In the late 1990s, Malaysia created a new way for corporations to raise money by issuing bonds that comply with Islamic law, which prohibits the payment or collection of interest.
The strategy paid off, according to a comprehensive study co-authored by UC Riverside business professor Jean Helwege. The study found Islamic bonds attracted billions of dollars in new investment without undermining the market for conventional corporate bonds, expanding businesses’ access to financing and helping drive Malaysia’s economic growth.
Published in the Journal of Financial Economics, the study examined two decades of activity in Malaysia’s corporate bond market after the country introduced Shariah-compliant bonds in 1997. Often called Islamic bonds, or sukuk, the securities comply with Islamic religious principles while providing investors with returns that closely resemble those of conventional bonds.
Rather than replacing conventional bonds, the researchers found that the new securities broadened the investor base by attracting people and institutions that otherwise would not invest in traditional interest-bearing debt.
“The overall finding was that these bonds increased in popularity,” said Helwege, a professor of finance in the UCR School of Business. “People did like to buy them, but it didn’t make the conventional bonds go away. The result was that there’s more financing overall, and it does seem to have been helpful to the growth of the Malaysian economy.”
The findings challenge a common assumption that introducing a new financial product simply divides an existing market. Instead, the researchers found that Islamic bonds expanded the total amount of capital available to businesses by bringing new investors into the market.
Islamic law prohibits the payment or receipt of interest, reflecting religious teachings that historically sought to prevent exploitative lending and promote fair financial dealings.
To comply with those religious principles, Islamic bonds are structured differently from conventional bonds. Rather than explicitly paying interest, they are designed around contractual arrangements viewed as profit sharing or asset-based financing while producing cash flows that are economically very similar to those of conventional bonds.
“You can say that they have the same cash flows as regular bonds, so from an investor’s perspective they look extremely similar,” Helwege said. “But there are details in the structure that make them consistent with the Islamic world.”
Islamic bonds also avoid financing companies that profit from activities generally prohibited under Islamic law. For example, Islamic bonds cannot be issued by companies that own casinos, Helwege said.
Although the arrangements are often described as profit sharing, Helwege emphasized they are not the same as owning stock in a company.
“It’s not equity,” she said. “From the investor’s perspective, it feels like they’re likely to get their money back. From the company’s perspective, they’re not giving up too much upside. And from the perspective of religion, it seems like a fair deal.”
Malaysia provided an ideal setting for the research because the country deliberately built an Islamic capital market beginning in the 1990s while maintaining a conventional bond market. That allowed the researchers to study how investors and corporations responded when they could choose between two securities with nearly identical financial returns but different religious eligibility.
The analysis found that many companies chose to issue both types of bonds. By doing so, they could reach both conventional investors and Islamic investors in wealthy Gulf states and elsewhere who would not purchase interest-bearing securities. Even as Islamic bonds became increasingly popular, conventional bonds continued to play an important role in the market.
The researchers also found that differences in pricing between the two types of bonds remained relatively small. Companies weighed the additional costs of issuing Islamic bonds, including meeting religious certification requirements, against the advantage of reaching a broader pool of investors.
Overall, the expanded investor base increased businesses’ access to financing rather than simply shifting money from one type of bond to another.
In the late 1990s, companies issued less than US $2.5 billion in Islamic bonds each year, compared with roughly $5 billion to nearly $18 billion in conventional bonds. Over the next two decades, Islamic bond issuance climbed sharply, reaching more than$20 billion by 2017. Meanwhile, conventional bond issuance remained relatively steady, generally ranging from $7.2 billion to $10.8 billion annually. The trend shows how Islamic bonds evolved from a niche financing option into a leading source of corporate funding.
The findings have implications beyond Islamic finance. As financial markets continue to develop specialized investment products aimed at different groups of investors—including environmentally focused and socially responsible investments—the study suggests that introducing new securities can expand access to capital when they attract investors who otherwise would remain on the sidelines.
For Helwege, one of the study’s most significant findings is that accommodating religious values strengthened, rather than fragmented, the bond market.
“It was a popular product,” she said. “The conventional bonds didn’t disappear. There was simply more financing available overall.”
The study’s title is “The Impact of Introducing a (Nearly) Redundant Security: Evidence from Malaysian Corporate Bonds.” In addition to Helwege, the co-authors are Antje Berndt of the College of Business and Economics at the Australian National University; Amanda Liu of Windpeak Corporation in Fremont, California; and Frank Packer of the Bank for International Settlements in Basel, Switzerland.