The Effect of Portfolio Diversification with the Use of Islamic Bonds Sukuk

Diversification is the core concept in investment management and generally in finance. Investors always seek for profitable opportunities in terms of high returns, but not forgetting about the risk-return trade-off. For the diversification purposes, investors include securities of companies from different continents, countries, sectors, industries, or use indices, which are already diversified. One of the particular issues regarding diversification arose over the last few decades concerning the effect of adding the Islamic securities. This study assesses the possibility of bond portfolio diversification using Sukuk for the non-Islamic fixed-income investors holders. For this purpose, the description of general principles of Islamic Finance is defined and Islamic financial products within the Islamic Economics are determined. Data used include returns for 3 year period from 31st May 2016 to 31st May 2019 for 5 bond indices, namely Dow Jones Sukuk Total Return Index as a proxy for Islamic bonds market, S&P 500 Bond Index for the USA, S&P Japan Bond Index for Japan, S&P Germany Sovereign Bond Index for Germany and S&P U. K. Guilt Bond Index for the United Kingdom. Preliminary statistical tests conducted in EViews were applied for assessing the time series of daily returns on the subject of stationarity (Augmented Dickey-Fuller test) and heteroscedasticity (Autoregressive Conditional Heteroscedasticity model, number of lags in which is determined by optimal lag selection procedure using Akaike Information Criterion). The idea of GARCH model is determined mathematically and based on Engle and Sheppard Test of dynamic correlation, DCC-MGARCH model is used for the correlation analysis. The obtained results show that Dow Jones Sukuk Index is relatively more correlated with S&P 500 Bond Index than with S&P U. K. Guilt Bond Index and S&P Germany Sovereign Bond Index, while it is much lower for Dow Jones Sukuk and S&P Japan Bond Index. The correlation between Dow Jones Sukuk Index with S&P U. K. Guilt Bond Index follows the similar trend with the S&P Germany Sovereign Bond Index. The highest diversification effectiveness using Dow Jones Sukuk is faced by Japanese fixed-income investors as the conditional correlation for this pair is the lowest. Comparing the findings to the results obtained for 2010-2015 period (Ahsan Bhuiyan et al., 2019), it can be suggested that correlation between Islamic Sukuk and other bond indices had increased over the last years. Furthermore, for the most recent periods correlation is never negative anymore. The main finding is that in terms of diversification benefits, Dow Jones Sukuk is still an attractive instrument, especially for Japanese fixed-income investors. Thus, investors can allocate some of funds in Dow Jones Sukuk, benefitting from geographic diversification. After that an attempt was taken for constructing an optimal portfolio comprised of several US companies’ bonds with the use of Single Index Model in order to examine the practical implication of conditional correlation analysis results.