Sukuk vs. conventional bonds: A stock market perspective

What is it about?

We examine whether investors react differently to the announcements of sukuk and conventional bond issues. Sukuk are Islamic investment certificates commonly used in Islamic finance. We use the event study methodology on Malaysian data. Our results show that the stock market is neutral to announcements of conventional bond issues. However the stock market reacts negatively to announcements of sukuk issues.

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Why is it important?

Our findings are relevant for two major debates in Islamic finance. First, Islamic finance is subject to criticism because its empirical application exhibits great similarity with conventional finance. Ayub (2007) observes that a major criticism of Islamic finance rests on the lack of differences with incumbent modes of finance. We provide countervailing evidence that stock markets can readily distinguish between sukuk and conventional bonds. Thus, market-based information supports the existence of differences between instruments emerging from Islamic finance and those associated with conventional finance. Regarding the economic effects of the expansion of Islamic finance, our results show that sukuk announcements likely lead to a negative market reaction that can adversely affect firm value. In contrast, issuance of conventional bonds has a neutral impact on market capitalization. Therefore, the increasing use of sukuk as currently structured and sold may be detrimental to firm value, at least in the short run. As negative stock market reactions may limit incentives for companies to issue sukuk, their expansion might be curbed, despite their religious underpinnings. Our results are related to the adverse selection mechanism that emerges from the coexistence of sukuk and conventional bonds on the Malaysian market. Such a mechanism would not exist if only sukuk are issued on an exchange, implying that the negative reaction to sukuk issues is likely to be reduced in a pure Islamic financial system.