukuk spreads. 

Technically, Sukuk that are traded in the secondary market are quoted based on the spreads to a particular risk-free security, such as government investment issues (GII). In the conventional bond market, these spreads are known as credit spreads. The credit spreads are the main focus of investors in corporate bonds. Similarly, the Sukuk spreads indicate the compensation to risk, referred to as the risk premium. 

The risk premium is the factor that makes investors willing to invest in Sukuk despite the risks that they may encounter. Even though Sukuk are structured based on the different kinds of contracts, which can be sale-based, leased-based, partnership-based or agency-based, the associated risks to Sukuk is mainly reflected in the spreads, which is comparable with other Sukuk that possess similar rating, duration and outlook for trading purposes.

For example, a fund manager observes that the 10-year ‘AAA’ Idaman Sukuk is trading at a spread of 108bps above the 10-year GII. If another corporate Sukuk with similar credit rating, duration and outlook were trading at a 115bps on a relative value basis, the second Sukuk would be a better buy. Why? This is because with the same risk, the investor could get a higher compensation or premium (115bps vs 108bps) by investing into the second Sukuk. This is one of the strategies carried out by the fund manager in an active Sukuk portfolio management.

As for the lower investment grade (‘A’,‘BBB’), the Sukuk spreads of both the short and long-term demonstrated an upward trend with the spike of the spreads also observed within 2008-09. As the spreads represent the risk premium to investors for holding corporate Sukuk (against the risk-free government Sukuk), the sharp increase suggests that the risk premium for holding such Sukuk had increased significantly, especially during the financial mayhem in 2007-08. Practically, the trends observed in the charts above may be explained by the shift of investment preference by the Sukuk investors.

As corporations struggled with declining revenue and cash flows during crisis, profits payable to the Sukukholders may also be interrupted. Hence, as investors opt for a much safer instruments like government Sukuk, the higher demand is translated to a lower yield of government Sukuk causing the spreads (against the yield of similar maturity corporate Sukuk) to increase further. For example, on the 1st January 2007, the yield of ‘AAA’ 10-year corporate Sukuk stood at 4.55% whilst GII of similar maturity yields stood at 3.82%, giving spreads of 73bps. Two years later on the same day in January 2009, following the shock of the global financial turmoil which had altered the US financial system and shook the economies of almost every country in the world, the yield of the similar rated Sukuk climbed up to 5.35%, while the GII, being the safe haven instrument, fell to 3.26%, causing the spreads to widen to a massive 209bps. This reflects the higher compensation demanded by the investors for holding a much riskier corporate Sukuk, during economic downturn.