Subsequently, the spike recorded in early January 2009 was also due to the plunge in the yields of Malaysian government bonds generally. In consideration of the sharp deterioration in the global economy following the global financial crisis, Bank Negara Malaysia slashed the overnight prime rate (OPR) by 75bps to 2%, larger than the anticipated decrease of 50bps. As a result, the conventional Malaysian government securities (MGS) dropped by 40bps, led by the three-year MGS (-40bps) and the 10-year MGS (-10bps) on a month-to-month basis (RAM Ratings, 2009). The sudden decrease in the MGS yields also triggered the plunge for the yields of GII, causing the Sukuk spreads to widen further.

The different trends as depicted by the spreads of the non-investment grades (‘BB’) in Figure 3 as compared to the investment grades (Figure 1/Figure2) also reflects the preference of Sukuk investors on different classes of Sukuk. In consideration that investment grades are generally much preferred than the non-investment grades, the spreads for the latter are much higher than the former. For example, the long-term spreads of a ‘BB’ 10-year paper was recorded at 148bps on the 1st August 2005, reflecting the higher risks possessed by the lower-grade Sukuk relative to the investment grade Sukuk (‘AAA’ 10-year: 120bps). A spike in the Sukuk spreads is also visible in early 2009, most probably also due to the worries on the state of the global financial crisis. It is also observed that post-crisis, the non- investment grade Sukuk spreads appeared to chart a different pattern than previously.

As such, it is obvious that the investor behavior is driven by the state of economy. During good economy, investors tend to invest more into corporate Sukuk, pushing its yield downward and tightening the spreads. Conversely, at times of crisis, investors remain sidelined on corporate Sukuk and prefer the safer government Sukuk, causing the yields to move in a different direction hence widening the spreads. In addition, with the high speculative nature of the non-investment grade Sukuk, any changes in the monetary policy driven by the changes in interest rates during the different state of the economy may cause the spreads of the non-investment grades to be deterred significantly relative to the spreads of the investment grades. This is also in line with the empirical evidence of the highly-cited work of Longstaff and Schwartz in 1995 where firms with higher default probabilities (lower grade bonds) are more susceptible to changes in interest rates.

Hence, an understanding of the risk premium reflected by the Sukuk spreads is essential to comprehend how the trading and management of Sukuk portfolio are undertaken. More importantly, the variation of Sukuk spreads, which are derived from the movement of the yields of corporate Sukuk against government Sukuk, is also able to signal trends in investor behavior during different states of the economy.

Dr Sutan Emir Hidayat is an assistant professor and academic advisor for Islamic finance at University College of Bahrain (UCB); Professor Dr Mohd Azmi Omar is the director general, Islamic Research and Training Institute, IDB; Dr Salina H Kassim is an associate professor at Kulliyah Economics and Management Sciences (KENMS), IIUM and Maya Puspa Abdul Rahman is a PhD scholar at the Institute of Islamic Banking and Finance, IIUM.

They can be contacted at sutan@ucb.edu. bh, azmiomar@isdb.org, ksalina@iium.edu. my and maya.puspa@live.iium.edu.my respectively.