Determinants of Islamic Bond (Sukuk): Evidence in Malaysia

Rusmawati Saida , Wan Nurhanan W. Suhaimi and Asmaddy Harisb

aUniversiti Putra Malaysia
bUniversiti Sains Islam Malaysia

Abstract

The virtual isolation of Islamic financial markets from 2008’s financial crisis
prompted a quest to find the underlying determinants that stabilise the market’s liquidity.
Utilising data from the Malaysian bond market, the paper first provides insight into the trend
and liquidity of the sukuk market before analysing sukuk’s liquidity level by using the latent
liquidity measurement. This is followed by a random effect regression to determine the
liquidity drivers for sukuk. Four variables (issuance amount, maturity, coupon rate and age)
are found to be significant drivers of sukuk’s liquidity level. The conclusions drawn from the
regression results indicate that sukuk’s investors favour to match long term sukuk with their
long term liabilities. In addition they also like to keep their sukuk to amortise the return.

Keywords: Sukuk, Islamic bond, liquidity, latent liquidity, Malaysia

1. Introduction

Any investor would be highly concerned with an asset’s liquidity level. Liquidity level
was even blamed as one of the causes for the recent 2008 financial crisis. Liquidity level is
always a lifelong problem faced by the investors; excessive liquidity also is an issue as the
economy is highly leveraged and exposed to economic bubbles. Islamic bond, or sukuk, has
risen in in popularity in the Islamic financial system and has been efficacious in shielding
from the effects of the financial turmoil since the 2008 financial crisis. Sukuk has attracted
immense interest from investors around the world and has prompted intensive studies to
explore the determinant of sukuk liquidity. In this paper, our goal is to describe the trend and
to find the determinants of sukuk liquidity level in Malaysia’s sukuk market.

Liquidity in practice is harder to explain as compared to its theoretical explanation.

Such difficulties arise because liquidity often relies on metrics with sparse yet high
transaction frequencies data. Bonds are commonly traded over the counter where direct

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liquidity measures are often not reliable and difficult to obtain. For this purpose, this paper
will utilise a liquidity measurement proposed by Mahanti et al. (2008) called latent liquidity.
Latent liquidity is defined as the weighted average turnover of investors who hold a bond, in
which the weights are the investors’ fractional holdings. Latent liquidity measurement is
suitable when dealing with illiquid markets as it does not require transaction data in its
calculations. We will apply this measure to the Malaysian sukuk market and take into account
Malaysia’s position as the biggest issuer of sukuk in the world. In addition, sukuk’s unique
risk sharing structure and prohibition of riba also prompt attention in this study. This paper
provides detailed analysis to prove our claim that Malaysia’s sukuk market is very illiquid;
hence this supports the use of latent liquidity as a suitable liquidity measurement applied in
this study. Afterwards, latent liquidity will be used to analyse the liquidity determinants of
sukuk.

This paper is organised as follows: Section 2 discusses previous literature that has
touched on the issues and on measurements’ pertaining to liquidity in the bond market.
Section 3 presents methodology used in achieving the objectives of the study, namely the
latent liquidity approach and the random effect regression model. Definition and elaboration
of the methodologies will be discussed in detail. Elaboration on the database that is used in
the analysis follows in Section 4. Initial elaboration on how representative the database of the
whole market is in terms of market composition, followed by a transaction data analysis to
illustrate the trading frequency of sukuk in Malaysia is provided. This section also provides
statistics on the market composition of sukuk by different bond characteristics, such as issue
size, time to maturity and industry distribution. In Section 5, characteristics of sukuk‘s
generated latent liquidity and the results of the random effect regression on the latent liquidity
against some bond characteristic is presented, in order to determine the drivers of sukuk’s
liquidity level. Section 6 concludes the paper with a short discussion of the overall findings
and implications of the paper for future research.

2. Literature

Most empirical research on liquidity level uses transaction data to measure liquidity.
These transaction data, despite being widely used, are only feasible in markets that are liquid
and dynamic. A study by Jankowitsch et al. (2011) was one exception when they managed to
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introduce a new liquidity measure that shows trade prices’ deviation from the expected
market valuation of an asset. Over the counter (OTC) data in US corporate bond markets
were made available with the establishment of the Trade Reporting and Compliance Engine
(TRACE). They were then able to directly quantify the price dispersion of an asset and prove
their liquidity measure is related to the bond’s characteristics. Other recent pieces of literature
have proposed several measures to estimate liquidity by utilising the bid-ask spread,
transactions data, daily trading volume data and some indirect proxies for liquidity—namely
issued amount, listed, euro, on-the-run, age, missing prices, yield volatility, number of
contributors and yield dispersion, according to Lesmond (2005), Dick-Nielsen et al. (2011),
Friewald et al. (2012), Amihud (2002), Houweling et al. (2005) and Jankowitsch et al.
(2011).

Lesmond (2005) uses the bid-ask spread based liquidity measurement and finds that
this and Roll’s (1984) measures perform better than volume-based liquidity in representing
cross-country liquidity. Chan et al. (2008) study the liquidity effect on the cross-country
American Deposit Receipt (ADR) premium and find that this premium is higher when the
ADR liquidity is high and home country liquidity is low. Amihud’s (2002) and LOT’s
measures (Lesmond et al. (1999)) are relevant in representing within-country liquidity level.
Amihud (2002) uses transaction data in its measurement and discusses the price impact of
market illiquidity, where market illiquidity is shown to have a positive effect on stock excess
return. Friewald et al. (2012) use a wide range of liquidity measures that cover a
comprehensive data set of 23,703 bonds and 3,261 firms to investigate the importance of
liquidity in the US corporate bond market. Their findings suggest that the economic impact of
the liquidity measures is significant during a financial crisis, more precisely for speculative
grade bonds. Dick-Nielsen et al. (2011) use TRACE transactions’ data and a new measure of
liquidity to analyse how liquidity affects bond spreads before and after the subprime crisis.
They find a significant effect from liquidity with the onset of the subprime crisis. However,
their multivariate analysis shows mixed outcomes for different classes of bond grade. Latent
liquidity as being proposed by Mahanti et al. (2008) is based on the institutional holdings of
bonds, which are accessible even with the absence of transaction data.

The conventional measurement of liquidity would not be applicable in a low trading

volume market with the absence of ample transaction data. Based on this, a measurement that
does not rely heavily on transaction data such as latent liquidity stands as the right option.
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Descriptive analysis on sukuk’s data shows how substantial the sukuk market is in Malaysia;
hence this paper is significant contribution to the existing literature. However, despite the
massive amount of sukuk in the bond market, the trading activities are still low and make the
market illiquid.

3. Methodology

3.1 Latent Liquidity measurement

The original latent liquidity by Mahanti et al. (2008) measures the liquidity level from
the investors’ perspective by using data from a custodial bank. The way they construct the
latent liquidity measure without a high reliance on the transaction data makes the measure
applicable to the paper. Instead of using data from a custodial bank, the paper uses data from
Bank Negara Malaysia. In the Bank Negara Malaysia database, the bond turnover ratio is
used to measure the sukuk’s market liquidity. The bond turnover ratio merely divides annual
turnover with the average outstanding of sukuk, without considering the individual sukuk
holding in the entire sukuk market. Latent liquidity in this paper is defined as the degree to
which an individual sukuk’s turnover level is a composition of the total sukuk market.
Precisely, the paper defines the fractional holding of sukuk i (as a percentage of the total
outstanding amount of the sukuk in the market) in the market as πit. Mahanti et al. (2008)
define the average portfolio turnover as the ratio of the dollar trading volume of the fund to
the value of the fund. However, the paper directly uses yearly average turnover data collected
from the database and denotes it as T,t. Latent liquidity in this paper is defined as

Lij = ∑ πit T,t (1)

Therefore, latent liquidity is defined as the aggregate-weighted average level of

turnover of the individual sukuk holding in the market. While an illiquid market is a good
place to study liquidity, the scarcity of transaction data can be a major problem. In
overcoming the data scarcity problem, any measurement that is highly dependent on
transaction data should be avoided. With this regard, the paper utilises the latent liquidity
measure as that being introduced by Mahanti et al. (2008) in order to measure the liquidity
level in the Malaysian sukuk market.

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3.2 Random effect regression model

Studies involving determinants commonly utilise regression for estimation purposes.

Kwack (2000) in his study on financial crisis determinants uses ordinary least square
regression on annual and cross-country analysis for seven countries from 1995-1997. In order
to capture the effect of time lag, he uses average values over a period of time. Houweling et
al. (2005) follow Brennan and Subrahmanyam (1996) to use two regression models in
identifying the different proxies for a bond’s liquidity. Instead of estimating their model on
individual bonds, Houweling et al. (2005) run estimates on constructed bond portfolios. In
contrast to pool estimation, a more specific random effect regression is used by Lesmond
(2005) to investigate the determinants of an emerging market’s liquidity level. The same
method is also used by Mahanti et al. (2008) to find the determinant drivers of a bond’s
liquidity. According to Baltagi (2005), the random effect model is useful in avoiding the loss
of degree of freedom, in contrast to the fixed effect model. In addition, the random effect
model is also an appropriate specification when a model only involves a few random cross-
sections drawn from a large sample population; the model assumes all individual regressors
are exogenous from each other.

In this study, the random effect model is an appropriate specification, as we are drawing
twelve sukuk bonds out of the entire population in the Malaysian sukuk market. This is the
case as we are trying to make our sample as representative as possible of the entire
population. Baltagi (2005) explains the term “population” in the model as “population of
infinite decision, not on individual number.” Another advantage of the random effect model is
that the model assumes exogeneity in all regressors in the model. The test runs in the
following form:

LLit = γit + δit Ln(Issuanceit) + ηit Ln(Couponit) + ρit Ln(Maturityit)

+ σit Ln(Ageit) + πit Ln(Ratingit) + uit (2)

Where:

LLit = Latent liquidity for each sukuk i at time t

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 Issuanceit = Issuance amount for each sukuk i at time t

Couponit = Coupon rate for each sukuk i at time t

Maturityit = Maturity period for each sukuk i at time t

Ageit = Age of each sukuk i at time t

Ratingit = Credit rating for each sukuk i at time t

γit , δit , ηit, ρit, σit and πit are the coefficients for each parameter in the variables.

uit = error term

The term i refers to the cross-section included, while t denotes the number of years the
observation is made in the study. All the independent variables in the model are run in logged
form because the semi-log model gives the best estimation of result for our regression.

4. Data

Over the counter (OTC) trading involves no central market place or a clearing house;
this makes data on the traded prices and volume not readily available. Even though the bond
market is a very interesting market to study the liquidity of, data unavailability has become a
major constraint for research. This is further worsened when one attempts to study a fraction
of a medium-sized bond market like Malaysia. A lower liquidity level associated with a
smaller potential investor base is mentioned by Petrasek (2012) in his study on the
multimarket trading effect on liquidity and pricing.

4.1 Malaysia Islamic bond database

The study uses sukuk data from the Malaysia bond market. This is the third largest
bond market in Asia (excluding Japan) and is the biggest issuer of sukuk in the world. At the
end of 2010, the Malaysian bond market stood at RM763.4 billion, approximately 97% of
total GDP. Globally, the sukuk market has been enjoying tremendous growth, with an

6
average annual growth rate of 40%. At the end of 2008, sukuk issuance was reported to be
USD14.9billion, with Malaysia’s representing 61% of this figure. This undoubtedly makes
Malaysia’s sukuk market an interesting venue to place this study in. All the data in this study
is taken from Bond Infohub, Bank Negara Malaysia’s website specifically for bond-related
issues. However, some transaction data are not readily available in the database, and this
requires the use of other proxy that does not rely highly on transaction data.

4.2 Liquidity proxies

4.2.1 Issuance amount

This study used the issuance amount to measure the liquidity because the issuance
amount is among the most important liquidity determinants tested by Howeling et al. (2005).
Houweling et al. (2008) quote a claim by Fisher (1959) that says bonds with large issues
should trade more often; hence the issued amount is actually a proxy for the direct liquidity
measure of trading volume. Following past literatures, Houweling et al. (2008) predicts a
positive effect of issued amount on liquidity. This is further supported by Amihud and
Mendelson (1991) who argue that bonds with smaller issued amounts tend to get locked in
buy-and-hold portfolios. Similarly, Mahanti et al. (2008) find a strong correlation between
liquidity and huge issuance amount. However, the liquidity level is found to diminish with the
bond’s issuance amount. Instead of the issuance amount, Friewald et al. (2012) claim the
most important proxy for liquidity is the outstanding amount variable, in which a high
outstanding amount is found to indicate a higher liquidity level.

4.2.2 Coupon rate

We tested the coupon rate as one of the determinants of liquidity. Although Mahanti et
al. (2008) could not find any clear relationship between coupon rate and a bond’s liquidity
level, the coupon rate is assumed to have a positive relationship with liquidity. No clear
pattern could be recorded between coupon rate and latent liquidity, because coupon effects
are confounded by credit rating, age, maturity and issue date. Strong correlations between
coupon rate and these bond characteristics have eased out the effect of the coupon on the
bond’s liquidity. In contrast, a study by Friewald et al. (2012) on liquidity during the
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subprime crisis shows that the coupon variable in their study indicates higher liquidity for
bonds with lower coupon bonds; therefore this prompts a negative relationship between the
two variables.

4.2.3 Credit rating

Consistent with Mahanti et al. (2008) and Friewald et al. (2012), we also expect the
liquidity effect of speculative grade bonds to be more pronounced. Comparing the two bond
grades during two sub-periods of financial crisis, Friewald et al. (2012) conclude the higher
liquidity level shown by the speculative bonds is due to the interaction between credit and
liquidity risk, in which the effect of the interaction is recorded to be much stronger during a
subprime crisis. Further support is shown by Dick-Nielsen et al. (2012) in their study on bond
liquidity before and after the subprime crisis, in which they also find liquidity dries out during
a subprime crisis. Dick-Nielsen et al. (2012) also see a larger liquidity component for lower
bond rating quality.

4.2.4 Sukuk age

We also used the sukuk age to measure the liquidity, as Mahanti et al. (2008) and
Houweling et al. (2005) both propose a negative relationship between a bond’s age and its
liquidity level. Older bonds get traded less often, and this indicates falls in their liquidity
levels. A bond’s latent liquidity is observed to reach is peak when a bond is just issued
according to Mahanti et al. (2008). Later, the latent liquidity falls steadily after issuance until
the bond reaches maturity. Commonly, bonds are initially placed into high turnover funds, but
later they are in lower turnover funds with decreasing liquidity. On the other hand,
Houweling et al. (2005) argue that the relationship between age and liquidity level is
negative. According to McGinty’s (2001) proposition, new issues are typically under-priced
so traders buy bonds after the offering and sell them afterwards.

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4.2.5 Sukuk maturity

According to Fabozzi (2000), the maturity term of a bond is important because the
volatility of a bond’s price is dependent on its maturity. Dick-Nielsen et al. (2012) propose
that the liquidity component rises proportionally with the increments of the bond’s maturity.
They find approximately a two-fold difference for bond premiums in basis points for long
maturity bonds compared to short maturity bonds. However, the opposite finding has been
recorded by Mahanti et al. (2008), with longer time-to-maturity bonds’ resulting in lower
latent liquidity levels. Bonds with 5 or 7 years of maturity have greater latent liquidities than
those with 10 or 30 years. Mahanti et al. (2008) reason this negative relationship is due to the
long-term buy-and-hold investors. Often, insurance companies which hold a substantial
amount of total bonds outstanding match their long-dated liabilities with equally long-dated
assets. Once they find these assets, they tend to lock in the buy-and-hold positions of the
assets. Similarly, cross-section analysis on bond characteristics by Friewald et al. (2012) also
find longer maturity bonds contribute less liquidity during both normal and crisis periods.

5. Results

5.1 Comparative analysis of Malaysia Islamic bond database

Sukuk comprises about 37% of the total market holdings in the Malaysian bond
market. This bond’s remarkable growth has given it a promising effect on Malaysia’s
economy. This paper provides some evidence of sukuk’s significant existence in the entire
Malaysian bond market. Table 1 presents the composition of sukuk and conventional bond as
compared to the entirety of that bond market. The comparison is based on the outstanding
amount of bonds from 2007 to 2012. In Table 1, the outstanding amount of sukuk represents
about 35.78% of the whole bond market, as compared to 64.22% by conventional bonds in
2007. Sukuk’s market composition rises nearly sixteen percent within those five years. On the
other hand, as a result of the rising composition of sukuk, conventional bonds suffer a
decreasing trend every year and reach a low of 58.36% in 2011.

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Table 1: Composition of sukuk and conventional bond outstanding in Malaysian bond market, 2007-2011
Composition of conventional bond Composition of sukuk outstanding in the
Year
outstanding in the market (%) market (%)
2007 64.22 35.78

2008 63.93 36.07

2009 61.41 38.59

2010 61.46 38.54

2011 58.36 41.64

Source: Bank Negara Malaysia (2012)

Table 2 shows the increasing issuance volume of sukuk from a mere RM10 billion in
2007 to RM36 billion in 2011. Sukuk issuance’s composition of the market has also shown a
tremendous growth from 18.49% in 2007 to 38.58% in 2011. The almost four-fold increment
(from RM10 billion to RM36 billion) shows sukuk’s issuance makes up almost half of the
total market issuance, which further supports our claim that the sukuk market in Malaysia is
significance enough to warrant further study.

Table 2: Growth of conventional and Islamic bond issuance composition in the market, 2007-2011

Conventional bond Sukuk issuance as

Conventional & Conventional Sukuk
issuance as percentage of
Year sukuk issuance bond issuance issuance
percentage of total Total issuance
(MYR ‘mill) (MYR ‘mill) (MYR ‘mill)
issuance (%) (%)
2007 54,080.89 44,080.89 81.51 10,000.00 18.49
2008 60,000.00 43,500.00 72.50 16,500.00 27.50
2009 88,500.00 60,000.00 67.80 28,500.00 32.20
2010 58,100.00 37,100.00 63.86 21,000.00 36.14
2011 93,312.35 57,312.35 61.42 36,000.00 38.58
Source: Bank Negara Malaysia (2012)

This study also analyses the outstanding amount of sukuk as a composition of

Malaysia’s Gross Domestic Product (GDP). Sukuk’s outstanding amount contribution to
GDP drops slightly in 2008 before its increasing tremendously from 2009 onwards. The
negative growth in 2008 is inferred to be caused by the financial crisis in that year.. However,
sukuk is indeed playing a bigger role in the Malaysian bond market and the economy as a
whole.

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Table 3: Composition of sukuk outstanding amount over GDP (%), 2007-2011

Year GDP Size (RM ‘mil) % GDP

2007 642,048.00 199,445.58 31.06
2008 740,906.00 211,369.03 28.53
2009 679,688.00 248,471.05 36.56
2010 765,966.00 294,186.06 38.41
2011 852,734.00 350,242.21 41.07
Source: Bank Negara Malaysia (2012)

Table 4 shows a high market presentation by sukuk according to its rating between
2007 and 2008 (24.69% and 12.76%), followed by lower market presentations in the
following years. Overall, sukuk is not deemed to represent the whole market, especially in
2009 when sukuk’s composition falls to a mere 1.42%. However, if we look at every bond
class, sukuk indeed proves to reasonably represent the market. For example, in 2007 sukuk
comprises 36.65%, 2.16% and 71.70%, respectively, of the total bond market for AAA, AA
and A bonds. The same observation can be seen until 2011. The reason behind these figures is
that sukuk bonds are only issued as investment bonds and rarely as speculative bonds, in line
with the prohibition of usury (riba) in Islamic law. Hence the low total market representation
by sukuk is caused by its non-involvement with BBB or lower grade bonds. Nevertheless, a
notable decrement in 2009 shows that the hostile conditions of the global financial system
have affected the performance of the sukuk market.

Table 4: Composition of sukuk outstanding amount in the market by credit rating, 2007-2011
Sukuk outstanding amount as percent of total outstanding amount (%)
Rating
2007 2008 2009 2010 2011
AAA 36.65 0.00 0.00 8.08 0.00
AA 2.16 11.15 0.00 7.33 6.75
A 71.70 46.45 7.97 0.00 57.67
BBB and below 0.00 0.00 0.00 0.00 0.00
Total 24.69 12.76 1.42 7.47 6.53
Source: Bank Negara Malaysia (2012)

Table 5 presents the statistics for sukuk outstanding amount in the market from 2007
to 2011 based on maturity and shows this type of bond as being issued as long-term (greater
than one year). The shortest maturity offered by sukuk is two years (in 2010) and the maturity
period can go as high as 50 years (in 2007). Most sukuk buyers tend to buy and hold the asset
until the maturity date in order to amortise its return. Generally, sukuk bonds are reasonably

11
representative for most segments in the market, as the percentages for five to thirty year
maturity segments are high.

Table 5: Composition of sukuk outstanding amount in the market by time to maturity, 2007-2011

Sukuk as percent of total (%)

Time to
maturity 2007 2008 2009 2010 2011

< 1 Year 0.00 0.00 0.00 0.00 0.00

2 Years 0.00 0.00 0.00 33.33 0.00
3 Years 0.00 0.00 21.43 27.40 0.00
4 Years 0.00 49.33 76.92 37.50 0.00
5 Years 28.57 49.01 43.48 32.61 7.14
6 Years 35.11 55.38 90.91 45.83 16.67
7 Years 31.52 53.44 50.00 37.04 5.26
8 Years 27.91 61.06 100.00 58.33 16.67
9 Years 25.00 60.75 80.00 83.33 16.67
10 Years 18.75 65.00 42.86 30.77 12.50
11-15
14.41 68.91 70.00 0.00 11.63
Years
16-30
17.65 91.00 33.33 0.00 11.76
Years
> 30 Years 100.00 0.00 0.00 0.00 0.00
Total 23.71 62.24 56.00 34.83 7.48
Source: Bank Negara Malaysia (2012)

After discussion about the significance of sukuk in the Malaysian bond market, this
paper will conduct an analysis on the liquidity level of this type of bond based on the
available transaction data. Table 6 provides data on the average daily volume of Islamic
bonds as a percentage of the market’s daily average volume from 2007 to 2011. In the table,
the average daily volume of sukuk makes up 1.09% of the total market daily average. In
2007, the sukuk daily average is higher than the average of 1.09%, and then it begins to
fluctuate around the average value in 2008 until the middle of 2010.

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Table 6: Comparison of monthly trade volume between Islamic Bonds compared to whole market, 2007-2011

Market total Islamic bond Average daily

volume of
Year Month Total Daily Average Daily Average (over Islamic bond
Volume
Volume (over number of number of days in (as percent of
(million)
(million) days in month) month) market)
2007 January 120,494.68 3886.93 1800.56 58.08 1.49
February 101,738.03 3633.50 2124.00 75.86 2.09
March 150,538.30 4856.07 1878.55 60.59 1.25
April 107,155.39 3571.85 1021.26 34.04 0.95
May 116,218.51 3748.98 1238.20 39.94 1.07
June 96,443.27 3214.78 1594.10 53.14 1.65
July 81,523.79 2629.79 2297.28 74.11 2.82
August 89,895.79 2899.86 2230.95 71.97 2.48
September 86,066.25 2868.88 2247.48 74.92 2.61
October 90,379.21 2915.46 2912.20 93.94 3.22
November 71,744.64 2391.49 1252.80 41.76 1.75
December 82,610.39 2664.85 1605.44 51.79 1.94
2008 January 121,744.85 3927.25 817.50 26.37 0.67
February 100,555.69 3467.44 422.40 14.57 0.42
March 99,188.89 3199.64 379.20 12.23 0.38
April 130,212.14 4340.40 1400.10 46.67 1.075
May 102,427.58 3304.12 432.30 13.95 0.42
June 119,063.55 3968.79 513.40 17.11 0.43
July 109,073.91 3518.51 1090.84 35.19 1.00
August 117,782.80 3799.45 584.95 18.87 0.49
September 135,517.72 4517.26 1396.13 46.54 1.03
October 115,287.02 3718.94 1366.76 44.09 1.19
November 89,060.23 2968.67 661.97 22.07 0.74
December 72,366.97 2334.42 1212.90 39.13 1.68
2009 January 79,339.17 2559.33 206.00 6.65 0.26
February 84,277.56 3009.91 541.85 19.35 0.64
March 80,374.56 2592.73 887.20 28.62 1.10
April 93,452.90 3115.09 469.80 15.66 0.50
May 79,186.10 2554.39 488.95 15.77 0.62
June 82,985.24 2766.17 814.00 27.13 0.98
July 88,754.90 2863.06 938.00 30.26 1.06
August 82,322.17 2655.55 1069.65 34.50 1.29
September 85,259.57 2841.99 774.52 25.82 0.91
October 89,147.53 2875.73 597.80 19.28 0.67
November 75,590.54 2519.68 552.20 18.41 0.73
December 81,588.47 2631.89 1343.15 43.33 1.65
2010 January 93,929.36 3029.98 608.80 19.64 0.65
February 64,835.95 2315.57 741.66 26.49 1.14
March 126,209.77 4071.28 1439.50 46.44 1.14

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 April 128,563.10 4285.44 993.75 33.13 0.77
May 99,308.48 3203.49 647.75 20.89 0.65
June 91,806.32 3060.21 1126.00 37.53 1.23
July 106,525.50 3436.31 702.70 22.67 0.66
August 106,103.41 3422.69 783.15 25.26 0.74
September 112,921.64 3764.05 7464.31 248.81 6.61
October 122,913.09 3964.94 1818.43 58.66 1.48
November 106,407.54 3546.92 299.85 9.99 0.28
December 96,433.46 3110.76 1300.34 41.95 1.35
2011 January 128,220.18 4136.13 2292.80 73.96 1.79
February 98,635.78 3522.71 2043.90 72.99 2.07
March 187,563.62 6050.44 1360.65 43.89 0.73
April 170,874.98 5695.83 1689.75 56.33 0.99
May 151,605.20 4890.49 1057.50 34.11 0.69
June 166,497.02 5549.90 587.15 19.57 0.35
July 164,923.58 5320.12 1113.26 35.91 0.68
August 207,471.24 6692.62 763.25 24.62 0.37
September 238,286.48 7942.88 1102.65 36.76 0.46
October 133,688.84 4312.54 589.05 19.00 0.44
November 122,343.17 4078.11 336.30 11.21 0.27
December 135,834.05 4381.74 918.05 29.61 0.68
Total 6,671,270.07 3655.490449 72944.94 39.96983014 1.09

Source: Bank Negara Malaysia (2012)

Table 7 provides data on the Islamic bond market liquidity based on trading frequency
to show the illiquidity of the Malaysian Islamic bond market. Due to data constraint, an
assumption is made that the frequency of transaction refers to the day of transaction. Trading
frequency drops from 2007 to 2011, despite the economy’s entering the post-crisis period in
2010. Such decrease can be caused by the sharp fall of sukuk issuance in 2008 to 2009 (see
Table 4); this reduces the amount of available sukuk and its trading. Across the year, no bond
transacts more than 200 times, and this is out of almost 1.200 sukuk bonds analysed in the
study. A large proportion of the sukuk (over 50%) trades at least once a year. With this
finding, Malaysia’s Islamic bond market can be viewed as illiquid and any measure of
liquidity that uses daily trading data is not appropriate to be used in this segment of the bond
market. Hence, using latent liquidity technique to measure the level of liquidity in this study
is a good idea because latent liquidity does not require daily trading data in its calculation.

14
Table 7: Sukuk trade distribution by frequency of trading, 2007-2011

Frequency of trading
(times/year) 2007 2008 2009 2010 2011
>200 0 0 0 0 0
150-200 2 0 0 0 0
100-150 0 2 0 0 0
50-100 2 1 2 3 6
30-50 8 1 1 3 3
10-30 75 24 23 27 29
5-10 70 43 40 40 47
at least 1 and at most 5 173 155 116 118 95
No trade 0 0 0 0 0
Total 330 226 182 191 180
Source: Bank Negara Malaysia (2012)

Table 8 provides an overview of sukuk trading distribution in ten industries in

Malaysia from 2007 to 2011. Sukuk is being traded in almost all industries in Malaysia
except for mining. . Construction industry is the most active industry involved with sukuk.
This is not surprising as most sukuk are issued to fund construction and development
processes. Despite the growing outstanding amount and issuance volume, the number of
sukuk trading decreases gradually from 2007 to 2011. This phenomenon could be attributed
to the reduction in sukuk issuance in 2008 and 2009 as compared to 2007; consequently, the
level of trading of the available sukuk falls.

Table 8: Sukuk trade distribution, based on ten industries in Malaysia, 2007-2011

Transaction
Industry 2007 2008 2009 2010 2011
Consumer product 3 2 0 2 0
Industrial product 27 25 18 17 18
Mining 0 0 0 0 0
Construction 109 86 69 92 75
Trading/services 45 32 27 10 10
Properties 27 15 11 8 18
Plantation 6 1 7 0 1
Technology 3 2 0 9 11
Infrastructure 76 46 40 36 27
Finance 21 15 11 18 19
Total 317 224 183 192 179
Source: Bank Negara Malaysia (2012)

15
 From the discussion of comparative analysis in this section, several conclusions can
be made in regards to the overall sukuk market in Malaysia. First, sukuk has become an
integral component of the economy with the increasing levels of issuance and outstanding
amounts over the years. This is further supported by the rising composition of sukuk as a
percentage of GDP in Malaysia. Second, the sukuk market is indeed illiquid as its trading
frequency is very low, with average trading’s occurring one to five times a year. This
supports our choice of liquidity measurement in the paper.

5.2 Characteristics of sukuk latent liquidity

From all 1200 sukuk bonds studied, this paper continues to further analyse sukuk
bonds which maintain their trading consistency throughout the sample period. As such, the
following two subsections will cover the analysis of the consistently trading sukuk. Figure 1
provides distribution analysis on latent liquidity generated for sukuk in the Malaysian bond
market. A high proportion of latent liquidity concentrates between the values of 0.00 to
0.0025, while the rest of the liquidity falls scattered between 0.0025 and 0.035. The
maximum latent liquidity value recorded is 0.037258, while the minimum value is 0.0000269.
The mean value falls relatively closer to the minimum value, at 0.001182. This figure
indicates that the low liquidity values shown in the figure are no surprise given the severity of
the liquidity level in the Malaysian sukuk market.

16
 70
Series: LL
60 Sample 2007 2012
Observations 72
50
Mean 0.001182
Median 0.000237
40 Maximum 0.037258
Minimum 2.69e-05
30 Std. Dev. 0.004624
Skewness 6.908176
20 Kurtosis 53.26118

Jarque-Bera 8151.232
10
Probability 0.000000
0
0.000 0.005 0.010 0.015 0.020 0.025 0.030 0.035

Figure 1: Distribution analysis on latent liquidity, 2007-2012

Source: Bank Negara Malaysia (2012)

Segregating the generated latent liquidity into each cross section in the study enables
a closer observation of the latent liquidity level for each sukuk. Graphs’ plotting the latent
liquidity time series from 2007 to 2011 in Figure 2 shows the trends for each respective bond.
Out of the twelve graphs, five graphs show a sharp fall in latent liquidity in 2009. However,
five other sukuk bonds show much earlier liquidity falls in 2008. Miraculously, two sukuk
show increments in their latent liquidity levels during the crisis period of 2008 to 2009.
Malaysian sukuk bonds have also suffered the effects of the liquidity breakdown in 2008.
After going through the turbulent years of 2008 and 2009, eight sukuk bonds suffer another
fall in 2010 and 2011, while almost all sukuk transcend to higher liquidity levels in 2012. The
fall in sukuk’s liquidity level during 2008’s financial crisis is compatible with findings by
Jankowistch et al (2012). They also recorded a drop in trading activity by American bonds in
terms of the number traded and trade volume during that same time period.

17
 Latent Liq uidity
1 2 3 4
.0004 .0005 .0005 .00035

.00030
.0003 .0004 .0004
.00025

.0002 .0003 .0003 .00020

.00015
.0001 .0002 .0002
.00010

.0000 .0001 .0001 .00005

2007 2008 2009 2010 2011 2012 2007 2008 2009 2010 2011 2012 2007 2008 2009 2010 2011 2012 2007 2008 2009 2010 2011 2012

5 6 7 8
.04 .0028 .00007 .0010

.0024
.00006 .0008
.03
.0020

.0016 .00005 .0006

.02
.0012 .00004 .0004
.0008
.01
.00003 .0002
.0004

.00 .0000 .00002 .0000

2007 2008 2009 2010 2011 2012 2007 2008 2009 2010 2011 2012 2007 2008 2009 2010 2011 2012 2007 2008 2009 2010 2011 2012

9 10 11 12
.0006 .0010 .0006 .0016

.0005 .0005
.0008
.0012
.0004 .0004
.0006
.0003 .0003 .0008
.0004
.0002 .0002
.0004
.0002
.0001 .0001

.0000 .0000 .0000 .0000

2007 2008 2009 2010 2011 2012 2007 2008 2009 2010 2011 2012 2007 2008 2009 2010 2011 2012 2007 2008 2009 2010 2011 2012

Figure 2: Trend of latent liquidity according to individual cross sections, 2007-2012

Source: Bank Negara Malaysia (2012)

5.3 Determinant drivers of sukuk liquidity

From the latent liquidity generated in the previous section, the study continues to find
the determinant drivers of sukuk’s liquidity level in the Malaysian market. Ascertaining the
liquidity determinants is the second objective of the study. The findings are believed to be
able to pave ways for improvement in the Malaysian sukuk market. The determinants are
believed to display the preference and behaviour of sukuk investors in the Malaysian market
because the study specifically focuses on this particular market. This enables sukuk issuer to
better comprehend the sukuk buyers, while they ease the government in their quest to make
Malaysia a global Islamic financial hub.
Determining the liquidity drivers for sukuk in this study involves a random effect
regression model. According to Jankowitsch et al. (2011), the most important liquidity
proxies are the amount issued, maturity, age, rating, bid-ask spread and trading volume.
Latent liquidity is regressed against sukuk’s time to maturity, issuance amount, coupon value,
rating and age as the independent variables. All data used are in the form of yearly data, from

18
2007 to 2012. The rating variable uses RAM’s rating, in which the AAA bond is weighted as
1, Aa1 as 2, Aa2 as 3, Aa3 as 4 and Baa downwards as 5. The Random Effect (RE) regression
model is used for estimation after performing the specification tests to determine whether
pooled regression (the Breusch-Pargan LM test) or the Fixed Effect models (the Hausman
Test) suffice.

Based on the random effect model above, a summary of the regression results
intended to determine the factors affecting sukuk’s liquidity level in Malaysia market is
presented in Table 9. From these reported results, liquidity is correlated with two independent
variables (issuance amount and maturity) at the 0.05 significance level, while two other
variables (coupon rate and age) are found to be significant determinants of sukuk’s liquidity
level at the 0.10 significance level. The credit rating variable is not significantly correlated to
sukuk’s liquidity. Consistent with theoretical expectation, the issuance amount of sukuk is
positively associated with sukuk’s liquidity level. The coefficient is statistically significant at
the 5% level; this suggests its importance in affecting sukuk’s liquidity. This is consistent
with Houweling et al. (2005) who relate the issuance amount to an indication of bond’s
liquidity. They support their stand by stating that most banks have been using issuance
amount as the liquidity criterion in building their bond indices.

Table 9: Random effect regressions for the drivers of liquidity

Ln (Issue Ln
C Ln (Coupon) Ln (Maturity) Ln (Age) R2
Amount) (Rating)

-0.028319 0.002475 -0.001136 -0.005398 -0.001470 -0.000625 0.350199

[0.0428]* [0.0444]* [0.0613]** [0.0440]* [0.0830]** [0.1180]

Source: Bank Negara Malaysia (2012)

* significant at the 5% level
** significant at the 10% level

Second, the coupon rate seems to be the statistically significant liquidity determinant
for sukuk at the 0.10 significance level, in which the coupon rate has a negative relationship
with the liquidity level. Similarly, coupon rate has also been proven to be a significant
determinant of liquidity level by Mahanti et al. (2008) and Friewald et al. (2012). In the
explanation of the inverse correlation, we make an assumption that sukuk investors are more
19
likely to lock in buy-and-hold activities when the coupon rate is high in order to amortise the
return. This in turn reduces the tradable amount of sukuk and, consequently, lowers its
liquidity level. Mahanti et al. (2008) can’t find any clear relationship between coupon and
liquidity and infer a positive relationship between the two variables. A vibrant market can
make bonds with high coupon rates be deemed as lucrative and more tradable. However, the
contrasting relation between sukuk coupon rate and the liquidity level in the study could also
be due to the confounding effect that the coupon rate imposes on liquidity, in which investors
consider other factors instead of coupon rate.

Third, the maturity of sukuk is found to be significant at the 0.05 significance level.
This finding shows consistency with Friewald et al. (2012) but differs from Mahanti et al.
(2008), who proclaim maturity as an insignificant liquidity determinant. Sukuk maturity in
this study also appears to be inversely related to liquidity. This implies that the longer the
sukuk’s maturity is, the lower the liquidity level of the sukuk. This is in line with the nature
of investment, where an asset with a shorter maturity is more liquid. Again, the buy-and-hold
nature of investors (such as insurance companies) who are keen to lock their long maturity
bonds to match their long term liabilities are believed to be the key factor for the decreasing
liquidity issue of longer-term bonds. However, from another point of view, we can say that a
bond with a short maturity is less risky as compared to a longer maturity one. This is because
a small difference in coupon value or bond yield can cause a bigger effect on bonds with
longer maturity levels as compared to bonds with shorter maturity levels.

The results further indicate that the age of sukuk is significant at the 0.10 level and
negatively related with liquidity. This suggests that sukuk’s liquidity level decreases as the
age of sukuk increases. This is consistent with Houweling et al. (2005) who conclude that as
a bond gets older, an increasing percentage of the issued amount is absorbed in the investor’s
buy-and-hold portfolio A bond’s on-the-run characteristic gives an explanation for the sukuk
high liquidity level right after the issuance date and a relatively low liquidity level after some
period of time as the bond become off-the-run.

Moreover, the results from Table 9 also reveal that the credit rating of sukuk is not a
significant driver of sukuk’s liquidity in this study, in contrast to Mahanti et al. (2008) who
find rating to be a significant liquidity driver. The possible explanation for this finding is as
follows: Sukuk bonds are commonly issued as good quality bonds, and this makes the rating

20
have little effect on investors’ investment decisions. On the other hand, a sukuk bond’s credit
rating is shown to be inversely related to liquidity level. In regressing the rating variable, the
higher credit class is being given a weightage of 1 and the weightage gets larger for lower
credit classes. Hence, the negative outcome is somewhat expected for the sukuk market.
Sukuk bonds are mainly issued for investment purposes; thus most of them are rated from
Aaa to A. Bbb and lower grade bonds are considered to be speculative bonds. One of the
main elements in Shariah law is the prohibition of Riba, which bars the manipulation of the
interest rate in assets. Sukuk’s being issued as speculative bonds is rare.

In summary, four bond characteristics—issuance amount, maturity, coupon rate and

age—are significantly related to sukuk’s liquidity level in the Malaysian bond market. On the
other hand, one variable—the credit rating—is statistically insignificant; thus it is not a
significant influence in driving sukuk’s liquidity level. The direction of correlation between
issuance amount, maturity, age and credit rating variables towards liquidity is consistent with
past literature. However, coupon in term of sukuk is contrary to the bond’s naturally positive
characteristics towards liquidity. This is explained by the behaviour of sukuk investors who
favour a buy-and-hold strategy in their investment decisions. Investors favour holding sukuk
bonds with higher coupon values in order to amortise returns.

6. Summary

This paper uses a liquidity measure introduced by Mahanti et al. (2008) and applies it
to the sukuk market in Malaysia. Latent liquidity is more applicable to the Malaysian sukuk
market for its non-reliance on transaction data in comparison to other liquidity measures. The
trends of the sukuk market are illustrated in this paper, along with an analysis of the liquidity
level in the market based on trading amount data. Latent liquidity measure is tested across
five basic bond characteristics in order to determine the drivers of sukuk’s liquidity level.
Four variables (issuance amount, maturity, coupon rate and age) are found to be significant
determinants of sukuk’s liquidity level, with an exception for the credit rating variable.

Sukuk issuance amount is found to be significant and positively related to liquidity, in

accordance to most empirical research conducted prior to this study. The same could not be
said for the rating variable, which is shown to have an insignificant negative effect on

21
liquidity level. This negative correlation is actually expected because sukuk bonds are being
widely issued as investment bonds rather than as speculative ones. Hence, investors are less
keen on sukuk’s rating in deciding on trading this type of bond, as all sukuk do not differ
much in terms of rating. Given the weightage used in this study in which AAA grade bonds
are weighted as 1, AA bonds as 2 and A bond as 3, an inverse relationship between the
independent variable and the dependent variable is somewhat within expectation.

On the other hand, the coupon rate displays a significant negative effect on sukuk
liquidity level. This is due to investors’ attitude towards and behaviour in regards to sukuk,
where investors prefer to keep this type of bond instead of selling it in order to amortise the
return. This causes sukuk’s liquidity to fall, as illustrated by the result. Meanwhile, sukuk
maturity shows a significant negative correlation with sukuk liquidity level, in compliance
with past literature. Longer maturity sukuk bonds lead to less liquid sukuk conditions due to
investors’ tendency to hold longer term sukuk. Another negative significant determinant of
sukuk liquidity level is age, where sukuk bonds are less liquid after some period of time due
to the off-the-run factor. Still, we can see that time-related characteristics of sukuk play a
significant role in influencing the liquidity level.

With the increasing demand for Islamic products, the study of Islamic financial
products will contribute considerably toward future research on this topic. This study is
believed to pave the ways for future studies’ pertaining to the liquidity level of Islamic assets,
as opposed to conventional assets found in much existing literature. Further research can also
be done to determine the driver of liquidity level by adding more variables such as interest
types, options attached to the bonds and many more innovative bond characteristics as the
market becomes more advanced.

22
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