Published on April 13, 2008
Slide1: GARP Evening Talk: Presentation Title: “Islamic Fixed Income Analytics & Risk Management” By: M. Damshal Awang Damit, CFA CEO, Muamalat Avenue Sdn Bhd Malaysia 24 March 2006 Slide2: Shariah Issues Market Trends & Statistics Case Studies Overview Slide3: Shariah Issues Shariah Issues Trend & Statistics Case Studies Shariah Endorsement Beyond Product Level Imbalances Global Acceptance Slide4: Shariah Endorsement Beyond Product Level Shariah Issues Trend & Statistics Case Studies Passive Approach Active Approach Proactive Approach Other Players Regulatory Screening (No Syariah Board) Regulatory Screening Regulatory Screening Internal Syariah Board Internal Syariah Board Proactive Screening & Islamic Analytics Muamalat Avenue’s Approach Towards Syariah Slide5: Imbalances Shariah Issues Trend & Statistics Case Studies Prevailing imbalances… More than 80% of global Islamic bonds are in Malaysia More than 50% of Islamic bonds are BBA which are not globally recognized More than 60% of Malaysian Islamic bond issuers are in the “infrastructure & utilities” sector (Conventional is about 30%) On ABS: Only 10% of ABS in Malaysia are Islamic. About 9% of conventional bonds are ABS, but only 4.5% of Islamic bonds are ABS. Yield curve on ABS is not reflective of the structure On the Demand Side: M’sian Islamic Bond: 51% Mid-East, 30% Asia Qatar (& IDB): 70% Mid-East, 15% Asia Sources: SC, IOSCO, RAM & MARC Slide6: Imbalances Shariah Issues Trend & Statistics Case Studies Impact on the global imbalances… Global diversification is limited. Hence optimization of risk-adjusted return is more challenging than comparable conventional products. Empirical evidence: 8 of the Top 10 largest Islamic funds globally are in Malaysia, but none in the Top 10 best performing funds. The top performing are mostly global funds Lack of global recognition contributes to issues being Malaysian-centric & spread movement is largely domestically driven Portfolio rebalancing would not optimize portfolio return as sectoral exposure skewed to only certain sectors Structural imbalances would impair price discoveries. Source: Bloomberg Slide7: Global Acceptance Shariah Issues Trend & Statistics Case Studies To gain global acceptance, these imbalances need some adjustments. Affective adjustment is a function of economic growth (supply-side), global liquidity (demand-side) and harmonization of shariah standards. On supply side, “produce what you can sell, not sell what you can produce”. Product structure should be “sellable” globally. On demand side, more aggressive on promoting awareness in the ability of Islamic funds to complement the conventional ones. Harmonization of shariah standards is always a contentious issue, although there are already some good efforts (e.g. IFSB) Slide8: Trends & Statistics Shariah Issues Trend & Statistics Case Studies Impact on Imbalances Unproductive Refinancing Movement From Islamic Banking to Islamic Finance Marketing Islamic Products Beyond Performance Slide9: Khazanah’s –ve spread… Issues – Is credit arbitrage really possible? (regulatory & Syariah issues) Perhaps khazanah is a better benchmark (but not as liquid as MGS) Shariah Issues Trend & Statistics Case Studies Impact on Imbalances (Local) Slide10: Malaysian Sukuk: Initial spread = 95bps above 3mth LIBOR (June 2002) Current spread = 20bps (estimate) Qatar Sukuk: Initial spread = 40bps above 6mth LIBOR (Sep 2003) Current spread = 25bps (estimate) The spreads are just too narrow relative to other papers of the same credit (single-A). Shariah Issues Trend & Statistics Case Studies Impact on Imbalances (Global) Slide11: However, the imbalances in Syariah papers are nothing compared to some prevalent global phenomena: Inverted US Yield Curve: Even Alan Greenspan called it a “conundrum” US triple deficit (trade, budget & consumer): Yet the economy remains “resilient”. Profligacy still reigns! Foreigners hold 55% of US Govt debt Bill Gross of PIMCO said, “No firm or economist totally understands this financial interplay of the early 21st century” Impact on Imbalances (Global) Shariah Issues Trend & Statistics Case Studies Slide12: Unproductive Refinancing Shariah Issues Trend & Statistics Case Studies Many companies refinance to capitalize lower rate rather than to finance new projects Not healthy for the economy as these companies are more occupied in capital restructuring rather than expanding businesses. Should introduce the “Refunding Provision” where the bond can be retired for any reasons other than refunding. Issuer will be more focused on enhancing business operations, hence possibly enhance its ratings Except for callable bonds, refinancing of plain vanilla bond is technically not helping the issuer in term of cost reduction as it has to pay premium to buy-back its bond (i.e. in down-trending rate environment) Slide13: Movement From Islamic Banking to Islamic Finance Shariah Issues Trend & Statistics Case Studies IOSCO 2003 report “Move from Islamic banking sector to Islamic capital market was observed as the industry matures” Slide14: Movement From Islamic Banking to Islamic Finance Shariah Issues Trend & Statistics Case Studies Empirical evidence that the more mature markets would tend to focus more on capital market than the traditional banking services Slide15: Marketing Islamic Products Beyond Performance Shariah Issues Trend & Statistics Case Studies Trend: Promoting Islamic Product Solely Based on Performance Myth: “Some Islamic products are not performing, it must be due to the structure” Promotion must be done in many perspectives: Risk-profiling & how it matches clients’ needs (liquidity, unique constraints, regulatory requirements etc) Proper benchmarking Proper selection of fund managers Right benchmarking: Islamic portfolio vs Islamic Index Benchmarking against conventional is only for fund managers’ guidance, e.g. to assess liquidity spread. Performance is mostly due to the skill of fund managers, can be further broken down into attribution analysis (selection & timing). Slide16: Marketing Islamic Products Beyond Performance Shariah Issues Trend & Statistics Case Studies Trend: Promoting Islamic Product Solely Based on Performance (cont’d) Myth: “Some Islamic products are not performing, it must be due to the structure” Are we saying that derivatives are flawed when ENRON, Barings & LTCM were brought down to their demise? Praises from the press before the scandals: Fortune magazine named Enron "America's Most Innovative Company" for six consecutive years from 1996 to 2001. The documentary The Midas Formula (1999) contended LTCM was the real-world laboratory for the equivalent in economics of the race to the moon. (Clark, 1999). Morale: Don’t miss the forest for the tree Slide17: Marketing Islamic Products Beyond Performance Shariah Issues Trend & Statistics Case Studies BUT then again, Islamic ethics propound “the virtue of earning good living by working hard & ethically, and then tawakal*”, and not just tawakal without any effort to earn a living (and other good deeds) Full submission to Allah does not relinquish the need to perform Muamalat activities to our best of abilities, as Allah said, “Verily never will Allah change the condition of a people until they change it themselves (with their own souls)” (Ar-Ra’d, no 13 verse 11). * Tawakal means full submission to Allah Slide18: Shariah Issues Trend & Statistics Case Studies Case Studies Islamic Fixed Income Analytics Challenges Opportunities Through Unique Strategies Slide19: Relative Valuation Analysis Shariah Issues Trend & Statistics Case Studies Islamic Fixed Income Analytics Sharpe Ratio (2001 to 2005) KLCI KLSI Bond* Avg Return 5.77% 3.97% 5.46% Std Deviation 16.90% 15.47% 2.90% Sharpe Ratio 16.70% 6.58% 86.52% Bond has outperformed both KLCI & KLSI KLSI performed poorly as KLCI gained from “Finance” sector Finance sector’s return = 7.28%, with Sharpe Ratio of 21.42% So, should asset allocation be more weighted to bonds? Slide20: Relative Valuation Analysis Shariah Issues Trend & Statistics Case Studies Islamic Fixed Income Analytics Economic Trend Forecasted by Spread Not much meat for bonds! But then again, earnings growth is projected to slow down, not good for equity either! Slide21: Overweight bond Overweight equities 170bps Std Deviation: KLCI = 16.9% Bond = 2.9% KLCI Geometric Avg = 5.8% Forward looking yields compared 428bps 560bps Shariah Issues Trend & Statistics Case Studies Islamic Fixed Income Analytics Balanced Fund seems ideal Slide22: Shariah Issues Trend & Statistics Case Studies Islamic Fixed Income Analytics Assessing Credit & Liquidity Spreads Slide23: Shariah Issues Trend & Statistics Case Studies Islamic Fixed Income Analytics (i) Bonds: Islamic GII* vs MGS (ST) *GII is Islamic MGS Low correlation GII has unique term structure Analysis of Liquidity Spread Source: RAM-Quantshop MGS Bond Index Slide24: Shariah Issues Trend & Statistics Case Studies Islamic Fixed Income Analytics (ii) Bonds: Islamic GII vs MGS (LT) High correlation Analysis of Liquidity Spread Slide25: Shariah Issues Trend & Statistics Case Studies Islamic Fixed Income Analytics (iii) Bonds: Islamic Bond vs Islamic GII (ST) Low correlation Implying GII (ST) has unique term structure Analysis of Credit Spread Slide26: Shariah Issues Trend & Statistics Case Studies Islamic Fixed Income Analytics (iv) Bonds: Islamic Bond vs Islamic GII (LT) High correlation Analysis of Credit Spread Slide27: Shariah Issues Trend & Statistics Case Studies Islamic Fixed Income Analytics High correlation (v) Bonds: Islamic Bond vs MGS (ST) Analysis of Credit Spread Slide28: Shariah Issues Trend & Statistics Case Studies Islamic Fixed Income Analytics (vi) Bonds: Islamic Bond vs Conventional Bond (ST) Implies high demand for Islamic bonds (ST) with good liquidity Analysis of Liquidity Spread Slide29: Shariah Issues Trend & Statistics Case Studies Islamic Fixed Income Analytics (vii) Bonds: Islamic Bond vs Conventional Bond (MT) Implies high demand for Islamic bonds (MT) with reasonable liquidity Analysis of Liquidity Spread Slide30: Shariah Issues Trend & Statistics Case Studies Islamic Fixed Income Analytics (viii) Bonds: Islamic Bond vs Conventional Bond (LT) Implies high liquidity Premium attached to Islamic bonds (LT) Analysis of Liquidity Spread Absence of data! Slide31: Shariah Issues Trend & Statistics Case Studies Islamic Fixed Income Analytics Assessing Credit & Liquidity Spreads: Summary of Findings Notes: The benchmarks are for assessing spreads, not portfolio performance Credit spread Liquidity spread Slide32: Shariah Issues Trend & Statistics Case Studies Islamic Fixed Income Analytics Assessing Credit & Liquidity Spreads: Summary of Findings Are the anomalies cyclical (new issue supply) or secular (dominance of certain structure) in nature? If cyclical in nature, then the lack of price discoveries are an adverse consequence to the Islamic bond market. The magnitude of supply is a function of economy and the promotion of Islamic structures to issuers/borrowers. If secular in nature, then the price premium could benefit fund managers and issuers alike. Nonetheless, the lack of supply would hinder effective rebalancing of portfolio. Whatever it is, the market lacks the depth & breadth necessary to enhance market efficiency & effectiveness. SOLUTIONS: see last slides Slide33: Shariah Issues Trend & Statistics Case Studies Islamic Fixed Income Analytics (Global) Sharpe Ratio (2001 to 2005) KLCI KLSI Dow Jones Islamic Avg Return 5.77% 3.97% -1.29% Std Deviation 16.90% 15.47% 16.02% Sharpe Ratio 16.70% 6.58% -36.13% Dow Jones Islamic Index (DJII) has underperformed badly. During this period of improving earnings, Dow Jones Islamic lags probably due to low beta position of most companies under its review (leveraged position is one of the filters). Other reason, similar to KLSI, is probably the absence of financials (about 24% of world market capitalization*) and these financials have performed well in the last few years. DJII may be more resilient during stagnant (or even in crisis) economic period as most companies are low in gearing. Nonetheless, there are some periods that DJII outperformed DJIA. Timing is definitely important. *Source: Calyx Financials Slide34: Attribution Analysis Attribution requires well established benchmarks: This is where the Islamic bond portfolio is lacking There are some benchmarks on Islamic bond portfolio, but the sub-indices are absent (or some are not well defined) Good attribution also requires good historical data to ensure reflective relationship between the indices & sub-indices (e.g. variance-covariance, correlation etc). It is also possible that attribution shows different result depending on period under study, if the benchmarks are not well constructed Shariah Issues Trend & Statistics Case Studies Slide35: Operational Challenges Rebalancing & risk management are a challenge as Islamic derivatives market lacks width & depth Immunization may be disrupted if some assets are turning non-Islamic/ or simply to rebalance portfolio as replacement of like assets is difficult. It is due to structural imbalances between demand & supply Sector & Subsector classifications are not consistent with international standards (International Classification Benchmark, ICB) – Attribution analysis is a problem Different requirement from actuary & accounting Challenges Shariah Issues Trend & Statistics Case Studies Slide36: Structural Challenges Price discovery for Islamic bond: Govt yield curve is not representative (negative spread for Khazanah!). Hence benchmarking has to be fine-tuned Asset allocation explains >90% of return. However, sectoral imbalances in fixed income as exposure skewed to capex hungry sectors like infra & utilities (>60% of Islamic bonds) Issues are “domestic flavour”. Should structure bonds towards internationally recognized Islamic structure such as Ijarah Risk management with the view to enhance risk-adjusted return is a challenge due to sectoral imbalances & unclear subsector definition (that could mess up correlation matrix). Challenges Shariah Issues Trend & Statistics Case Studies Slide37: Tactical Asset Allocation Strategic asset allocation is still key, but in this Islamic market where sectoral diversity is still low, tactical allocation could enhance the portfolio more effectively. For institution where risk sharing is key (e.g. Takaful), asset allocation that starts with risk parameters could match its liability more effectively. Shariah Issues Trend & Statistics Case Studies Opportunities Through Unique Strategies Slide38: Relative Yield Comparison Strategic asset allocation to be driven by relative yield comparison. Early 2000, bonds provided relatively higher yield than equity (the opposite happened in 2003). Asset allocation was relatively simpler during that period as the yield disparity was obviously significant (>400 bps) Yield differential between bond & equity late 2005 suggests the risk pricing is about right (equilibrium?). Balance fund may provide the optimal risk-adjusted return. LT Islamic bonds appear relatively cheap, if illiquidity is tolerable. On some tenure, there are trading opportunities as anomalies in pricing occur. Opportunities Through Unique Strategies Shariah Issues Trend & Statistics Case Studies Slide39: Industry Reforms The SC’s Capital Market Masterplan 2001 aims to turn Malaysia into international Islamic Capital Market by: i. introducing more Islamic capital market products ii. mobilising funds effectively iii. establishing a comprehensive accounting, tax & regulatory framework based on Islamic tenets. Slide40: Industry Reforms The BNM’s Financial Market Masterplan 2001 advocates three recommendations to enhance Islamic Financial Market: i. Institutional capacity enhancement ii. Financial infrastructure development iii. Regulatory framework development Slide41: The Implementation of Capital Market Masterplan Implementation of recommendations to improve regulatory framework under the Capital Market Masterplan has been impressive with more than 60% completion and the rest with works in progress status. Source: Securities Commission This slide is prepared by Sharul Nizam, CFA Slide42: THANK YOU & WASSALAM Disclaimer: This presentation is prepared by Muamalat Avenue Sdn Bhd (“MUAV") solely for general information, without taking into account any specific investment objectives, financial situation or needs of any particular category of investors, and should not be construed as a recommendation, offer, invitation or solicitation to subscribe for, buy or sell the securities mentioned herein. The opinions, statements and information contained in this presentation are based on available data believed to be reliable. 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