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IN DEFENSE OF JUNK
Market watchers were cheered in late January, when
Capital Market Authority Chairman Abd El Hamid Ibrahim announc-ed
that the government was taking further steps to activate the nation’s
sluggish market for bonds. Among those steps were a promised issue
of 10-year treasury bonds, the longest yet; the licensing of companies
to deal in bonds; and a declaration that companies rating at least
a BBB- (minimum investment grade) in the eyes of one or more agencies
would be free to issue bonds in volumes of their choosing. Each
of these sounds fine except the last.
The minimum-rating floor is a tough policy to argue against, because
it seems so reasonable that the government should seek to protect
investors from bad investments. If companies can’t demonstrate
their financial soundness, why should they be allowed to issue bonds?
And considering the damage done when governments stand aside until
it’s too late – as in the case of Rayan’s Islamic
investment fiasco and Albania’s pyramids – it only seems
prudent to stamp out bad investments be-fore they gather too many
suckers.
But there’s a real difference between protecting investors
from fraud and protecting investors from risk. The former is the
government’s responsibility. The latter, even if it were the
government’s responsibility, could never be accomplished.
Risk is inevitable, as even highly rated companies sometimes fail
to repay their debts. The danger in setting a ratings floor for
bond issuers is that companies that make the grade will appear to
have the government’s backing. Investors might choose to lend
money to those companies not on the merits of the investment itself,
but because the government says it’s safe. If one of the approved
companies were to default, the government’s credibility could
be tarnished. The government might even find itself compelled to
bail out the bondholders.
Protecting investors from legitimate risk, however well-intentioned,
distorts investment decisions and implies guarantees where there
are none. It also limits reasonable options. BBB- is Egypt’s
sovereign rating – the credit rating of the government, the
country’s least-risky borrower. No company can secure a higher
mark than the sovereign. As EFG-Hermes Chair-man Mohamed Taymour
pointed out in January, establishing the sovereign rating as a floor
would mean very few Egyptian companies could issue bonds.
Additionally, not all investors want safe bonds. Outside of Egypt,
there’s a thriving market for low-grade corporate debt –
otherwise known as junk bonds – because investors are willing
to trade the increased risk for the prospect of higher returns.
Such behavior isn’t as dangerous as it sounds. Studies have
shown that well-diversified portfolios of junk bonds outperform
portfolios of quality bonds over the long run.
Junk-bond investors also provide a crucial source of capital for
companies that lack the track record necessary to borrow from banks,
or decent companies whose track records have been marred by serious
but extraordinary setbacks. In a market like Egypt’s, where
few companies have any financial track record at all, such fi-nance
will be crucial if companies outside the top tier are to be able
to expand and Egypt is to meet its goals regarding growth and employment.
The government might be uncomfortable with such lending, but it
shouldn’t be in the business of preventing it. Opponents to
this line of thinking could argue that Egypt’s markets are
young, and its inves-tors inexperienced. But placing limits that
shield investors from the need to research their own investments
won’t make them more sophisticated. It will just make them
incautious, which will make life riskier for all of us.
ANDREW DOWELL
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