Pessimism, fear and familiarity bias
Most asset pricing models have a basic assumption that investors have rational expectations about economic variables; an assumption that turns out not to be true. Two particular departures from rational expectations affect investment return the most i.e. pessimism and fear.
When faced with an uncertain economic environment these two factors grip the masses, consequently they tend to move towards safe investment avenues. This phenomenon is called familiarity bias.
Our domestic experience
Pakistan was facing a looming default on its foreign debt obligations in 2H’08 which was averted through the lifeline provided by the IMF. As a consequence of the central bank’s monetary tightening policy, a credit crunch in the domestic money market in the last quarter of 2008 was ominous. This crunch forced the comparatively weaker financial institutions to default on their obligations. Panicky investors moved their assets from foreign and weaker banks, some DFIs to the most familiar avenues like National Savings Schemes and better rated domestic commercial banks, NBFCs, and smaller and perceivably high-risk banks resulting in literally a run on deposits. The imposition of the floor on KSE prices caused a much larger upheaval for the nascent mutual funds industry. The liquidity crunch and redemptions arising from fear and pessimism forced lower asset prices for debt and equity securities. Equity funds were rightly suspended for redemptions in view of the extraordinary circumstances. Off market transactions of equity securities at 40-60% discounts were executed further exacerbating the fears of investors. Income (debt) funds which were open for redemptions had to bear the most of the brunt and it was observed that good quality corporate bonds traded between 5-25% discount from Face Value while illiquid debt securities were transacted within the range of 10-45% discount from their Face Value in distress sales. Rational investors jumped in to grab such opportunities and utilised their surplus cash for a buying spree of quality Corporate Bonds of Banks etc. One of the AAA rated foreign bank’s TFC traded at a sizeable discount of 10%. Some of the weak debt issuers defaulted, faced with serious cash flow problems, and the banks suspending their credit lines. Banks proved right the adage: “Banks give you an umbrella when the sun is shining and take it away when it rains.” Long-term Government Bonds (PIBs) gave the best investment opportunity when their yield skied to peak of almost 17%.
The floor was removed in mid-Dedember when the MSCI removed KSE-100 index from their global index (MSCI Barra). The already problematic situation compounded afterwards when brokers and investors were asked to deposit margins against CFS leverage and margin financing and a few of them defaulted.
Mature income (debt) fund managers who focused on liquidity and asset quality rather than mere returns from risky assets were the winners, as they managed to pay back all redemptions by selling liquid assets and foresaw a rebound in asset prices as things turned to normality. Here, one must stress upon the quality of information available to investors. There is absolutely no independent research available on fund managers and their investing styles.
Securities prices are reliant upon the liquidity, transparency and price discovery mechanisms in the money market as well as capital markets. A transparent bond market was non-existent in Pakistan and most of the volume was traded in OTC market with very few trades happening on KSE counters. No one amongst the regulators i.e. SECP, KSE, financial institutions or the asset management industry took practical steps for establishing a vibrant bond market. Globally, bond market traded volumes are much larger than that of equity markets. BATS has, so far, failed miserably in terms of enhancing the depth of the bond market as liquidity among market participants remains tight.