Determinants of Sukuk Risk Premium

Sukuk have become increasingly popular due to significant advancements in the Islamic capital market over the past few decades. While the influence of external and internal factors on the risk premium of conventional bonds has been extensively studied, there has been less focus on understanding these effects on sukuk spreads. This study aims to investigate the impact of various factors, including financial elements like default risk, liquidity risk, and maturity risk, as well as economic externalities such as pandemic, inflation, and interest rate hike, on both conventional bonds and sukuk risk premiums. Empirical analysis includes panel data from 45 pairs of sukuk and bonds that primarily gathered from Malaysia and Indonesia, as well as a matched sample from the UAE and internationally issued sukuk. A key focus of this study is on the post-COVID-19 pandemic transition phase, which has notably impacted market liquidity and credit risk, alongside heightened inflation, and an evolving interest rate environment along with differentiating structural dynamics of sukuk issuance. The results indicate that financial factors such as default probability, liquidity measured as bid-ask differentials, and residual maturity significantly affect the yield spreads of both bonds and sukuk, albeit to varying degrees. The findings also suggest that during a pandemic and periods of high market interest rates, sukuk spreads may be more sensitive than bonds, particularly in liquid markets like Malaysia. Moreover, inflation increases negatively affect spreads to different extents depending on the market and instrument. This underscores the potential benefits of diversifying between sukuk and conventional bonds based on prevailing market conditions during times of crisis.