Assessing the viability of Sukuk for portfolio diversification using MS-DCC-GARCH

Many of the earlier researches postulate that Sukuk, being of some fundamental difference from conventional bond, offers a diversification strategy for investors and portfolio managers. However, other works have argued that Sukuk has many properties it shares with the conventional bonds and as a result it might not be a viable strategy for portfolio diversification. In essence, the viability of Sukuk for portfolio diversification remains unresolved both theoretically and empirically. This paper therefore examines the viability of international diversification benefits of Sukuk for equity investors in conventional stock markets. A comparison of the Sukuk diversification benefits with other conventional alternatives from advanced and emerging markets was carried out. Markov regime-switching GARCH model with dynamic conditional correlations (MS-DCC-GARCH) was applied. The regime-based model provides insight to possible segmentation (or integration) of these securities from global markets during different market states for weekly return series for conventional (advanced and emerging) and Islamic stock and bond indices examined. Asymmetric shocks are observed from conventional stocks and bonds into Sukuk. Compared to emerging market bonds, Sukuk are found to display a different pattern in the transmission of global market shocks. The analysis of dynamic correlations suggests a low degree of association between Islamic bonds and global stock markets with episodes of negative correlations observed, particularly during market crises periods. Portfolio performance analysis suggests that Islamic bonds provide valuable diversification benefits that are not possible to obtain from conventional bonds.