Stirring the moribund corporate bond market

  • Business
  • Saturday, 09 May 2009

After a decade of robust growth, the corporate bond market seems to be cooling off. Unleashing the pent-up retail demand for bonds may be one way to go.

AN important avenue of long-term financing for companies seems to be losing steam as risk aversion takes centre stage in the country’s bond market. As such, many expect the corporate bond market, which hit a record issue of RM123bil in 2007, to reach only 60% of that value this year, which is indicative of companies deferring expansion plans as well as investors becoming deeply cautious over the type of bonds they hold amidst the climate of economic uncertainty.

Data from of a leading bank further prove this. Last year, they revealed that RM1.8bil worth of bond deals were aborted and RM6.6bil more deferred, largely involving conglomerates and companies in infrastructure, utilities and gaming.

While pointing out that the cautious behaviour on the buy side in the face of market uncertainties is understandable, RAM Ratings chief executive officer (CEO) Liza Mohd Noor says what is more alarming is that investors’ interest in top-rated AA2 and AA3 papers has waned considerably. “Our concern is that the double-A rated market will not recover even when the dust settles; and will suffer the same fate as that of the single-A and triple-B rated markets, which have long disappeared,” she says.

“It is not as healthy compared with the year before in terms of issuance and amount,’’ says Malaysian Rating Corp (MARC) CEO Mohd Razlan Mohamed, adding however that the rating agency has secured mandates for RM2bil-RM3bil worth of higher grade bonds. He points out that there are also some restructured bonds (that are almost in default or have defaulted in small amounts) of RM100mil-RM200mil that have come in for rating at MARC.

Voicing concerns over the trend, industry players suggest that the retail space be further tapped and for the domestic market to harness the high savings in Asia before all of them gets ploughed into foreign treasuries and bonds. Some players are also calling for institutional investors, which traditionally invest in safe AAA-rated bonds, to support debt papers with lower grades to help revive the lacklustre secondary bond trading market for private bond deals.

Still, it is worth noting the phenomenal growth chalked up by the bond market over the past decade; in terms of value, it has grown four-fold to RM585bil in 2008, thanks to the numerous measures implemented by the Government to develop a robust bond market. A key lesson learnt from the Asian financial crisis in the late-90s was the need to develop a sound and liquid bond market as an alternative source of funding for businesses as the crisis had highlighted the flaws of being over-reliant on the banking system for borrowings which made the system vulnerable to short-term volatilities.

The corporate bond route for capital is largely tapped by companies involved in the infrastructure, finance, utilities and communications sectors. The bond market provides businesses with an effective avenue to raise funds, particularly for projects with long gestation periods, at lower cost. In the process, investment banks have benefited as arrangers of such deals while the investing public can channel their savings into productive investments such as bond funds and enjoy good returns.

The turning point

Late last year, the bond market was visibly shaken by the Government’s move to impose a windfall tax on independent power producers (IPPs). IPPs are large issuers of Islamic bonds, a new growth area and a favourite among institutional investors. It was a double whammy as the sudden collapse of global markets happened hot on the heels of the IPP windfall tax.

As a result of the uncertainty and worry that some of the IPPs may face difficulties repaying their bond obligations due to the windfall tax as well as potential renegotiation of the power purchase agreements looming in the horizon, the bond market suffered a severe hit. For that reason, until today, the utility sector is viewed as a “delicate sector” among bond investors.

In addition, foreign issuers of ringgit bonds, which were later swapped into US currency, had also disappeared following the increase in swap rates.

Fortunately, according to industry observers, the bond market appears to be mending (the IPP windfall tax was revised to a one-off payment instead) as visible signs of stabilisation in the global economy trickle in.

The challenge faced by the corporate bond market these days, however, comes in a different form – bumper government issues which command higher long-term rates, hence better returns are giving corporate bonds some stiff competition. Against such a backdrop, smaller companies eager for funding may face difficulties as on one hand, banks have become more picky on providing loans and on the other, if they opted for the bond market, they may have to match the higher rates to attract the risk averse investors.

Amidst some debate over the feasibility of smaller companies turning to the bond market, government measures such as the setting up of the Financial Guarantee Institution (FGI) are aimed at giving support via the provision of guarantees.

Wooing the retailers

The pent-up demand for government savings bonds indicates that the savings pool of the retail segment can be further tapped.

By law, the bond market play is designed for large and sophisticated investors. Private banking facilities and bond funds are currently available for retailers.

To woo retail participation, suggestions range from listing bonds on Bursa Malaysia (where Internet trading has gained popularity) to breaking up the bonds into more palatable retail portions.

“Investors should also be able to buy bonds at banks and post offices at no fee using the current infrastructure. If the market is open, they can trade directly,’’ says Meor Amri Meor Ayob, CEO of Bond Pricing Agency Malaysia (BPAM). Banks can also further break up the portions they currently offer to high net worth individuals.

However, Razlan of MARC finds that bonds is a sophisticated instrument and it may be better for retailers to invest through bond funds which have some element of risk diversification. Moreover, the cost of issuance can be driven up by dividing them into smaller denominations.

Even among the proponents of the retail concept, the quality of the offering is a major issue. “We have to make sure retailers don’t get burnt. There must be certain criteria for listing, such as companies with steady cashflow and a minimum credit rating of AA3 which historically have zero default,’’ says Lee Kok Kwan, group treasurer of CIMB.

For starters, this could perhaps involve the bond papers issued by PLUS, the highway concessionaire, suggests Lee.

“Among the safer investments would be those providing services that are used daily and consistently,’’ Meor adds.

To allow for the listing of bonds, the authorities will need to consider the ability of investors to comprehend the products and understand issuers’ credit profile. Potential candidates for initial bond listing on Bursa Malaysia could be Cagamas Bhd or Bank Simpanan Nasional Bhd. Cagamas is considering the plan to list its bonds on Bursa Malaysia, but it has to study certain structures and mechanisms first.

For the listing exercise to be successful, observers say there must be mechanisms in place to shorten the time and cost to bring to market as issuers may want to seize on a good rate. The presence of a steady stream of investors will not only help to build up the market but also make it cheaper for corporates as more investors come in and bid down the rates, says Lee. In terms of market making, the bond lead arrangers should play a key role.

Blue Oceans

Within the sukuk market, there are still funding and investing opportunities, especially in real estate, financial services and infrastructure (power, oil and gas, and roads), says Liza of RAM Ratings.

In fact, the widening appeal of Islamic bonds will be an opportunity to tap further into the sukuk market, says Steven Choy, CEO of Cagamas. Currently, Islamic bond issues make up 40% of total issuance (targeted at RM12bil this year) at Cagamas.

Tackling the issue of global syariah compliance and building a global network of investors are important in the current soft environment, he adds.

Ringgit bonds has emerged as a major growth area following the recent crisis where countries have taken measures to develop their domestic capital markets to avoid being held hostage to developments in foreign countries and currencies, CIMB’s Lee points out.

In this respect, Choy says foreign issuers of ringgit bonds should be encouraged. “We cannot be insular in this and regard them to be taking away the liquidity or raising the costs of issuance,’’ he says.

The special guarantee accorded by the FGI will facilitate access to long-term funds for deserving companies, which may not possess specially high credit standing but are operating in key economic sectors.

However, the FGI itself will be rated using a risk-based approach that looks into every aspect of risk management, corporate governance, diversification of portfolio and sensitivity to loss, says Razlan, adding that the FGI can start by providing guarantees to sectors with low chances of default, for example, government-related projects.

Takaful premiums and the Asia infrastructure bond fund represent untapped areas, while for this year, financial institutions are expected to issue bond papers in a bid to top up their Tier 1 and 2 capital.

Kickstarting the lower grades

Many industry players concur that it is time to get the lower rated papers moving as well. International high yielding bonds of BB rating are starting to come back to the market but these are at the moment confined to sovereign issuers like Indonesia, Thailand and the Philippines. “It is a bit difficult for Malaysia to kickstart the single A market unless an effort is taken to attract sovereign issuers to tap funding in the ringgit bond market,’’ Razlan observes.

Institutions can play a bigger role. “They should not be so rigid,’’ says Razlan, attributing their extreme caution to the herd mentality of capital preservation. The default rate for single A so far, in MARC’s rating universe, is 2%.

To improve confidence in single A papers, surveillance and pre-emptive recovery work should be stepped up. “The relationship between the rating agencies and bond trustees (who represent the investors) can be further improved,’’ suggests Razlan.

Rating agencies should tighten their surveillance while trustees should monitor if there are signs of stress and engage in active remedial work at a pre-emptive level.

As a regulator, the Securities Commission’s surveillance is all round with increased focus on rating downgrades; it also constantly emphasises that trustees have an important role in investor protection.

The returns are higher (around 7%) in single A rated papers and some of the well-known names in this category include Petra Perdana Bhd, Road Builder (M) Holdings Bhd, Radicare (M) Sdn Bhd, Silver Bird Group Bhd, Cahya Mata Sarawak Bhd and EON Cap Bhd.

Secondary trading

Bond market trading is done over the counter (OTC) in private deals. Average daily secondary trading is about RM3bil, a bulk of which involves government bonds valued at RM2bil-RM2.5bil.

Some factors cited as major dampeners which has kept a lid on trading volume in the market include defaults and downgrades as well as last year’s sudden imposition of windfall tax on IPPs.

Overall, the default rate as a percentage of bonds issued has been low.

To address concerns over defaults and downgrades, Razlan of MARC says a robust system has been put in place to provide early warning signals.

RAM’s Liza points out that for those issuers who had defaulted between 2003 and 2008, their credit ratings have already been downgraded to speculative grade before the eventual default.

In the case of the Royal Mint of Malaysia, the default was triggered by a termination of a key agreement rather than the result of a missed payment by the issuer.

The issue of fair valuation

New rules on accounting for bonds will enhance the development of the bond market.

“Disclosure of information in the notes will facilitate better quality information and exchange between readers of the financial statement and the board of directors,’’ says Dr Nordin Zain, executive director at Deloitte Malaysia.

The bond market applies standards issued by the Malaysian Accounting Standards Board. In the case of issuers, bonds are generally accounted for using FRS 132 on financial instruments which requires classification based on their features.

Issues surrounding fair valuation consider yield curves and market inputs which are necessary to determine fair value that’s measurable.

“When these are not readily determinable from the market, those who prepare financial statements will turn to models,’’ says Dr Nordin.“Confidence should follow when there’s a more reliable measure,’’ says Dr Nordin.

The International Accounting Standards Board (IASB) is working on issues involving an illiquid market.

In Malaysia, an independent valuation is provided by BPAM, taking into account factors such as credit and market risks, interest rates and mark-to-market.

Unit trusts involving investments in bond funds are required to mark-to-market to an independent bond pricing agency. BPAM prices are also used by big financial institutions for risk management in comparing price differences.

However, there is a debate brewing among market players who have challenged the BPAM shareholders to sink money into their “theoretical’’ prices.

“We are a fair valuation company. The valuation that we give does not guarantee that a transaction should be at that price,’’ says Meor. “All net asset values of bond funds are based on the same source. With only 1% traded, having an independent pricing agency does make sense for transparency purposes.’’

Having said that, a bond fund can use its own price provided it meets certain requirements such as board approval.

The time is right

There is strong consensus for a more developed market where more companies and investors can take part with a long menu of bonds, sukuk and other capital market instruments. To achieve this, intensive education is required on how to balance risk and reward.

The current environment is conducive for bond issuance – low interest rates, ample liquidity and narrowing yields between some government and AAA bonds.

Moreover, the majority of industry players believe that the IPP scare is largely over and the market is poised to move on to its next stage of growth.

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