Preference for bonds over equities


  • Business
  • Monday, 20 Jan 2003

Bond markets are in favour worldwide. In Malaysia the outlook is bright for bond fianncing. As one of the major investment banks, Aseambankers Malaysia Bhd. is targetng agressively at this sector. In the first of a monthly series of six articles on the economy and bond market, Asembankers looks at why there is now a preference for bonds over equity. 

In THE contemporary investor is more often than not embroiled in discussions about the apparent schism between bonds and stocks, and the impact they have on the concept of risk and return.  

Baljeet Kaur Grewal

Bonds have been deemed confusing, arcane and even dull in terms of investment returns – but post-Asian crisis, investors learned why dull can sometimes be profitable.  

Bonds and stocks differ dramatically in their structures, payouts, returns and risk. Bonds are essentially a form of debt or an IOU issued by a borrower (corporations, government agencies) to a lender, at a stipulated interest rate (coupon) over a specified period of time (maturity).  

As a low risk, liquid asset with moderate returns, bonds offer investors an edge over equity investments, primarily because of the steady income stream. Coupon payments are made throughout the tenure of the bond whilst the principle remains intact.  

The rating of a bond forms an integral component of the issue and provides an objective assessment on the risk element of each bond, taking into account credit risk and potential defaults.  

Also, bonds are liquid investments with attractive yields (rate of return), which offer predominantly higher rates than bank savings and deposits, whilst maintaining a low risk premium (i.e. investors are paid coupons irrespective of whether the company makes a profit, again depending on the risk element).  

As bonds are generally deemed safe haven investments, there is an apparent “decoupling” that occurs as bonds and stocks trend in different directions i.e. when there is a pick-up in market conditions, investors tend to shift out of safer investments into higher risk reward instruments like stocks, and vice-versa (See chart).  

Ultimately, a portfolio mix will hinge on the risk appetite palatable to the investor, known as the risk/reward tradeoff. While some investors can handle the equivalent of financial skydiving without batting an eyelid, many others remain terrified to climb the financial ladder without a secure harness. In this instance, bonds provide the safety net of fixed returns.  

In Malaysia, bonds generally fall under 2 broad classifications: Malaysian Government Securities (MGS) or government-backed bonds, and Private Debt Securities (PDS) or bonds issued by corporates to raise capital for funding needs.  

If anything good emerged from the financial crisis, it is that incidental to the recovery process; Malaysia developed one of the most successful domestic currency bond markets in the region. The economic crisis underscored the vital need for a balanced mix of bonds and equity when making investment choices.  

Bonds account for a more stable source of long-term financing, and thus spread the risk element associated with cyclical downturns.  

The development of Ringgit bonds across a range of tenors, credit ratings, issuers and products has created one of the fullest, most diverse bond markets in the region.  

Total PDS issued increased multi-fold from RM12.3bil in 1996 to an estimated RM33bil in 2002, reflecting the depth of the bond market.  

This year, fund raising through PDS is expected to increase by a further 17% year-on-year, largely due to the improvement in credit demand, a pick-up in economic activity and the continuous preference for corporates to raise capital using debt instruments.  

Concurrently, demand for Islamic debt instruments, which accounted for only 7% of total bonds raised in 1999 grew to 25% in 2000 and subsequently to 36% in 2001, primarily due to investor awareness of alternative funding sources and the increased number of Islamic funds launched over the years.  

No fewer than 60% of all Malaysian domestic bonds are now Syari’ah-compliant, and this proportion continues to grow. Syari’ah compliant bonds are the instruments of choice for issuers because they guarantee access to a larger investor base.  

The result is that Malaysia’s Islamic financing landscape has advanced in terms of diversity of instruments and its modernity, as well as boasts a dual banking model whereby a developing Islamic financial system exists in parallel to the conventional banking system. 

In contrast, funds raised through the equity market are expected to contract from RM12bil in 2002 to approximately RM4bil this year, fundamentally due to the jittery external environment and lacklustre equity markets which continue to fan the flames of global economic obscurity.  

Domestically, the economic environment remains resilient. Low inflation and accommodative interest rates, as well as growing war anxiety in the Middle East will likely sustain the allure for bonds in the medium term.  

Thus, as investors toss the proverbial coin in contemplation between bonds and equities, it remains crucial to balance the resonant domestic macroeconomic fundamentals against dwindling global economic dynamics.  

 

Note: The author is an economist with Aseambankers Malaysia Bhd, the investment banking arm of Malayan Banking Bhd (Maybank). 

The next article will examine the implications of a potential war and global economic uncertainty on the bond market. 

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