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29 October 2020 CFA Institute Journal Review

Investor Tastes: Implications for Asset Pricing in the Public Debt Market (Summary)

  1. Karl Strauss, CFA

CFA Institute Journal Review summarizes "Investor Tastes: Implications for Asset Pricing in the Public Debt Market," by Emily Shafron, from the Journal of Corporate Finance, April 2019.

Innovative debt structuring by bond issuers to accommodate unique investor preferences may reduce the cost of borrowing. Islamic finance investors may drive asset pricing inefficiencies by purchasing suboptimal portfolios because of their preference for Shariah-compliant assets.

What Is the Investment Issue?

Islamic finance investors may influence asset prices if they have a portfolio constraint, or preference, for Shariah-compliant assets. This work builds on the Fama–French theory that investor preferences affect asset prices when they cause investors to hold suboptimal portfolios.

Shariah compliance requires securities to be interest free. Shariah-compliant bonds actually represent ownership certificates of an asset that is leased back to the issuer. Rather than earning interest on lending, investors earn profit on the leasing. Ownership of the asset transfers back to the bond issuer at maturity, and the investor receives principal and profits through the lease payments. Bond issuers may enjoy a lower cost of capital by structuring their debt offerings to meet this specific investor demand for Shariah-compliant bonds.

How Did the Author Conduct This Research?

Malaysia, a leading marketplace for Shariah-compliant bonds, has the fourth-largest conventional bond market in Asia. Investor demand for conventional and Shariah-compliant bonds is estimated by comparing the total daily number of bonds for sale in the Malaysian market with the number of bids to purchase these bonds. This daily bid-to-coverage (BTC) ratio indicates which bonds were over- or undersubscribed. The author performs a t-test of means and a Kolmogorov–Smirnov test of the resulting demand distributions, controlling for bond covenants as well as the possibility that bond prices and demand are determined simultaneously. Unfortunately, bond price information was unavailable; rather, coupon rates and benchmark market rates serve as a proxy for price information.

Bond and rate information from 2005 to 2013 was obtained from the Rating Agency of Malaysia, producing a sample of 480 bond issuance observations (108 conventional and 372 Shariah compliant) from 83 issuers (24 conventional-only, 55 Shariah-compliant-only, and 4 dual issuers). The main subsample consists of the four dual issuers, which account for 23 conventional and 53 Shariah-compliant bonds. The number of observations in the subsample seems notably small, and these dual issuers represent a disproportionately large volume share of total issuances.

The assumptions behind the Fama–French theory are tested and affirmed to hold true in the Malaysian Shariah-compliant bond market.

What Are the Findings and Implications for Investors and Investment Professionals?

The author demonstrates that Shariah-compliant bonds account for substantial wealth. Investors in these bonds buy a wide range of assets while holding positions different from those of a market portfolio, and they underweight assets that are not correlated with Shariah-compliant bonds.

Global investors should be aware of the impact on asset prices caused by demand for Shariah-compliant assets and the potential opportunities resulting from a group of investors pursuing suboptimal portfolios: The study shows that distributions for Shariah-compliant bonds are statistically different (at the 1% level) from those of conventional bonds. Conventional bonds may be more attractive in largely Islamic finance markets. Bond issuers should consider structuring innovative issuances to address specific investor preferences in order to potentially lower their overall cost of capital. Shariah-compliant bonds are found to pay between 51.6 bps and 75.5 bps less than conventional bonds, on average, during the sample period.

Malaysia uses the International Financial Reporting Standards (IFRS). IFRS 16 recognizes leases as liabilities and categorizes a portion of lease payments as interest rather than profit. This standard was implemented in January 2019, and similar reporting standards are being implemented in the United States by the Governmental Accounting Standards Board (GASB 87) and the Financial Accounting Standards Board (FASB ASC 842). The new accounting standards around leases may have implications for maintaining Shariah compliance.

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