THIS year is likely to be another challenging year for fixed-income investors as the weak market sentiments that persisted in the 2H08 will continue in the current year. In view of slowdown in business activity, there is strong likelihood of significantly lower issuance of corporate debt in contrast to an expansion of government bond issuance.
The prevailing economic uncertainty will continue to assert downward pressure on credit quality and corporate spreads.
According to MARC’s head of Fixed Income Research Wan Murezani Mohamad, the relatively stable rates and credit market in 1H08 took a sharp turn in the early 2H08 as investors reacted to the government decision’s to hike domestic retail fuel prices by 41% and to impose a windfall tax on Independent Power Producers (IPPs).
As surging crude oil demand pushed prices above US$140/bbl, the yield curve steepened as bearish sentiments took hold.
“But barely a few months later, the landscape changed with the inflation conundrum taking a backseat to growth concerns after most of the G7 economies slipped into recession as the global credit crunch began taking its toll on the real economy.”
Government bond yields drift lower
The prospects of a significant slowdown in inflation has totally changed the shape of the yield curve and as such, Wan Murezani, anticipates that the flattening bias to persist in 1H09.
Although the government has recently stated that it is unlikely to extend any further cut in the domestic retail fuel prices, the current level of crude oil prices of below US$50/bbl will provide support for a sustained downward trend in inflation.
Against this backdrop and in anticipation of further interest rate cuts, the appeal of a relative overweight exposure to long-dated bonds has increased and should persist over the next six months. He added that there is an expectation of another 50 bps of rate cut in 1H09 as implied by the flattening short-end of the MGS yield curve and the ringgit interest rate swap curve.
“However, this view covers a limited six-month horizon because at this juncture forthcoming economic data and implication of policy responses from authorities for the next six months would have an important bearing on the shape of the MGS yield curve in 2H09,” Wan Murezani said.
“If the economic and financial outlook improves and fiscal and monetary measures employed by the government to counter the impact of the global economic slowdown gain traction, setting the course for a reversal in the flight to quality phenomenon, rates on MGS should start to move higher.”
Busy domestic government issuance calendar
With the fiscal deficit expected to be at 4.8% of GDP in 2009 (or RM36.7bil vis-à-vis RM34.4bil in 2008), the expansionary fiscal policy would continue to be financed by local bond issuance.
In addition, with RM36bil of government bonds expected to mature in 2009, Wan Murezani said MGS/GII issuance to fall within the range of RM70bil -RM75bil in 2009.
In view of supply-side considerations, the government may issue more longer-dated bonds include the significant percentage of outstanding bonds maturing over the next 20 years falling within 1-7 years segment, i.e. 71% of outstanding.
Additionally, a motivation for the government to do so would be the cost of funds which is well below the post 1997-98 crisis average, Wan Murezani asserted, but on the demand side, investors may continue to favour longer durations consistent with MARC’s view of bull flattening particularly in 1H09.
Corporate yields to remain elevated
MARC envisages corporate bond market to remain under pressure in 1H09 and slowing market activity seen in the second half of 2008 is expected to persist.
“We do not think that corporate yields will come down in the near future in contrast to government bond yields.
“With recent data indicating that the economy would be facing a tough ride in 2009, downward pressure on corporate credit quality would continue, particularly among issuers rated A and below.”
From a rating migration perspective, credit quality measured by the downgrade to upgrade ratio among ringgit corporate issuers in 2008 (as at Dec 15) stands at 1.5 times (x), which, he pointed out, is still well below its 10-year average of 3.0 x and about 7.0 x lower than 1997-98 Asian Financial Crisis.
The same measure of credit quality across the Asia ex-Japan (AEJ) credits rated by S&P and Moody’s exhibits visible signs of stress with the ratio currently standing at 10.0 x vis-à-vis 10-year average of 2.8 x.
“The contrasting measures can be explained by the fact that issuers in our domestic market are not directly exposed to the first order effects from the recent credit crunch compared to AEJ universe,” he said.
“Nonetheless, the second order effects are unavoidable because this crisis has impacted the real economy.”
Although corporate spreads currently suggest cheap valuations there is further room for spreads to widen in 1H09 as the domestic spillover effect of the global financial crisis has not been fully priced in the current valuations, Wan Murezani opined.
“During the last US recession, our economy was growing at a weaker pace and the spread between 3-year AA rated bonds to MGS of similar maturity was around 200 bps.
“Presently, apart from US, other G7 economies have also slipped into recession which acts as strong catalysts for continuous pressure on credits.
“The current spread for 3-year AA rated bonds against 3-year MGS about 2.9 standard deviations above the long-run mean whilst the previous high in our sample was 2.6, recorded in April 2002.
“At this juncture, there is a high likelihood that this index will remain elevated on the basis of unpromising economic fundamentals,” Wan Murezani said.
Based on the view of a slowdown in economic activity and the corresponding lower financing needs as issuers are likely to scale down or put their expansion plan on hold in anticipation of further stress in the global economies.
Wan Murezani foresees a considerable decline in activity in the primary market in which an issuance of RM25bil-RM30bil is envisaged for 2009.
For the record, corporate bond issuance as at November 2008 stood at RM45.9bil.
“We believe that observations on the economy in the first six months of 2009 would provide vital indications as to the real implications of the global economic slowdown on the domestic economy.
“Corporate yields along the lower credit spectrum remain elevated at this juncture, translating into higher financing cost.”
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