Georges El Hedery Tells Why Investors Hold Bonds

So far in these monthly columns we’ve reviewed the monthly performance of the region’s bond markets, looking at the major events that have happened over the past few weeks. However, what we’ve not done yet is look at why regional investors should look at the bond markets at all, and why so many investors chose to hold bonds as part of their portfolios.

The reasons investors chose to hold bonds are split between macro points – i.e. why hold bonds at all and micro: why hold specific bonds from specific issuers. Before we look at the region’s bond markets, we perhaps need to take a look at what bonds are and how they work.

Bonds function essentially like a loan – where you, as investor, lend money to the borrower, called the ‘issuer’ of the bond. Governments and corporations both need to issue bonds, whether they are raising money for expansion – such as a new factory, or, in the case of a government, a new infrastructure project. In this respect, bonds are launched as a funding source for the issuer, sitting alongside bank loans and the organizations cash reserves.

Of course, this ‘loan’ needs to be repaid eventually, and bonds are issued with a specific maturity date, spelling out exactly when the investor will be repaid. This is one of the reasons they are called ‘fixed-income’ – investors know the amount of cash they will get back if they hold the bond until maturity.

This means that investors don’t just get a chance to invest in bonds from a specific issuer, but can invest in the issuers’ 5 or 10 year bonds, for instance. And investors don’t need to hold them until maturity. Many – if not most – regional investors chose to trade these bonds in the ‘secondary’ market; buying and selling bonds for profit. HSBC recently launched a retail bond platform to help investors actively buy and sell regional bonds – ensuring that there’s a market of buyers and sellers for all regional bonds. Already established in the UAE, this has been rolled out to Bahrain and Qatar.

But why should investors look to hold bonds at all as part of their portfolio at all? Perhaps the prime reason is the perceived level of risk when compared to equity stocks. Bonds represent debt, and stocks represent equity ownership so they are treated very differently if there’s a default. When we look at who gets paid back first, debt holders have priority over shareholders.

This means that in a worst-case scenario – such as bankruptcy – it might well be that after bond holders have been paid out, equity shareholders face losing their entire investment. Of course, if the default was severe, and assets low, there’s even a risk Bond holders are impacted – but they remain insulated by a buffer of equity holders. This is, of course, not to say that investors should not hold equities – many provide a dividend, and equities have historically proven an effective method of growing capital over the long term and protecting against inflation, but that investors should be aware of the opportunities presented by bonds.

Second, as ‘fixed income’ many bonds offer investors a set coupon, reliably and regularly paid under the terms of the bonds, differing from the floating rate of any equity dividend. This means that any investors who chose to hold the bonds until their maturity at least get paid for doing so.

When we look at how investors hold bonds, many chose to do so though bond or Sukuk funds. These are specifically designed to provide investors with access to a range of funds on a specific theme – for instance technology, or real estate. While they provide diversified exposure, as they are often ‘actively’ run, i.e. by a fund manager, there are fees attached to this. However, what we recently noticed from the activity on our retail bond platform is that the number of investors coming into branches and buying specific bonds after conducting their own research has massively increased. We’re only in the first part of 2012, but already volumes have exceeded the 2011.

Typically, investors are looking at bonds that they know and understand – the so called ‘national champions’. These are household names that give investors a level of comfort in their investment. These are often more liquid – meaning that investors who want to cash out of the bond, find a range of ready investors through the platform.

But investment isn’t limited to regional buyers and sellers. Over the last decade, international investors have shown a clear interest in buying MENA issued bonds. Part of the reason for this is the levels of return available in the region, which means that the bonds are particularly attractive to international investors looking for yield.

However, I think this ‘hunt for yield’s is only part of the story. While important, it’s more significant that international investors have the confidence to invest in a region they have, perhaps, not even visited. Regional companies issuing bonds have made great steps in improving their transparency and reporting, and this has lifted the reputation of not just the issuer of the specific bond, but the whole region.

Second, it was less than a decade ago that the only regional bond issuers were banks. Over the past five years, we’ve seen a massive increase in the number, and type of issuers who have sought to come to market. From utility companies to regional corporations, issuers have all found willing international buyers for their bonds.

So, the final question needs to be what’s holding the region’s bond markets back? Bonds are typically issued in a minimum denomination of US$100,000 and above meaning that retail investors looking to access the bond markets may be better served by bond funds.

However, this might not be the problem it first appears to be. First of all, many investors in bonds are affluent and experienced investors, so US$100,000 invested in one asset may well just match their other investments. Second, these bonds are actively traded, so investors can trade in and out of specific bonds, matching the needs of their overall investment strategy.

It’s therefore clear that bonds are an important option for regional and international investors – whether they are seeking a regular coupon payment or want to actively trade bonds.  But what is more significant is how the range, and the depth of bonds offered in the region has increased. They stand as a testament to the maturity and the importance of MENA to international investors, and that’s something we can be proud of.