Jamal Abbas Zaidi, CEO
Islamic International Rating Agency
It is well known that the debt markets consist of government and agency bonds, corporate bonds, municipal bonds, asset-backed securities and Islamic financial instruments. Participants in secondary debt markets include institutional investors, governments, traders and individuals; while the dominant players in the issuer’s market are sovereign and sub-sovereign bodies, the secondary market is usually dominated by banks and financial institutions.
Developed economies have efficient public debt markets where most primary offerings are sold. As indicated by its rating, an issuer’s financial strength and external support, define the credit strength and determine the pricing of an issue. The nature of sovereign debt means it is less risky than other forms. As a result, it normally sells at less attractive yields compared to non-sovereign debt.
In emerging capital markets, as in developed markets, the dominant role is normally played by the sovereign. The corporate debt instruments are also emerging on the scene.
Once issued, debt securities are traded on the secondary market. This process contributes to efficient pricing for upcoming issues. Unlike the stock markets or futures and options markets, secondary trading in debt securities remains decentralised in most countries, although some securities regulators have sought to promote trading by requiring that the debt be listed on stock exchanges.
Liquidity of an issue is predicated on the breadth and depth of the buying base. It is measured with the help of the difference between bid and ask prices (generally called bid-ask spread) and is determined by the trading volume. For sovereigns or sub-sovereigns, high volumes lead to efficient pricing and lower bid-ask spread, while debt issued by lesser-known borrowers suffers from lack of liquidity, resulting in a higher bid-ask spread.
The size of the international bond market is estimated at US$45 trillion and the size of the outstanding US dollar bond market is estimated at US$25.2 trillion. The conventional debt secondary market has certain characteristics, such as:
High liquidity, as reflected by the large number of buyers and sellers and high trading volume (average daily trading volume for the US bond market is estimated at US$923 billion).
Market depth, meaning that money market traders can execute large orders without compromising substantially on the price.
Efficiency, indicating that the pricing reflects issuer credit strength, fundamental value of the investment and diversity in the participants (both issuers and traders).
Well-defined yield curve. Traditionally, yield curve is observed to be upward sloping with a difference of approximately 200 to 300 basis points (reflecting liquidity risk premium) between long- and short-tenure maturities. A large deviation between short- and long-tenure yields can be due to temporary mispricing (subject to future adjustment) or due to fundamental reasons (not subject to adjustment).
Other useful curves, reflecting expectations for forward and swap rates, facilitate pricing of the instruments. The forward curve is supposed to be an unbiased predictor of future spot rates and the swap curve is supposed to serve as a proxy rate for longer maturity instruments not readily available or traded in the debt market.
Valuation of new and upcoming issues continually validates the pricing of outstanding issues set by actual trades.
Credit risk premium is determined by credit strength of the issuer. Independent credit rating agencies provide credit opinions and these form the basis of risk-based pricing.
Interest rate risk resulting from changes in market interest rates affecting cash flows for variable rate securities and market value for fixed rate securities are controllable with the help of derivatives.
Despite high liquidity and a large number of issuers, debt markets are not as fast moving as equity markets, and unlike organised exchanges for equity, debt instrument trading in the secondary market is decentralised.
Liquidity Management: Barriers and Issues
Liquidity management by Islamic financial institutions (IFIs) is constrained by a number of issues. These arise due to a number of reasons including market-driven factors (deficiencies in the market instruments), limited choice of instruments available to Islamic investors, regulatory environment and lack of insight into the information and risk profile of Shariah-compliant instruments. Let’s consider these issues in some detail.
Islamic debt issuance is relatively new compared to conventional debt, which has been in existence for a long time. The secondary market for Islamic instruments lacks key features required for efficient functioning of the debt market, such as:
A consensus Islamic benchmark rate because of which a conventional market benchmark rate (such as Libor or Euribor) is used as a proxy to determine the pricing of the Islamic instruments.
Low liquidity, suboptimal market depth, lack of efficiency and relatively small number of participants.
Lack of price validation mechanism which facilitates issuance of new and upcoming issues.
Absence of a focused risk-based pricing mechanism (a demand for credit ratings with a focus on Islamic finance can provide this mechanism).
Mitigants to manage and hedge the risk of fluctuations in the market value of instruments on account of movements in benchmark rate.
Limited choice of assets to be used as collateral.
Limited Number of Instruments
Currently, the Islamic debt market consists of sukuk, which are bonds that can be structured in a number of ways to reflect the various modes of Islamic finance. Examples include ijarah sukuk and al-salam sukuk. Besides sukuk, Islamic banks use interbank borrowings and placement for short-term liquidity management through the use of commodity murabahah.
Due to a lack of products or assets in which to invest their money, IFIs are finding it increasingly difficult to manage temporary and/or short-term excess liquidity. In addition to a regulatory environment which is still evolving, another factor constraining efficient Islamic financial markets that can provide liquidity management instruments is the pricing issue and informational limitations.
Since investors with a preference for Shariah-compliant products may have limited appreciation of the risks and rewards associated with such investments, the secondary market has not developed an appetite for such instruments.
Impediments to Securitisation
It is a given that Islamic institutions conduct a major part of their business in the Muslim world. Securitisation is common primarily only in countries with a developed regulatory framework such as Organization for Economic Cooperation and Development countries and a few emerging economies like Singapore and Malaysia. The regulatory environment, in countries where demand for Islamic finance is the strongest, needs to be made supportive of the evolution of Islamic finance products.
Securitisation has not been used by Islamic banks because of the lack of demand. This lack of demand arises because of the underleveraged status of the balance sheet of most of the Islamic banks. Demand for securitisation is typically felt by banks having a high level of disposable risk assets compared to capital. Securitisation is also done to remove a class of assets from the balance sheet to reduce the strain on the capital. This situation will arise once the Islamic banks grow to adequate size in relation to the resources available to them.
Buy-and-hold is the opposite of active portfolio management of debt securities. With a buy-and-hold policy, the portfolio manager normally buys a security and holds it to maturity. He may decide on a percentage allocation of the total portfolio in the various instruments at the outset, and then maintain that portfolio composition.
Unlike theoretical efficient markets where active trading is not supposed to be a beneficial strategy, since the market price of securities fully reflects the risk profile and return expectation of an instrument, secondary market trading in less efficient markets has incentives and rewards available to the portfolio manager capable of superior security selection and sector allocation.
There is a number of reasons responsible for the buy-and-hold culture in the secondary debt market for Shariah-compliant instruments, such as:
A lack of trained personnel who can handle pricing and trading in the instruments.
Islamic financial institutions that are often underleveraged. They also tend to lack avenues to invest their money. This results in excess liquidity with little incentive to sell the existing instruments.
Treasury managers may be forced to keep extra cash in order to support unanticipated demand which may be inconsistent with the budgeted amount.
Treasury is viewed as a cost centre acting as custodian of the bank vault. In such a situation, treasury managers are not expected to generate profit.
A final reason for the lack of trading in sukuk issues is the settlement problem associated with sukuk’s lack of adherence to international bond conventions. Most important is if it has a euro clearable status. Euro clearable status enables quick and efficient transfer in case of a change in ownership of the instruments.
Despite the impediments discussed, demand for Islamic finance instruments exists because of the desire to earn short-term trading profit and to manage the short-term and, in some cases, medium- to long-term liquidity. In addition to these two major incentives, other incentives for trading are:
Yield pick-up trade – The manager may find the risk quality difference between, say, an AA-rated instrument and an A-rated instrument unimportant and trade in A-rated instrument (offering higher yield) against AA-rated instruments.
New issue swap – Managers may swap on-the-run issues with old issues since on-the-run issues are perceived to provide greater liquidity. The manager might be interested in changing/rotating sector exposure. And changing/altering portfolio duration may also be a reason for trading in the secondary market.
Credit-upside trade – As soon as a credit upgrade is announced for a security, the yield spread on that security narrows, causing a corresponding increase in the market price. Under-rated – and therefore, undervalued – securities are purchased to profit from any probable credit upgrade.
Credit defence trade – As soon as the credit downgrade is announced, the security price declines, reflecting the wider yield spread. To prevent this loss, overvalued securities are divested.
Sector rotation trade – To change sector exposure, issues in one sector are swapped with those in another sector. It is usually done to adhere to the benchmark allocations stipulated in the investment policy.
Yield curve adjustment trade – To shift/modify portfolio duration.
It has to be stressed that IFIs have stronger needs for liquidity than conventional banks because of their reliance on lender of last resort is, to some extent, limited. It can be concluded that the buy-and-hold culture prevalent in Middle Eastern markets – specifically in Islamic financial markets – is due to supply constraints, where the choice of instruments is limited and demand for the instrument despite the presence of incentives to trade is discouraged.
Path to Liquid Secondary Market
As discussed, liquidity in the secondary market is a function of demand and supply of Islamic financial instruments and value changes that offer profit opportunities. These are market-driven factors (arising due to inefficiencies in the market), the limited choice of instruments available to Islamic investors, regulatory environment and lack of insight into the risk characteristics of Shariah-compliant instruments.
To remove inefficiencies in the market, the following measures are suggested:
Evolution of a consensus Islamic benchmark rate beyond Libor
Increase the number of market participants offering a variety of new Islamic instruments that cater to a wider selection of investors.
Refinement of price validation mechanisms based on prices set in the market, which will facilitate further issuance of new and upcoming issues.
Evolution of ratings-based pricing to ensure proper allocation of capital.
Deployment of derivatives and structured products designed to hedge the risk of fluctuations in market value resulting from movement in rates, such as swaps and forwards.
As observed in the case of various stages of development in the conventional debt market, availability of the Shariah-compliant debt instruments will grow with the level of acceptability and understanding of the same.
The regulatory environment is evolving and it has to be able to support the financial engineering innovations, the cornerstone of efficiency in the debt market. The stages of evolution that the developed countries have witnessed in the development of the conventional debt market suggest there is no quick fix.
The process is gradual where the regulatory environment in the first place has to provide a level playing field for all the existing players in the market and then gradually with the evolution of new products and instruments, it has to keep pace with new developments.
Plain Vanilla versus Exotic
Are the complex instruments more difficult to trade? The answer lies in an analysis of trading in various plain vanilla and exotic instruments. As the financial markets reach maturity, participants start realising the need to manage various risks inherent in such instruments. The market responds and product innovations lead to development of structured financial products.
Initially, plain vanilla products such as interest rate swaps and forward rate agreements were introduced. To meet the needs of various other participants, inclusion of certain options in the securities resulted in the structuring of various mortgage-backed and asset-backed securities.
To sum up, financial instruments continue to become more complex as time passes and the need for hedging is felt by market participants. Finally, there are complex structured products such as instruments with floors and caps and swaptions, which combine more than one derivative or a number of options into a single product.
The interesting point to note here is the fact that the complexity is a function of evolution in the market and the level of maturity the market has realised. It has never been a question of one instrument being more difficult to trade than another. Rather, it is always a question of what market participants need.
At a primary level where the rudimentary instruments have not achieved the acceptability for all participants, the focus should be on making sure there is a level playing field so as to encourage further market development. The complex instrument will create its own demand once the participants are comfortable with what is available.
Jamal Abbas Zaidi is CEO of the Islamic International Rating Agency based in Manama, Bahrain.
This article first appeared in Islamic Finance news (Volume 4, Issue 48).