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The roots of Sukuk in Malaysia are embedded in the Islamic banking and financial system. It began in 1973 with the establishment of Tabung Haji (Pilgrims Fund), the country’s first Islamic financial institution.
A decade later, with the enactment of the Islamic Banking Act 1983, Bank Islam Malaysia became the first full-fledged Islamic commercial bank in Malaysia. In 1993, the government took another bold step and introduced the Interest Free Banking Unit (IBU), which is an Islamic window within existing commercial banks. IBU allows the parallel existence of conventional and Islamic banking systems in a bank.
Other infrastructure set up to support the Islamic banking system included the Sukuk financing and Islamic interbank money market. The Islamic money market was established in 1994 as the final major requirement for a complete Islamic banking system.
It currently serves as a place to trade Islamic financial instruments. In addition, the establishment of a National Shariah Council, a single source of reference to advice on the legality and compliance of Islamic financial instrument transactions with the Shariah, streamlined the development process.
The first Sukuk issuance in Malaysia was for Shell MDS in 1990. A syndicate of financiers arranged a Bai Bithaman Ajil transaction of RM75 million (US$22 million) for a tenure of five years, and another RM50 million (US$14.73 million) for eight years.
The next notable development was the RM300 million (US$88.42 million) Sukuk issuance by Petronas Dagangan in 1994. The first Sukuk in Malaysia to be rated, it was assigned a long-term AA1 rating by Rating Agency Malaysia (now known as RAM Rating Services) in February 1994. It was also the first Islamic instrument to be listed on the Kuala Lumpur Stock Exchange (now Bursa Malaysia).
The Islamic financial market is one of the fastest-growing capital pools, and is quickly being drawn into the mainstream of the financial system. The Malaysian Sukuk market has successfully outgrown its infancy phase.
The viability of Islamic finance is no longer an issue as the success of the domestic Sukuk market within a short period is testimony of the widespread acceptance of Islamic financing principles in the country. In Malaysia, Sukuk constituted 34.24%, or RM212.11 billion (US$62.5 billion) of RM619.53 billion (US$182.58 billion) total outstanding debt securities as at the 30th June 2008.
Sustaining such growth requires a good legal and price discovery mechanism to enable market participants to be updated on valuation levels and their rights. In this regard, Malaysia has a good legal framework in place, which has shown its impartiality. However, the issue of valuation remains a grey area.
In marking-to-market using market price, the last transacted price of the instrument is taken. Market price is reliable only in an efficient market where information infrastructures are established and liquidity is sufficient. In the bond and Sukuk markets, less than 1% of bonds is traded on a daily basis.
Furthermore, bonds and Sukuk that were traded may encounter the next trade only after several weeks or months. Hence, the last traded price may no longer reflect the bond’s true value as certain pricing factors, such as interest rate and credit environment, have lapsed.
Due to the low level of liquidity in the bond and Sukuk markets compared to the equity market, the ability of players to obtain market prices is extremely difficult.
Moreover, the “non-independence” of traditional sources of bond and Sukuk prices in Malaysia, as well as the lack of a comprehensive set of rules and regulations regarding the origination and usage of generated bond and Sukuk prices, create a situation of information asymmetry between market players.
Despite the market growing to a substantial size, the ability of market players to obtain independent pricing as well as to compare and evaluate the portfolio performance of fund managers comes close to impossible. To eliminate this impediment to the bond and Sukuk markets, the Securities Commission of Malaysia (SC) decided to create a new capital market infrastructure: the bond pricing agency.
The beginning
Bond Pricing Agency Malaysia (BPAM) is the first such agency in the country to deliver pricing exclusively on the ringgit bond market. The private sector-led initiative was developed with the support of key bond market players to complement the government’s objective of building a more efficient, sophisticated and liquid bond market.
BPAM delivers systematic valuations for nearly 2,000 unlisted bonds daily. The company’s alliances with over 17 local business partners ensure market movements are captured in its pricing database faster than any available source. This will enable market players to facilitate finer price discovery, spur trading activity, enhance risk management and optimize capital allocation.
For now, BPAM has more than 70 institutions as its clients (including unit trusts, asset managers, banking groups, insurers, statutory bodies and corporations), and more than 2,000 users worldwide as registered users on its website.
The agency conducts daily mark-to-market pricing on all long-term rated ringgit-denominated bonds and Sukuk, including rating-exempted government and quasi-government bonds. Mark-to-market is an act of providing a price that is market relevant and may be done via fair valuation or taking the market price.
BPAM’s pricing methodology is in compliance with regulatory policies such as those stipulated in the “Guidelines on the Registration of Bond Pricing Agencies”. Research and development began in 2001 while operations commenced in August 2005.
BPAM achieved its status as a bond pricing agency in April 2006. The methodology was evaluated by market players from diverse backgrounds such as regulators, unit trusts, asset managers, banking groups and insurers, and it successfully gained mutual acceptance and regulatory approval from the SC.
Generally, the entire pricing process is a daily yield adjustment exercise. Other input that affect price calculations such as bond specifications and ratings are extracted from the bond’s terms and conditions sheet. Input is refined by the issuance date from official sources.
In most cases, these parameters are either static or have scheduled adjustments in the future. In the event there are sudden changes to these parameters, a downgrade for instance, the impact of the changes then will be immediately reflected in the bond price once public announcements are made.
Fair valuation for Sukuk market
Under Islamic economics and finance, scholars have broadly defined the concept of gharar in two ways: Gharar implies (i) uncertainty; and (ii) deceit.
The Quran has clearly forbidden all business transactions that cause injustice in any form to any of the parties. It may be in the form of hazard or peril leading to uncertainty in any business, or deceit, fraud or undue advantage.
Apart from the above simplistic definition of gharar, some definitions seem to have a parallel in the concept of uncertainty in conventional finance. Gharar is defined by the Hanafi jurist al-Sarakhsi as “any bargain in which the result of it is hidden”.
With this context in mind, the lack of a price discovery mechanism for the Sukuk market provides an avenue for gharar to occur. The ability to transact and gain from having an advantage in information causes injustice and this is something that should not be allowed in Islamic finance.
Therefore, the goal of creating an efficient market should be seen as an important duty for everyone who professes to aspire to the ideals of Islamic finance. Only in an efficient market would the ability of certain players to record supernormal profit be minimized as all market players would have the same market information.
Having an independent body to generate a calculated price is the next best thing in the absence of direct market prices. Using a transparent methodology and following strictly the concept of consistency, such an entity could provide players with a good reference to evaluate its bond and Sukuk portfolios. In the Malaysian context, this is usually referred to as fair valuation.
In fair valuation, a methodology is used to provide a rational and unbiased estimate of the potential market price. Fair valuation methodologies include using recent arm’s-length market transactions and relative comparison with peers and benchmarks in deriving an instrument’s estimated current price. It must demonstrate that the estimated prices are reliably close to actual market transactions.
However, it must be mentioned here that the evaluated prices or fair valuation should not be mistaken as a proxy for trading prices. It is not meant to be used as the only definite price to which a transaction should be concluded, but as a reference for valuing bonds in the absence of a definitive market price.
Another compelling reason why it is best to get an independent professional entity to do the valuation is the fact that the Sukuk market (like the bond market) is a professional market. From 2004 until end-2007, the Malaysian Sukuk market had issued structures using Islamic financing in 16 different compositions (either singly or in combinations).
Compounding this is the sheer volume of structures totaling 444 different Sukuk facilities as at end-July 2008. The cost of setting up a pricing unit purely for this function is just too high for the average investor. For the market, replicating such a unit for every investor is an inefficient use of limited resources.
Fair valuing Sukuk
Sukuk and conventional bonds are fundamentally different in both structure and thus valuation. Sukuk is not an exchange of paper or money but of Shariah approved assets. Therefore, in principle, Sukuk structures are similar to asset securitization. As such, the asset now becomes the center of the analysis, unlike conventional bonds where the issuer remains the focus.
The market itself plays a direct role in the valuation performance of Sukuk. Due to differing perception vis-à-vis conventional bonds, the demand and supply dynamics of Sukuk as well as its trading behavior could result in different pricing performance.
For Sukuk, demand pull is a pivotal component to its valuation. Apart from Shariah investors, it can also be bought by conventional investors, whereas conventional bonds can only be bought by conventional investors. This situation does create some level of price premium for Sukuk compared to conventional bonds in the same tenure and rating basket.
There is also no imposition of interest (paid in the form of coupons) in Sukuk. However, Sukuk uses secondary notes as profit payments. The financial consideration for the profit earned for the exchange is calculated by applying Shariah principles. Although the profit-sharing ratio is fixed, the quantum is not. Depending on the actual profit, investors will have to take into consideration the likely profit volatility, going forward.
Additional risks that are uncommon in conventional bonds such as the addition of Shariah laws also add an extra dimension to valuation. Although Shariah law is universal, its interpretation is not. Depending on the school of thought prevalent in every jurisdiction, some Sukuk structures may be permissible in one jurisdiction but not in another. The act of one jurisdiction approving the permissibility of a Sukuk structure from another jurisdiction effectively increases the investor pool and, hence, the potential demand for such Sukuk. This will have a direct impact on the valuation.
The opposite is also true. If one jurisdiction decides that a particular Sukuk from another jurisdiction is incompatible with its interpretation of the Shariah, the potential investor pool reduces and, hence, the potential demand for such Sukuk. These factors should be taken into consideration when valuing Sukuk.
Apart from the differences highlighted earlier, some additional variables should also be taken into consideration. This list is not exhaustive but shows some of the key variables required:
• Inclusion of asset volatility;
• Term structure of asset;
• Floating rate mechanism for the forward rate agreement in the unconditional and irrevocable purchase of asset at maturity;
• Prepayment risk modeling; and
• Counterparty risk modeling.
Active participation crucial
Making valuation a standard requirement in the Sukuk market should be promoted as a basic prerequisite. Since price is the most important component in any decision-making process for buyers and sellers of Sukuk, all efforts must be made to improve the price discovery process.
Due to the lack of information, players in the Malaysian Sukuk market use the same valuation methodology for conventional bonds to price Sukuk. Although this market convention simplifies the valuation process, the current prices of Sukuk in the market may not reflect true value.
The evaluated prices generated by a bond pricing agency must follow market conventions so as to be market relevant. Even so, it is also its professional duty to highlight valuation issues to the market as well as to recommend improvements. Active participation from all market players is crucial for this valuation concept to take hold. Continuous improvement will promote credibility.
BPAM is in the forefront of this effort. The company has done extensive research on Sukuk valuation, and with market participation, Malaysia can become the center of Sukuk valuation methodology.
Meor Amri Meor Ayob
Chief operating officer
meor@bpam.com.my
Bond Pricing Agency Malaysia
(formerly Bondweb Malaysia)
17-8 & 19-8, The Boulevard, Mid Valley City
Lingkaran Syed Putra
59200 Kuala Lumpur
www.bpam.com.my
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