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Issuer’s Choice of Islamic Bond Type
Saad Azmat, Michael Skully, Kym Brown
PII: S0927-538X(13)00051-6DOI: doi: 10.1016/j.pacfin.2013.08.008Reference: PACFIN 643
To appear in: Pacific-Basin Finance Journal
Received date: 12 July 2013Accepted date: 17 August 2013
Please cite this article as: Azmat, Saad, Skully, Michael, Brown, Kym, Is-suer’s Choice of Islamic Bond Type, Pacific-Basin Finance Journal (2013), doi:10.1016/j.pacfin.2013.08.008
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Issuer’s Choice of Islamic Bond Type
Abstract: This paper analyses factors affecting an issuer’s choice of Islamic bond structure
as compared with conventional financial instruments. This choice is considered in the context
of issuer firm variables, the 2008 Accounting and Auditing Organization for Islamic
Financial Institutions (AAOIFI) Islamic bond recommendations, and Shariah advisor effect in
relation to Islamic instruments. A sample of Malaysian Islamic bonds is analysed using
ordered probit model techniques. The results suggest that there are some significant
differences between Islamic and conventional bond issuer’s choice determinants which can
be attributed to characteristics specific to Islamic bonds. For instance unlike conventional
bonds, the stock valuation of the issuer did not impact debt-equity targets with Islamic Joint
Venture (IJV) bond issuance. Other results from issuer firm characteristics were mixed and
suggest that IJV bonds have little in common with equity and issuers should concentrate on a
bond’s security and seniority as with conventional bonds, rather than their Islamic structure.
Secured Against Real Asset (SARA) bonds were found not to always represent ownership of
the underlying asset. AAOIFIs reported concerns in 2008 over Shariah quality of IJV bonds
appears to have led to an aversion of IJV bond issuance. Finally, Shariah committees as
opposed to individual Shariah advisors demonstrated an aversion to IJV bond issuance.
JEL: G15, G24
Keywords: bond structure, Islamic bonds *
* Saad Azmat
Assistant Professor
Suleman Dawood School of Business
Lahore University of Management Sciences
D.H.A, Lahore Cantt, 54792
Pakistan
Ph: 92 42 111 11 5867; Email: [email protected]
Professor Michael Skully
Department of Accounting and Finance
Monash University
P.O. Box 197
Caulfield East Victoria 3145
Australia
Ph: 61 3 9903 2407; Fax: 61 3 9903 2422; Email: [email protected]
Dr Kym Brown (corresponding author)
Department of Accounting and Finance
Monash University
P.O. Box 197
Caulfield East Victoria 3145 Australia
Ph: 61 3 9903 1053; Fax: 61 3 9903 2422; Email: [email protected]
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1. Introduction
The factors that affect an issuer’s choice of different financial instruments have been widely
researched. Decisions like issuing debt as opposed to equity or secured rather than unsecured
bonds have been attributed to different combinations of firm specific variables such as debt
and profitability ratios (Julio et al., 2008). In addition, those characteristics unique to each
instrument such as security, seniority, and tangibility of the assets may also have a significant
impact on this decision as well as industry specific and macroeconomic factors.
The unique characteristics of Islamic bonds may further affect the issuer’s choice. One
difference, for example, is that secured against real asset (SARA) Islamic bonds have
entitlement to actual ownership of the underlying asset rather than just a first charge.1 This
means that SARA bonds are more secure than their conventional counterparts. In contrast,
Islamic joint venture bonds (IJV) have more similarities with equity than debt. The prior
literature has not investigated the impact that this wider range of Islamic bond characteristics
may have on an issuer’s debt selection. This gap motivates us to question whether the factors
that affect an issuer's choice of Islamic bond are the same as for conventional bonds.
This paper analyses the determinants of the issuers’ bond preference for 456 Malaysian
Islamic bonds. The impact of firm specific variables, specific events (such as the 2008
Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)
recommendations) and specific Islamic instrument characteristics (such as Shariah advisor
effect) are analysed. The results show that some firm specific variables affect issuer’s choice
in a conventional bond like manner but others impact it differently. The findings suggest that
1 A holder with a first charge over a specific asset will be entitled to be the first in line to be repaid first from the
proceeds of its sale in case of default.
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both specific events and Islamic instrument characteristics are significant determinants of the
issuer’s decision. For example, the results show that in the aftermath of 2008 AAOIFI
recommendations, issuer’s aversion for IJV bonds increased. Also it is found that IJV bonds
are less likely to be approved by Shariah committees.
The findings have implications for regulators and Islamic bond issuers. For regulators, it is
suggested that they further support Shariah harmonization for the industry to prosper. For
issuers, the results imply that firm specific variables should affect their choice of Islamic
bond type not unlike that of conventional debt. The rest of the paper is organized as follows.
Section 2 considers the unique features of Islamic bond structures. Section 3 provides the
literature review, with data described in Section 4. Section 5 presents the methodology,
Section 6 the results and Section 7 concludes the paper.
2. Islamic Capital Market Features
This section considers the characteristics of three main types of Islamic bonds: Islamic joint
venture (IJV), secured against real asset (SARA) bonds and debt bonds2, as well as the role of
Shariah advisors and the AAOIFI (2008) updated Shariah standards.
2.1 IJV Bonds
IJV bonds (Musharakah/Mudarabah Sukuk) have both debt and equity characteristics. Their
holders become part owners of the issuer or more commonly of a specific project. If
successful, IJV bond holders share in the profits and receive periodic payments depending on
a pre-agreed percentage. They must also bear any loss according to their investment
2 AAOIFI has standards for more than 14 different types of Islamic bonds but the focus here is on the most
popular.
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proportion on maturity; the issuer can then buy back the IJV bonds but at their market price
rather than face value (Usmani, 2006). Furthermore on bankruptcy, IJV bond holders rank
equally with shareholders rather than normal creditors, but unlike shareholders have no
voting rights.
2.2 SARA Bonds
Secured against real asset (SARA) bonds (Ijarah Sukuk) are typically structured using a
special purpose vehicle (SPV). While it may be created by the issuer, the SPV is legally
separate and considered a bankruptcy remote entity just as in conventional structured finance.
The originator sells the SPV some specific assets which are agreed to and then leased back at
a periodic rental rate and then repurchased at a certain price and a certain date. The SPV uses
this set of agreements to support a SARA bond issue and uses the issue’s proceeds to pay the
issuer for the assets. The SPV collects the rental payments and pays them to the bond holders
as well as on maturity, the face value. SARA bonds differ from conventional ones in that
their holders have the legal and economic ownership of the underlying assets rather than just
a charge against them (Usmani, 2006, Ali, 2008). If the initial issuer defaults or goes
bankrupt, the bond holder can claim the possession of the underlying asset.
2.3 Debt Bonds
Debt bonds (Murabaha Sukuk) are based on buy and resale arrangement. This is where the
Islamic bank or an issuer SPV first buys a real asset and then immediately sells it back to the
client at a higher price creating a debt which their client periodically repays. These bonds can
be either secured or unsecured depending on their link with the underlying asset.3 Debt
3 Some Islamic debt bonds have a first charge on the underlying asset and hence can be considered similar to
secured conventional bonds but the rest are unsecured (Dusuki and Mokhtar, 2010).
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bonds, however, do not represent the ownership of the underlying asset and so are less secure
than SARA bonds (Ali, 2005, 2008; Howladar, 2006; Dusuki and Mokhtar, 2010). Unlike
IJV and SARA bonds, debt bonds are considered non-Shariah compliant in most countries
other than Malaysia (Ayub, 2007).
2.4 Shariah Advisors
As Shariah compliance is a key requirement for any Islamic financial instrument, Islamic law
experts known as Shariah advisors are needed (Karim, 1990; Karim and Archer, 2007). They
can be an individual, a firm or several advisors in the form of a Shariah advisory committee
(Grais and Pellegrini, 2006). Since Islamic law (particularly with regards to contracts) can be
subject to different interpretations, designing new financial structures can be challenging,
especially across countries. So an Islamic instrument approved in one country may be
considered non-Shariah compliant in others. Islamic debt bonds for example are considered
Shariah-compliant in Malaysia but not in the Middle East and Pakistan (Usmani, 2002).
These Shariah differences stem from their adherence to particular Islamic school of thought.4
2.5 Shariah Standards
This lack of Shariah harmonization is costly for the Islamic finance industry. Regulatory
bodies such as AAOIFI have tried to address these differences by devising uniform Shariah
standards for most existing instruments. Many countries, like Bahrain, Sudan, Jordan, Qatar,
Saudi Arabia, Dubai, Syria, Lebanon, Pakistan, Singapore, and South Africa, are trying to
adopt these standards.
4 They are four major Madahibs (Islamic school of thought), Hanafi, Shafee, Hanbali and Maliki, named after
their founders.
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In February 2008, AAOIFI’s issued stringent guidelines for Islamic bonds (Usmani, 2007) as
many were being issued in a form similar to conventional debt. It argued against IJV bonds
where the issuer guaranteed the return and the principal irrespective of the firm’s
performance. Instead it required the IJV bonds be structured like equity where neither the
principal nor return guaranteed. AAOIFI (2008) also criticised those SARA bonds for being
structured like conventional secured debt. It required instead that SARA bonds represent real
ownership of the underlying asset rather than just a first charge5 and declared those Islamic
debt bonds with no link to the underlying asset non-Shariah compliant (Usmani, 2007). These
2008 recommendations had severe repercussions and billions of dollars of losses (Salah,
2010). This happened irrespective of whether a country complied with AAOIFI or not. For
example, Malaysia although an AAOIFI member country follows its own standards
developed by Bank Negara Malaysia but also suffered after these announcements (Dusuki
and Mokhtar, 2010).
3. Literature Review
This review begins with an overview of the determinants of an issuer’s choice of financial
instruments and then investigates elements that are particularly relevant to Islamic bonds. The
first focus is on those factors affecting corporate issuance of equity as opposed to debt. The
idea is to infer an issuer’s choice of IJV bond with equity like structure. Then the
determinants of a conventional secured bond versus unsecured bonds choice are examined
and then applied to examine the issuer’s choice of the more secured SARA bonds to Islamic
debt bonds. Finally, the impact of changing Shariah standards on the issuer’s choice of
5 SARA bond holders with first charge would only receive payments after undergoing lengthy bankruptcy
proceedings. Moreover, a first charge does not result in the full proceeds from the sale of the asset as some cost
and expenses might need to be paid (Dusuki and Mokhtar, 2010).
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Islamic bonds is investigated as are the impact of Islamic instrument specific variables such
as Shariah advisor effect.
3.1 Overview of Issuer’s Choice of Financial Instruments
Conventional bonds differ in terms of many characteristics including maturity and security.
This diversity is caused by a range of factors. Bond maturity, for example, may be affected
by the firm’s risk. A low quality firm with high risk may avoid short-term debt as their poor
cash position could result in frequent rollovers (Flannery, 1986). The decision on secured as
opposed to unsecured bonds may be affected by other factors such as firm performance and
project risk. Companies that perform poorly or start risky projects may use secured bonds to
attract reluctant investors (Berger and Udell, 1990). Since Islamic bonds have certain
similarities with conventional bonds, implications can be drawn for them by analysing the
determinants of conventional bonds characteristics.
3.2 Determinants of Issuer’s Choice of IJV Bonds
As IJV bonds have a number of features similar to equity, the trade-off theory of capital
structure can be used to analyse issuer’s choice of IJV bond type. This tries to balance the tax
advantage of debt against its cost of financial distress (Modigliani and Miller, 1958).6 While
irrelevant in an ideal Miller-Modigliani world, market imperfections like asymmetric
information, taxes and financial distress costs make capital structure choice important. Given
debt and equity have differing costs and benefits, an optimal capital structure will balance
them. Trade-off theory suggests that taxes and financial distress costs would be important in
choice of IJV over SARA or debt bonds. In most jurisdictions however, IJV bonds, have a
6 There are also agency costs associated with equity, which negatively affect its favourability over debt (Jensen
and Meckling, 1976; Myers, 1977; Stulz, 1990) but some of them are not present in IJV bonds.
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similar tax treatment as SARA and debt bonds (Ali, 2005, 2008). Distress cost may also
affect the issuer’s preference for IJV bonds as given their equity like nature IJV bonds are not
susceptible to default.7
Pecking order theory suggests that in a world with asymmetric information, capital structure
offers an important signal about the nature of the firm (Ross, 1977). It assumes that managers
are better informed than investors, (Myers and Majluf, 1984) and so view equity issues as
negative signals about an overvalued share price. This cost makes firms prefer internal as
opposed to external financing. If external financing is inevitable, then firms prefer debt over
equity as debt issues avoids the negative signals of equity financing. So in Islamic terms, all
things being equal, a firm should prefer SARA and debt bonds, which are more similar with
conventional debt, over equity type IJV bonds.
Another strand of the literature uses theoretical arguments from both the trade-off and
pecking order theories and empirically examines the impact of different factors on the firm’s
debt-equity ratio (Bayless and Chaplinsky, 1993; Graham, 1996). It argues that firms target a
particular debt-equity ratio. If the actual ratio differs from the target, the firm would change
its debt or equity to adjust it (Marsh, 1982; Hovakimian et al., 2001). This implies that the
debt-equity ratio is affected by two types of factors: those that shift the target ratio and those
that cause deviations from the target. The former include the cost of financial distress,
bankruptcy risk, size, and asset composition which may affect the target level of debt (Marsh,
1982). In contrast, the primary catalyst for deviations is over or under-valued stocks
(Hovakimian et al., 2001). If stocks are over-valued, issuing equity would be less costly. This
7 We are referring to AAOIFI compliant IJV bonds which like ordinary shares have no default and hence, would
endure no financial distress costs. In the real world though, IJV bonds are being issued in a very debt like
manner and could face a default and hence would have to bear financial distress costs.
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in turn might induce firms to issue equity irrespective of their target ratio alternatively if
stocks are under-valued, firms may restrain from issuing equity (Ross, 1977; Myers and
Majluf, 1984).
Given the above arguments, if the firm’s current debt is higher than its targeted level, firms
may prefer an IJV bond over SARA and debt bonds to readjust to their target. In contrast, if
the current debt level is lower, then SARA or debt bonds will be preferred over IJV bonds.
Similarly undervalued firms should prefer SARA or debt bonds over IJV. Overvalued firms,
however, should prefer IJV. This motivates the following hypotheses:
H1: Firms exceeding their targeted debt levels will prefer IJV bonds over SARA bonds and
debt bonds (and vice versa).
H2: Holding other firm specific variables constant, firms with higher market to book values
should prefer IJV bonds over SARA and debt bonds (and vice versa).
3.3 Choice of SARA and Debt Bonds
This section examines the security and seniority preferences of a conventional bond issuer
and then extends them to Islamic bonds (SARA and debt). The security and seniority choices
with conventional bonds are explained by opposing views in the literature. One argument
states that secured debt is suitable for a highly levered firm with potential growth
opportunities as the financing of profitable projects that would otherwise been rejected if
financed through unsecured debt (Stulz and Johnson, 1985). The opposing view states that
only secured debt allows poorly performing firms to raise finance (Berger and Udell, 1990).
According to this view, high risk firms with limited growth opportunities would tend to issue
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secured debt. Julio et al. (2008) for example find that firms issuing secured debt tend to be
small, highly levered, have low cash flows, low stock returns and limited growth options.
SARA and debt Islamic bonds differ in their seniority and security. SARA bonds are secured
by their ownership of the underlying asset. So on default their holders are entitled to the
underlying asset’s sale proceeds. In contrast, Islamic debt bonds are less secured but rank
above IJV bonds. If the views of Berger and Udell (1990) and Julio et al. (2008) can be
extended to Islamic bonds, then highly levered, poor performing and high risk firms would
prefer SARA bonds. In contrast, firms with lower leverage, high profitability and low risk
may prefer debt bonds. This leads to the following hypotheses:
H3: Firms with high leverage (total and long-term debt) prefer SARA over debt bonds and
vice versa.
H4: Firms having high profitability (operating margin and interest coverage ratio) prefer debt
over SARA bonds and vice versa.
H5: Firms having higher risk (market beta and standard error) prefer SARA over debt bonds
and vice versa.
3.4 Impact of 2008 AAOIFI Standards
The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)
stringent guidelines for Islamic bonds were designed to improve their Shariah quality
(Usmani, 2007) and suggested more stringent IJV structures. Issuer’s aversion for IJV bond
should therefore increase in 2008.8 This motivates the following hypothesis.
8 These standards also required SARA bonds to represent real ownership of the underlying asset (AAOIFI,
2008) while Islamic debt bonds were also criticised that it was expected they should have some link with the
underlying asset (Usmani, 2007).
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H6: Issuer’s aversion for IJV bonds increased in 2008, ceteris paribus.9
3.5 Shariah Advisor Effect
Shariah scholars have different opinions over the Shariah compliance of particular Islamic
bond types. Some scholars consider Islamic debt bonds to be non-Shariah compliant while
others dislike particular IJV bond structures. In contrast, SARA bonds are the least
controversial (Usmani, 2002). The effect of Shariah advisor preferences may be captured by
comparing the bonds approved by Shariah committees against those approved by individual
Shariah advisors. The rationale is that a Shariah committee with multiple members is less
likely to be affected by individual preferences and, so would approve only bonds on which
they all agree. Shariah committees, therefore, should have a higher probability of approving
the less controversial SARA bonds than debt and IJV bonds. The issuer’s choice of Islamic
bond type, hence, should be affected by whether the issuer uses a Shariah committee or
individual advisor. This leads to the following hypothesis:
H7: SARA bonds, in contrast to debt and IJV bonds are more likely to be approved by
Shariah committees than individual advisors.
4. Data
The sample consists of 456 Malaysian corporate Islamic bond issues and covers from 2002 to
2010 while data for banks and other financial institutions is excluded (Julio et al., 2008;
9 In the multivariate probit model issuer’s aversion is measured as the probability of IJV issuance.
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Blume et al., 1998).10
The issuing firm’s name, issue date, bond type and Shariah advisor
information were obtained from IFIS (Islamic Finance Information Service). Datastream was
used to extract daily data for stock prices, market to book value ratio of the issuer and Dow
Jones Total Market Index. Compustat was employed for other firm specific financial
variables.
An initial sample of 1166 Islamic bonds from a cross section of countries was obtained from
the IFIS database. Given the focus is on corporate Islamic bonds, 206 sovereign Islamic
bonds were excluded as more than 90% of the remaining sample were Malaysian Islamic
bonds, the study was restricted to Malaysia. Due to missing data, some issues had to be
eliminated leaving 456 Islamic bonds from 83 issuers (Table 1). The sample included 391
debt bonds, 48 IJV bonds and 17 SARA bonds.
<Insert Table 1 about here>
5. Methodology
Multinomial probit model is a generalization of the probit model for comparing multiple
choices (more than two) for unordered data (Greene, 2003; Kumar et al., 2010). It uses a
latent variable to establish a link between the discrete variable and its determinants. The data
described is composed of three types of Islamic bonds IJV, SARA and debt bonds. Equation
1 shows the discrete variable, Y, that represents each of three types of Islamic bonds.
10
The availability of data before 2002 was more limited. For removal of outliers to avoid sample bias refer to
Wooldridge (2009) and Greene (2003).
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(1)
The firm’s choice is determined by firm specific, event specific and Islamic instrument
specific variables. These are captured by the latent utility shown in Equation 2.
(2)
The variables are defined in Table 2 with their expected results in IJV bonds and SARA
bonds given in Tables 3 and 4 respectively. When estimating the model, Islamic debt bond
(with 3) is used as the base case against which the IJV bonds (with 1) and SARA
bonds (with 2) choices are compared. The multinomial probit model in this case
generates two panels (Panel A and Panel B) of results (Table 5). Panel A compares the IJV
and Islamic debt bonds. A positive coefficient for the IJV and Islamic debt bond variables
comparison suggest that higher values should make the issuer prefer debt over IJV bonds. A
negative coefficient, however, implies a preference of IJV over debt bonds. Panel B compares
SARA and Islamic debt bonds. A positive coefficient in Panel B again reflects the fact that
variables’ higher values would cause the issuer prefer Islamic debt over SARA bonds. In
contrast a negative value makes SARA preferred over debt bonds.
<Insert Table 2 about here>
<Insert Table 3 about here>
<Insert Table 4 about here>
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5.1 Measurement of the Variables
This section focuses on how firm specific, event specific and Islamic instrument specific
effects are measured for Equation 2 and the determinants of Islamic bond type. The issuer’s
choice between the three Islamic bond types (IJV, SARA and debt bond) can be analysed at
two stages. The first is when the issuer decides between issuing equity against debt. If certain
issuer’s characteristics favour equity, then IJV bonds are preferred. If the issuer chooses debt
instead, a second stage decision is required on whether to issue SARA bonds or Islamic debt
bonds (Dusuki and Mokhtar, 2010).
The decision to issue IJV bonds might be affected by the issuer’s current position relative to
its target debt to equity ratio (H1) and the causes of any deviation from this target (H2). The
firm’s current debt position is captured by long term debt to assets (LTDA) and total debt to
assets (DTA). A firm with high LTDA and DTA compared to the target would issue less debt
and more of equity type IJV bonds (Marsh, 1982; Hovakimian et al., 2001). The coefficient
therefore, should be negative. The target debt to equity ratio is determined by bankruptcy
risk, firm performance and firm size (Marsh, 1982; Hovakimian et al., 2001). Bankruptcy risk
is captured by the standard error (SE) and market beta (BETA). Higher SE and BETA
increases bankruptcy risk and so reduces the firm’s debt target level. These both should,
therefore, have a positive impact on issuing IJV bonds and hence a negative coefficient in the
model. Firm performance is captured by interest coverage (IC) and operating income to sales
ratios (OIS). These two ratios reflect the firm’s ability to service its existing debt and its
propensity to issue more debt (Marsh, 1982; Hovakimian et al., 2001). Higher IC and OIS
ratios, therefore, should discourage issuing the equity like IJV bonds. Hence, the coefficient
should be positive. Firm size is captured by LA (log of assets). Since larger firms issue more
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debt, a higher LA should result in greater debt and lower IJV bond issuance. The coefficients
should be positive.
Over or undervalued stock, captured by the market to book value ratio (MtB), is an important
determinant in the issuer deviating from the target ratio (Hovakimian et al., 2001). Holding
other variables constant, a low MtB suggests undervalued stock and so would discourage
equity raising, including IJV bonds (Ross, 1977; Myers and Majluf, 1984). MtB, therefore,
should have a negative coefficient in the model.
Highly levered (H3), poor performing firms (H4) with high bankruptcy risk (H5) are
expected to issue secured bonds (Berger and Udell, 1990; Julio et al., 2008). Therefore, a
SARA bond issuer should have higher long term debt (LTDA) and total debt (DTA) ratios.
These variables in the model should be negative (H3). Firm performance is captured by
operating margin (OIS) and interest coverage (IC) ratio. Firms issuing SARA bonds should
have a low level of operating margin (OIS) and interest coverage (IC). These ratios should
have a positive coefficient in the model (H4). Risk is captured by beta (BETA) and standard
errors (SE). SARA bonds should have a high level of SE and beta and hence a negative
coefficient in the model (H5).
The impact of the 2008 AAOIFI recommendations, captured by SS (2008) year dummy, were
particularly critical of prevalent IJV structures and suggested much more stringent
alternatives (Usmani, 2007). So, the number of IJV bond issues should decline in 2008,
implying a positive coefficient for their dummy variables (H6).
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The Shariah advisor effect is captured by a Shariah committee dummy variable. Individual
Shariah advisors may prefer certain type of bonds (Karim, 1990; Grais and Pellegrini, 2006;
Karim and Archer, 2007; Dusuki and Mokhtar, 2010). Shariah committees with multiple
members, however, may reduce such individual preferences in reaching a final decision.
SARA bonds, unanimously agreed upon by scholars as Shariah compliant, should have a
higher probability of being approved by Shariah committees (H7). In contrast, debt bonds and
some structure of IJV bonds are less likely (AAOIFI, 2008; Dusuki and Mokhtar, 2010).
Hence, the coefficient of the Shariah committee dummy variables should be positive for IJV
bonds and negative for SARA bonds.
5.2 Robustness of the Model and Industry Effect
As a firm’s industry might impact on its bond choice, a robustness test of the results is
conducted by running Equation 3 with dummies for three industries: manufacturing, property
and agriculture.11
Given the nature of SARA bonds, they are used frequently in the property
industry as real property can serve as the underlying asset. Therefore, the sign of the property
dummy variable should be negative for SARA bonds.
11
The numbers of observations for SARA bonds issuers belonging to the energy sector are not large enough for
it to be included in the model.
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6. Results for Islamic Bond Type Determinant
This section begins by examining firm specific factors that may impact a firm’s Islamic bond
choice, followed by an examination of the impact of new Shariah standards in 2008, and
Shariah advisor effects.
Equation 2 is estimated using multinomial probit analysis with Huber (1964) and White
(1980) robust variance-covariance matrix. The results are generated for IJV and SARA bonds
using Islamic debt bonds as the base case and are reported in Table 5: Panel A for IJV bonds
and Panel B for the SARA bonds. Table 6 also shows the impact of firm specific variables
affecting issuer’s choice of IJV (H1 and H2), SARA and debt bonds (H3, H4 and H5). The
impact of changes in Shariah standards (H6) and Shariah advisor effect affecting issuer’s
choice of Islamic bond type (H7) are similarly reported in Table 5. Finally, the robustness
results after accounting for industry effect by estimating Equation 3 are presented in Table 6.
<Insert Table 5 about here>
<Insert Table 6 about here>
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6.1 Impact of Firm Specific Variables Affecting Issuer’s Choice of IJV
Two types of firm specific variables affect the IJV choice, those that capture the firm’s
current position relative to the target debt to equity ratio (H1) and those that cause deviations
from the target (H2). The results for firm specific variables are reported in Panel A of Table
5, and the corresponding robustness tests, after addressing any industry effect are in Panel A
of Table 6.
H1 tests the impact of firms’ current debt level relative to its target debt to equity ratio. The
current’s position is captured by the total debt to asset ratio (DTA) and long term debt to
asset ratios (LTDA). Holding the target ratio constant, these variables should have a positive
impact (negative coefficient) on issuer’s choice of IJV bonds. According to Table 6, only
DTA is negative and significant at the 1% level. In contrast, LTDA is positive and significant
at the 5% level. This suggests that the long term debt as a proportion of total assets negatively
affects issuer’s choice of IJV while short term debt has a positive impact.12
Therefore, only
the DTA results support H1, while LTDA rejects it. A possible explanation for this is that
Islamic debt bonds have shorter maturities than IJV and SARA bonds. Therefore, holding
target debt to equity ratio constant, higher long term debt ratio (LTDA) should increase the
issuer’s propensity to issue Islamic debt bonds.
The target debt to equity ratio is determined by bankruptcy risk, firm performance and firm
size (Marsh, 1982; Hovakimian et al., 2001). Bankruptcy risk in Equation 2 is captured by
standard error (SE) and market beta (BETA) (expected impact on IJV bonds: positive,
coefficient in the model: negative). Firm performance is reflected in interest coverage (IC)
12
In the presence of long-term debt variable in the regression model, the coefficient of total debt represents the
effect of issuer’s choice assuming long-term debt is constant. Therefore, the total debt coefficient would only
capture the impact of short-term debt (Blume et al., 1998).
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and operating income to sales ratios (OIS) (expected impact on IJV bonds: negative,
coefficient in the model: positive). Firm size addressed by LA (log of assets) (expected
impact on IJV bonds negative, coefficient in the model positive). Table 5 shows that BETA is
significant at the 10% level and has the expected negative coefficient. In contrast, standard
error (SE), which also measures bankruptcy risk, is insignificant. Nevertheless, once the
industry effect is considered, Table 6 shows that SE becomes significant but with an
unexpected positive coefficient. These results further indicate that the log asset (LA) variable
capturing firm size variable, insignificant in the original model in Table 5, becomes
significant at the 1% level with the expected positive sign given the industry effect. Table 5
also reflects that the IC result is contrary to expectations and the wrong sign (negative). The
result for OIS is significant at the 10% with the expected positive coefficient. Panel A of
Table 6 shows that both IC and OIS results are robust to any industry effect. Therefore, it can
be concluded that only the results for DTA, BETA, LA and OIS have the expected sign and
hence partially support H1. In contrast, LTDA, IC and SE reject the hypothesis.
H2 tested whether firms with high market to book value ratio (MtB) prefer IJVs over SARA
or Islamic debt bonds. A low MtB reflects that a stock is undervalued, (Ross, 1977; Myers
and Majluf, 1984), firms with lower market to book value are expected to issue less IJV and
more debt (H2). Panel A of Table 5 and Table 6 show that the MtB is significant at the 10%
level but with the incorrect positive sign. Hence, H2 is rejected. This implies that over or
undervalued stocks do not affect the issuer’s preference for IJV.
The lack of convincing support for H1 and H2 corroborate the assertion that IJV bonds have
little in common with equity and should be treated more like conventional debt bonds
(Usmani, 2007; Ali, 2008).
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6.2 Firm Specific Variables Affecting Issuer’s Choice of SARA Bonds
The issuer’s choice of SARA and debt bonds is determined by variables capturing leverage
(H3), firm performance (H4) and risk (H5). The results for each are reported in Panel B of
Table 5 and their robustness results after accounting for industry effect are reported in Panel
B of Table 6.
The leverage ratios (H3) of long term debt to asset ratio (LTDA) and total debt to asset ratio
(DTA) were both expected to have a positive impact (negative coefficients) on issuer’s
choice of SARA bonds. Panel B of Table 5 and Table 6, however, show that LTDA and DTA
are statistically insignificant. Therefore H3 is rejected.
Firm performance (H4) as captured by operating income to sales ratio (OIS) and interest
coverage ratio (IC) was expected to have a negative impact (positive coefficients) on SARA
bond issues. Panel B of Table 5, though; show that IC is statistically insignificant. In contrast,
OIS is significantly positive at the 5% level. Panel B of Table 6 suggests that these results are
robust to changes in industry effect. IC remains statistically insignificant while OIS become
positively significant at the 1% level. This partially supports H4 suggesting that firms with
higher operating margin prefer debt bonds over SARA bonds.13
The issuer’s risk (H5), as captured by BETA and standard error (SE), was expected to have
positive impact on issuer’s choice for SARA bond. Panel B of Table 5, however, shows that
BETA is statistically insignificant. In contrast, SE is significantly negative at the 1% level.
The results partially support H5 suggesting that issuers with risk proxies of higher standard
13
The results are consistent with the signalling hypothesis (Ross, 1977).
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errors (SE) prefer SARA over debt bonds. Thus firms with high bankruptcy risk may have a
preference for secured SARA bonds.
6.3 Results for Changes in AAOIFI Shariah Standards
The 2008 change in AAOIFI Shariah standards (H6) on instrument choice is captured by SS
(2008) year dummy. In line with expectations, PANEL A of both Tables 5 and 6 shows that
the SS coefficient is positive and statistically significant at the 1% level. This suggests that
holding other things constant, the issuer’s preference for IJV bonds declined in 2008. This
can be attributed to AAOIFI’s tougher Shariah standards which require IJV bonds to be
structured in equity like manner (Usmani, 2007). The results support H6.
6.4 Results for Shariah Advisor Effect
The Shariah advisor effect on the issuer’s choice of Islamic bond type (H7) reflects the
potential for personal preferences in Shariah interpretations (Karim, 1990; Grais and
Pellegrini, 2006; Karim and Archer, 2007; Dusuki and Mokhtar, 2010). The effect is captured
by a Shariah committee (SB) dummy variable, which takes on the value 1 for bond approved
by Shariah committees and 0 for those approved by individual advisors. Panel A of Table 5
shows that the coefficient for SB is significantly positive at the 1% level suggesting that
Shariah committees have an aversion for IJV bonds. This is in line with expectations as some
Shariah scholars have been very critical of the previous IJV structures (Usmani, 2007). The
SB variable for the SARA bonds as shown in Panel B of Table 5, however, is insignificant.
The results partially support the H7 suggestion that issuer choice of IJV bonds is determined
by Shariah advisor preferences.
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7. Conclusion
The paper examined the firm specific determinants of issuer choice of Islamic bond type. It
was expected in theory, that an issuer should view IJV bonds as equity instruments (Usmani,
2006). The empirical results however, suggested that issuers do not consider them as equity
replacement in that their choice is not being affected by the normal firm specific determinants
of equity. The impact of firm specific determinants of issuer’s choice of SARA bonds was
then tested. As SARA bonds are supposed to represent ownership of the underlying asset,
they should be more secured than conventional secured bonds. Our results though, implied
that not all SARA bonds in the sample actually represent ownership of the underlying asset
and so are no different from secured conventional bonds. The impact of changes in the 2008
AAOIFI Shariah standard on IJV bonds was then tested and the issuer’s aversion for IJV
bonds was found to have increased. In regards to Shariah committees, issuers disliked the
controversial IJV structures as this preference appears reflected in the issuer’s choice.
In conclusion, the findings suggest that an issuer’s choice of Islamic bond type is not the
same as for conventional bonds. This study extends the academic literature related to the firm
choice of debt to equity ratio to provide evidence that IJV bonds are not viewed by issuers as
equity instruments. Furthermore, it also the first to employ the literature on issuer’s
preference for secured versus unsecured bonds to show that SARA bonds are not different
from secured conventional bonds.
These findings have several implications for regulators, Islamic bond issuers and investors.
For regulators, the findings magnify the lack of Shariah harmonization in the Islamic finance
industry and suggest that for the Islamic finance to prosper policy makers / regulators must
support Shariah harmonization. For issuers, the findings suggest that firm specific variables
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affect an issuer’s choice of Islamic bond type are not unlike that of conventional debt. This
implies that issuers should be more concerned about the bond’s security and seniority rather
than simply their IJV or SARA like structure. Issuers should nevertheless prefer Shariah
compliant structures to protect themselves from changes in Shariah standards and to avoid
conflict with their Shariah committees. For investors they may want to further investigate the
asset backing of SARA bonds before investing.
We would like to acknowledge comments from participants at the 15th
Malaysian Finance
Association conference, Kuala Lumpur, 2-4 June 2013.
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Table 1: Issues by Industry 2002-2010
Industry Total
Manufacturing 144
Property and infrastructure development 102
Energy (electricity, gas and oil) 55
Agriculture, food and palm oil 86
Others* 21
Total sample 456
*These include shipping, transportation and technical
services (IFIS database).
Note the data is for corporate Malaysian Islamic
bond issues.
Source: IFIS data.
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Table 2: Variables for the Issuer’s Choice of Islamic Bond Type Model
This table details variable measurement for Equation 2:
where is the latent utility function.
Variable Description Measurement
LTDA Leverage Ratio I Long term debt / total assets
DTA Leverage Ratio II Long term debt + debt in current liabilities / total assets
BETA Beta Market beta
SE Standard Error
IC Interest Coverage (Operating income after depreciation + interest income) /
interest expense
OIS Operating Margin Operating income before depreciation / sales
LA Firm Size Log of total assets
MtB Stock Valuation Market value / net total assets
SS Shariah Standards Dummy variable that takes the value 1 for bonds issued in
2008
GFC Global Financial
Crisis
Dummy variable that takes the value 1 for bonds issued in
2009 and 2010
SB Shariah Committee Dummy variable that takes the value of 1 for Shariah
Committees
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Table 3: Expected Impact of Variables in the Issuer’s Choice of IJV Bond Type Model This table provides the expected impact, hypothesized coefficient and associated hypotheses related to variables affecting issuer’s
choice of IJV bonds for Equation 2*:
where is the latent utility function.
Variable Effect Expected Impact
for IJV
Hypothesized Coefficient
Sign for IJV
Hypotheses
LTDA Leverage Ratio I + - H1: Higher current debt, relative to
targeted debt, results in firms
preferring IJV over SARA and debt
bonds (and vice versa).
DTA Leverage Ratio II + -
BETA Beta + -
SE Standard Error + -
IC Interest Coverage - +
OIS Operating Margin - +
LA Firm Size - +
MtB Stock Valuation + - H2: Holding other firm specific
variables constant, firms with higher
market to book value should prefer
IJV bonds over SARA and debt
bonds (and vice versa).
SS Shariah Standards - + H6: Issuer’s aversion for IJV bonds
increased in 2008, ceteris paribus.
SB Shariah Committee - + H7: SARA bonds, in contrast to debt
and IJV bonds are more likely to be
approved by Shariah committees
than individual advisors.
*GFC dummy variable included in Equation 2 is not discussed here because it is not related to any of the hypothesis. It is instead
used as a control variable to capture the effect of the GFC.
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Table 4: Expected Impact of Variables in the Issuer’s Choice of SARA Bond Type
Model This table provides the expected impact, hypothesized coefficient and associated hypotheses related to variables affecting issuer’s
choice of SARA bonds for Equations 2:
where is the latent utility function.
Variable Description Expected
Impact for
SARA
Hypothesized
Coefficient Sign for IJV
Hypotheses
LTDA Leverage Ratio I + - H3: Firms with high leverage (total
and long-term debt) prefer SARA
bonds over debt bonds and vice versa. DTA Leverage Ratio II + -
IC Interest Coverage - + H4: Firm having high profitability
(operating margin and interest
coverage ratio) prefer debt over
SARA bonds and vice versa.
OIS Operating Margin - +
BETA Beta + - H5: Firms having higher risk (market
beta and standard error) prefer SARA
bonds over debt bonds and vice versa. SE Standard Error + -
LA Firm Size - +
MtB Stock Valuation
2008 Shariah Standards + -
SB Shariah Committee + - H6: SARA bonds, in contrast to debt
and IJV bonds are more likely to be
approved by Shariah committees than
individual advisors.
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Table 5: Issuer’s Choice of Islamic Bond Type Model Results This table presents the estimation of the multinomial probit model show in Equation 2:
where, subscripts i denote individual bond issues. captures bond type. is the latent variable that links the
dependent variable with . DTA is total debt to asset ratio. LTDA is long term debt to asset ratio. BETA is the
market model beta. SE is standard errors. IC is interest coverage ratio. OIS is operating income to sales ratio. LA
is log of assets for 2002 - 2010. MtB is market to book value ratio. SS is a dummy that equals 1 for bonds issued
in 2008. GFC is a dummy variable that equals 1 for bonds approved in 2009 and 2010. SB is a dummy variable
that equals 1 for bonds approved by Shariah committees. In the result shown in this table debt bonds is used as
the base case. PANEL A provides the results for IJV bonds. Panel B provides the results for SARA bonds.
Adjusted P-values (Prob. Adj.) using Huber-White test are also provided.
Issue Coef. Std. Err. Z-Stat Prob. Prob.(Adjusted)
PANEL A (Issuers’ choice of IJV bonds vs. Islamic debt bonds)
DTA -8.27915 2.751596 -3.01 0.003 0
LTDA 6.113098 2.813355 2.17 0.03 0.035
BETA -1.09855 0.655874 -1.67 0.094 0.095
SE -33.8354 25.12348 -1.35 0.178 0.42
IC -0.12308 0.055935 -2.2 0.028 0.026
OIS 2.78282 1.577453 1.76 0.078 0.085
LA 0.069683 0.173934 0.4 0.689 0.758
MtB 0.273912 0.150924 1.81 0.07 0.099
SS 2.566097 0.629726 4.07 0 0
GFC 0.099917 0.43109 0.23 0.817 0.835
SB 2.10014 0.541412 3.88 0 0
_cons -0.43129 1.743708 -0.25 0.805 0.839
PANEL B (Issuers’ choice of SARA bonds vs. Islamic debt bonds)
DTA -2.68262 3.510771 -0.76 0.445 0.297
LTDA 3.743863 3.315118 1.13 0.259 0.125
BETA 0.841531 0.823889 1.02 0.307 0.15
SE -125.358 48.61427 -2.58 0.01 0.001
IC 0.005254 0.014146 0.37 0.71 0.641
OIS 2.987766 1.782678 1.68 0.094 0.031
LA -0.2187 0.205182 -1.07 0.286 0.301
MtB 0.165214 0.180923 0.91 0.361 0.304
SS 0.270215 0.887627 0.3 0.761 0.722
GFC -0.98672 0.545146 -1.81 0.07 0.034
SB -0.49824 0.561417 -0.89 0.375 0.379
_cons 1.229856 2.097052 0.59 0.558 0.582
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Table 6: Industry Effect Results This table presents the estimation of the multinomial probit model shown in Equation 3.
where, subscripts i denote individual bond issues. captures bond type. is the latent variable that links the
dependent variable with . DTA is total debt to asset ratio. LTDA is long term debt to asset ratio. BETA is the
market model beta. SE is standard errors. IC is interest coverage ratio. OIS is operating income to sales ratio. LA
is log of assets. MtB is market to book value ratio. SS is a dummy that equals 1 for bonds issued in 2008. GFC
is a dummy variable that equals 1 for bonds approved in 2009 and 2010. SB is a dummy variable that equals 1
for bonds approved by Shariah committees. Property is a dummy variable that equals 1 if the issuer belongs to
the property industry. Manufacture is a dummy variable that equals 1 if the issuer belongs to the manufacturing
industry. In the result shown in the table debt bonds is used as the base case. PANEL A provides the results for
IJV bonds. Panel B provides the results for SARA bonds. Adjusted P-values (Huber-White test) are provided.
Coef. Std. Err. Z-Stat Prob. Prob.
(Adjusted)
PANEL A (IJV bonds vs. Islamic debt bonds)
DTA -15.7001 4.173263 -3.76 0 0
LTDA 9.992165 3.727618 2.68 0.007 0.029
BETA -1.45586 0.764833 -1.9 0.057 0.012
SE 37.99625 22.47332 1.69 0.091 0.04
IC -0.14879 0.054958 -2.71 0.007 0
OIS 3.555497 1.800129 1.98 0.048 0.079
LA 0.529083 0.216547 2.44 0.015 0
MtB 0.329576 0.171572 1.92 0.055 0.053
SS 2.860449 0.759338 3.77 0 0
GFC -0.45045 0.48809 -0.92 0.356 0.292
SB 3.166288 0.684501 4.63 0 0
Manufacture 2.738119 0.823975 3.32 0.001 0
Property 1.905076 0.665876 2.86 0.004 0.012
Agriculture 3.961999 1.018763 3.89 0 0
_cons -5.99666 2.242103 -2.67 0.007 0
PANEL B (SARA bonds vs. Islamic debt bonds) DTA -3.09623 4.194972 -0.74 0.46 0.359
LTDA 4.191526 3.909983 1.07 0.284 0.14
BETA 0.824404 0.875921 0.94 0.347 0.245
SE -83.043 46.79482 -1.77 0.076 0.007
IC 0.004852 0.015165 0.32 0.749 0.661
OIS 5.655009 2.259231 2.5 0.012 0.002
LA -0.08901 0.224404 -0.4 0.692 0.649
MtB 0.276328 0.191515 1.44 0.149 0.104
SS 0.289479 1.052435 0.28 0.783 0.772
GFC -1.193 0.638267 -1.87 0.062 0.041
SB -0.51802 0.686602 -0.75 0.451 0.412 Manufacture 0.063251 0.840112 0.08 0.94 0.918
Property -1.58731 1.178701 -1.35 0.178 0.114
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Agriculture 1.253038 0.812069 1.54 0.123 0.089
_cons -1.42471 2.718931 -0.52 0.6 0.549
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Issuer’s Choice of Islamic Bond Type
Highlights
Using conventional bond theory it is expected that firms would view IJV bonds as
equity.
Results suggest that issuers do not consider IJV bonds as equity equivalents.
SARA bonds did not appear to always represent the ownership of the underlying asset
as they should.
The 2008 AAOIFI Shariah standard on IJV bonds seem to have led to an aversion on
their issuance.
Issuers using Shariah committees as opposed to individual advisors avoided IJV bond
issuance.