This study explores the influencing factors of the Islamic bond (sukuk) spreads, by employing the generalised autoregressive conditional heteroscedasticity (GARCH) method. Apart from the general GARCH (1,1) model, a higher order of lags for both ARCH and GARCH terms are also considered which is applied onto both the investment and non-investment grade sukuk. This study is among the first few to document the empirical evidence on sukuk spreads and its volatility which is expected to further enrich the empirical literature of the financial markets especially in the Islamic finance. This is in line with the pressing demand for more in-depth information on various dimensions of the sukuk market given the importance of the sukuk in the global capital market. This study contributes significantly to the benefit of the investors, portfolio managers as well as regulators to better understand the underlying factors influencing the pricing and risk management of sukuk instruments. In addition, the assessment on the impact of the recent global financial crisis allows for a thorough understanding on the behavior of sukuk spreads so as to pre-empt the impact of future financial shocks to the sukuk market.

The exercise of modelling the risk and volatility of corporate bonds is undertaken through credit spreads analysis, a practice normally used in bond pricing and risk management. Despite the rapid growth of the Malaysian bond market, very few studies on the behaviour of credit spreads, and whether its volatility is influenced by external shocks have been conducted. This paper aims to unveil the trends and behaviour of credit spreads during the 2007/2008 global financial crisis. It examines the credit spreads of the Malaysian bond market by modelling the conditional variance and asymmetric response to past shocks of the long and short term investment and non-investment grade papers. A generalised autoregressive conditional heteroscedasticity (GARCH) is applied to 10 different ratings and maturity over the period ranging from 1 August 2005 to 31 December 2011. More specifically, modelling the asymmetry via the threshold GARCH (TARCH) and exponential GARCH (EGARCH) models meets the aim of this paper which examines the asymmetric response to past shocks of the Malaysian bond market during the 2007/2008 global financial crisis. The empirical analysis of this paper provides evidence of strong time-varying conditional variance of the Malaysian bond credit spreads with the expectation of future rate being the main determinant for credit spreads. Additionally, the evidence also indicates that past news or shocks as well as forecast variance are important in explaining the volatility of the spreads. The insignificant TARCH and EGARCH coefficients, nonetheless, indicate that there is no evidence of asymmetric response to past shocks in the volatility of bond spreads.

Technically, sukuk that are traded in the secondary market are quoted based on the spreads to a particular risk-free security, such as government investment issues (GII). In the conventional bond market, these spreads are known as credit spreads. The credit spreads are the main focus of investors in corporate bonds. Similarly, the sukuk spreads indicate the compensation to risk, referred to as the risk premium. The risk premium is the factor that makes investors willing to invest in sukuk despite the risks that they may encounter. Even though sukuk are structured based on the different kinds of contracts, which can be sale-based, leased-based, partnership-based or agency-based, the associated risks to sukuk is mainly reflected in the spreads, which is comparable with other sukuk that possess similar rating, duration and outlook for trading purposes. For example, a fund manager observes that the 10-year 'AAA' Idaman Sukuk is trading at a spread of 108bps above the 10-year GII. If another corporate sukuk with similar credit rating, duration and outlook were trading at a 115bps on a relative value basis, the second sukuk would be a better buy. Why? This is because with the same risk, the investor could get a higher compensation or premium (115bps vs 108bps) by investing into the second sukuk. This is one of the strategies carried out by the fund manager in an active sukuk portfolio management.