“The corporate bond markets in the Gulf region are likely to gain added depth and versatility in the coming few years, as the need increases for long-term capital borrowed at a fixed rate.”
The bond markets in the Arab region are still in their early stages of development, with total value of corporate bonds issued at around $5 billion by the end of 2002, compared to the total capitalization of Arab stock markets of around $200 billion. Not only the primary markets — where new securities are issued — are thin, but also the secondary markets for bonds are illiquid. Bond trading makes up less than 1 percent of total trading on the region’s stock exchanges. Investors, typically banks, social security and insurance companies, tend to hold bonds to maturity. Getting a competitive quote on a corporate bond listed for example in Jordan and Morocco could take days, compared to seconds in the Eurobond market.
Arab corporates have the opportunity today to lock in the lowest borrowing cost we have seen for years. Interest rates on the US dollar, which are the major factors determining domestic interest rates in several Arab countries, are more likely to rise than fall in the medium term, pulling up domestic rates in the process. A prime corporate in the region could issue today a 5-year bond at around 2 percent below the rate at which he could have borrowed two years ago.
Interest rates on the US dollar and on the Arab currencies pegged to the dollar (mainly those of the Gulf countries, Jordan and Lebanon) have been on the decline in the past few years, and are unlikely to fall much from their current levels. On the contrary, rates have plenty of room to rise, and almost certainly they will, as they did in previous economic cycles. Geopolitical uncertainty, especially the war on Iraq, have dominated the regional and international capital markets since September last year, with investors moving out of riskier assets such as stocks to the safety of bonds, leading to higher bond prices (lower yields).
But once the war is over, investors will be willing to assume more risks, making bonds less attractive. Beyond the impact of the war, an upturn in the US economy may still be several months away, but the bond market always looks ahead. This suggests that dollar bond yields and short term interest rates have reached, or are very close to reaching their trough for the current cycle. If interest rates on US bonds, which are the major factor determining corresponding rates in the region, may soon bottom out, it would be timely for Arab corporates to start tapping their local bond market.
The corporate bond markets in the region are likely to gain added depth and versatility in the coming few years, as the need increases for long-term capital borrowed at a fixed rate. This will complement the region’s fast developing equity market and provide a fresh source of financing for private and public projects.
It will also encourage the creation of new risk management instruments such as interest rates, futures and options, while adding to the scope of the central banks to conduct monetary policy through open market operations.
Bonds provide corporates with another source of financing at fixed rates which many companies prefer because they do not require collaterals or guarantees. Bonds also facilitate long-term financial planning for corporates and protect them from future increase in interest rates. Bonds typically have a longer maturity than bank loans and are usually repaid in one bullet payment at maturity. Indeed, many chief executives now consider restructuring their debt from short to medium term and fixing their borrowing cost as a strategic tool for management, that allows them to strengthen their balance sheets.
Three factors determine interest rates on domestic corporate bonds. The first is the “risk free” government bonds, which provide a benchmark for pricing corporate bonds. Corporates have a higher credit risk than that of their corresponding government and should therefore pay a higher interest on their bonds compared to government bonds of the same maturity. This interest rate differential constitutes the second factor determining the price of corporate bonds. Over the past 20 years, for example, the top rated US bonds (AAA) have paid on average about 1 percent less interest than medium rated bonds (BBB).
The third factor is the maturity of the bonds. During times where interest rates are more likely to rise than fall in the years ahead, as is the case today, the yield curve tends to be sloping upward. This means that the same corporate borrower issuing bonds with various maturities has to pay higher interest on the longer maturities than what he is likely to pay on bonds with shorter maturities. Coupons would be higher if additional features are added to the bonds, such as a call option that gives the issuer the right to buy back the bonds after a specific period of time. A subordinated bond, whereby other creditors will be paid first in case the company goes into liquidation, will have higher coupons.
The presence of excess liquidity in the domestic banking system should not be a reason to delay the development of a local corporate bond market. The argument that banks can provide all the capital that corporates need does not always hold. A viable local bond market would provide “patient capital”, i.e. a new source of long term financing for corporate borrowers, that would help reduce their over dependence on short term lending from banks. The shortage of medium to long term funds at fixed interest rates is perceived to be a significant impediment for industrial growth in the region.
There is a growing trading culture in the country, as seen by the rising number of individual investors in the local stock market. The challenge is to transfer the same process to the bond market, whereby trading the bonds rather than holding them to maturity becomes the norm. Putting in place the right infrastructure is equally important. Bond markets rely, even more than equity markets, on strong corporate governance, transparency and full disclosure, viable legal system, contract enforcement, international accounting standards and active market participants.
There are only a few Arab financial institutions with sufficient expertise to price, underwrite and sell a corporate bond issue, while the legal mechanism whereby bonds can be listed on the local stock exchanges is still unclear in certain cases. The secondary bond market also needs to be supported by an institutional infrastructure that includes, among other things, efficient clearing and settlement arrangements and the presence of active market makers.
There is a growing trading culture in the region as seen by the rising number of individual investors in local stock markets. The challenge is to transfer the same process to the bond markets, where trading the bonds rather than holding them to maturity becomes the norm. Putting in place the right infrastructure is equally important. Bond markets rely, even more than equity markets, on strong corporate governance, transparency and full disclosure, viable legal system, contract enforcement, international accounting standards and active market participants. Bond markets will not only promote the general development of the countries of the region, they will also reflect it.
(Henry T. Azzam is chief executive officer at Jordinvest)
Arab News Business 7 April 2003
