This article first appeared in Personal Wealth, The Edge Malaysia Weekly on June 22, 2020 - June 28, 2020
Local bond fund managers are expecting to make returns of 3% to 6% in the next three years amid a challenging environment, assuming a low default rate in the local bond market coupled with central banks continuing to ease monetary policies to support their respective economies.
Covid-19 has infected about 6.6 million people, with nearly 400,000 deaths worldwide at the time of writing. The pandemic has made a huge dent in the global economy as many countries locked down their cities and controlled their borders in an effort to stem the spread of the disease.
The global economy is expected to fall 3%, according to the International Monetary Fund. On the home front, Bank Negara Malaysia expects the country’s GDP to be between -2% and 0.5% this year.
Nevertheless, local bond fund managers are optimistic about making decent returns in the next three years. Ng Lee Peng, head of fixed income at Opus Asset Management Sdn Bhd, says a return of 4% to 6% this year is achievable. She is looking at an annualised return of 3% to 6% over the next three years.
One of the key reasons is that the default rate of the local bond market may only increase marginally. The default rate is not expected to spike as most local bonds are investment-grade paper rated AA or AAA by local rating agencies, which means these have a strong or superior capability to meet their financial obligations, says Ng.
She adds that the central bank could cut interest rates further to help the Malaysian economy recover from the pandemic. Persistently low or lower interest rates are favourable to existing bond prices as their yields are more attractive to investors.
“There are also signs of a better-than-expected recovery in the global and local economy. But it is expected to be slow as there will be structural changes to consumer behaviour, which will limit demand,” says Ng.
From a historical point of view, bond prices are already high, but they are not expected to fall yet, she adds. “The global economy will continue to be sluggish. There is also the fear of a second wave of Covid-19 infections that is weighing on market sentiment.
“Moreover, we are now seeing rising trade tensions between the US and China. Hence, we believe interest rates will continue to be low and monetary policy will remain accommodative for some time.”
While the expected rate of return is superior to the fixed deposit rate, it pales in comparison to the overall performance of local bond funds last year. Many of these funds made about 8% in 2019 as the global and domestic economic outlook was rosier despite the US-China trade war. The bond market was also less volatile while central banks around the world were cutting interest rates, says Ng.
Roszali Ramlee, CEO and managing director of AmanahRaya Investment Management Sdn Bhd, is expecting bond funds to generate a return of 4% to 6% this year as well as in the next three years. He expects the default rate of the local bond market to only increase slightly in the face of the pandemic.
“There will be a slightly higher default rate from certain sectors such as oil and gas and property. We do not foresee this happening to bigger sectors like the power, financial and utilities sectors as many of these issuers have strong government support,” says Roszali.
The demand from local institutional investors such as the Employees Provident Fund, sovereign wealth funds and insurance companies also remains strong, which is supportive of local bond prices, he adds. “The demand is still stronger than supply, especially for issuances with AA and AAA ratings. There were only a few issuances of these securities in the past year.”
Roszali took advantage of the strong local demand to buy more bonds in March after the Movement Control Order was implemented. Bond prices fell while yields increased, but not for long.
“There was a capital flight, which impacted local bond prices. However, with high local liquidity, coupled with a risk-off mode in the market, the yield was adjusted back [and prices recovered] after Bank Negara cut the overnight policy rate by 50 basis points. Some active fund managers should have benefited from such fluctuations,” he says.
Edward Iskandar Toh, chief investment officer at Areca Capital Sdn Bhd, has a more conservative estimate of the rate of return over the next three years as the health of the global economy remains uncertain and markets are volatile. “Our flagship bond fund had produced more than 8% in terms of annualised returns as at the first five months of this year. To expect the same performance in the second half of this year is overly optimistic. It will require a significant interest rate cut for that to be realised,” he says.
“We would adopt a more conservative stance going forward, looking mainly to focus on preservation of capital. We are happy to project a prudent return of 3.25% for the next three years.”
Rating downgrades and unredeemed perps
While the default rate is expected to increase slightly, fund managers are confident that the credit rating of more companies will be downgraded. Bond issuers that may suffer from credit downgrades are those operating in the hospitality and tourism, oil and gas and property sectors.
Opus’ Ng says hospitality and tourism have been severely affected by the pandemic as many countries have gone into lockdown mode and borders are controlled. Oil and gas companies have also been impacted by the low crude oil prices over the past few months.
Brent Crude plunged about 67% since February to less than US$20 a barrel on April 21 while West Texas Intermediate dived into negative territory for the first time in history in May.
Although crude oil prices have recovered to about US$40 a barrel, the recovery is due to a supply cut by the Organization of the Petroleum Exporting Countries (Opec) and its allies, says Ng. Demand, however, remains weak. “The demand for crude oil will only recover slowly on the back of sluggish global growth,” she adds.
Ng is also concerned about perpetual bonds (also known as perps), especially those issued by property companies. Unlike a typical bond, a perp does not have a maturity date. Instead, it has a call date of usually five years, when holders are expected to receive their principal.
A perp issuer not redeeming its bonds on the call date is not considered a default. However, the issuer will have to pay a higher yield in the years to come and the increase in interest rate could occur once or more throughout the lifetime of the bonds. Such a mechanism incentivises the issuers of perps to call back its bonds to avoid an increase in borrowing costs.
Perps are seen as hybrid securities as these are debt securities with equity-like features. They also have higher yields than ordinary bonds to compensate for the higher risk taken on by investors.
Ng says investors of perps issued by property companies may not receive their principal on the call date as some of these companies have been badly hit by the pandemic and have a tight cash flow. “There is already an example in Singapore, where Ascott Residence Trust [the largest hospitality real estate investment trust (REIT) in Asia-Pacific] decided not to call back its perp.”
Ascott Residence Trust decided that it would not redeem its S$250 million (RM767.85 million) perp with a yield of 4.68%. It intends to preserve cash flow amid the ongoing pandemic, which has led to lower demand for accommodation.
The REIT also announced that the drawing on debt to redeem the securities would increase its leverage and reduce the debt headroom available for acquisition opportunities during a market recovery. Furthermore, its property valuations could come under pressure on the back of a softer operating performance, potentially increasing its leverage further.
Daniel Brown, head of fixed income at CGS-CIMB Securities Sdn Bhd, agrees with Ng’s view, noting that the call dates of several perps fall between 2020 and 2022. “However, these perp issuers could issue new bonds to pay off their perp bondholders, which is what you call refinancing,” he says.
AmanahRaya’s Roszali singles out the oil and gas and property sectors as having a potentially higher default rate going forward. Areca’s Toh is more concerned about companies in the airline, tourism and oil and gas industries that could suffer from a downgrade in credit ratings. “Unfortunately, some highly leveraged companies will be susceptible to defaults in such times,” he says.
Risks include sovereign rating downgrade and exclusion from WGBI
A key risk to the local bond market is the possibility of a downgrade in Malaysia’s credit rating by international rating agencies as the government announced that it would double the country’s fiscal deficit to stimulate its economy, says Brown. “Whether this translates into a downgrade in the sovereign rating is the million-dollar question for bond investors.”
A downgrade in sovereign rating will have a huge impact on the country’s bond market as Malaysian bonds, including corporate bonds issued by various government-related companies, will most likely be downgraded as well. That could trigger a sell-off in the bond market and increase the cost of borrowing for the country.
“For Malaysia, a large portion of government revenue has gone towards operating expenses, which are expenses that do not generate returns, as compared with development expenses. A downgrade of the sovereign rating will hurt the overall and fiscal wealth position of the country. Similarly, the debt costs of all government-related companies will rise,” says Brown.
“In 2017, the government targeted to reduce our fiscal deficit to less than 3% [so that its sovereign rating would remain intact]. Unfortunately, we are moving in a different direction quite substantially, which is a 6% fiscal deficit.
“Yes, you can justify it by saying that the pandemic hit everyone and not just us. But it is also important to remember that we have not been able to achieve our fiscal deficit target since 2017.”
Brown reminds investors that FTSE Russell, the leading global index provider, has been keeping Malaysia on the watchlist for exclusion from its World Government Bond Index (WGBI) since April last year. It made another announcement in April to extend the review for another six months.
The Malaysian bond market’s illiquidity is the main reason why its bonds are being put under review by the index provider. “Bank Negara had committed to FTSE Russell that it would try to resolve such issues and it is a good thing that the index provider is willing to wait. However, we are still not clear about how the final decision will be made,” says Brown.
The exclusion of Malaysian government bonds from the WGBI will see international funds that refer to the index pull out their money from the local bond market. According to a Maybank Investment Bank report, Malaysia carried 0.37% weight on the WGBI as at March. The estimated foreign positions in Malaysian government bonds linked to the index was about US$5 billion to US$6 billion.
While acknowledging the risk of a sovereign downgrade due to a much higher fiscal deficit, Opus’ Ng says such a risk is not at the top of her list. “Yes, the fiscal deficit could double. But the government also mentioned that it aimed to bring it down to less than 4% in the next three years. If the rating agencies are convinced of this, there should not be a downgrade of Malaysia’s sovereign rating.
“Such a measure is necessary to sustain our country’s economy under the current environment. Doing this is better than letting the economy collapse and for it to take a long time to recover after the pandemic. We could be worse off. This is not an imminent risk to me.”
Denise Thean, deputy CEO and chief rating officer at RAM Rating Services Bhd, is of a similar mind. “Given the unprecedented nature of the Covid-19 pandemic and its impact on economic and fiscal performance this year, we believe that sovereign rating sustainability should focus on the sovereign’s ability to recover from this shock, rather than based solely on a fiscal empirical measure such as fiscal deficit-to-GDP ratio,” she says.
“Several considerations should be taken in concert to evaluate sovereign strength and sustainability. These include monetary space for support, depth of capital markets, the existence of manufacturing bases as well as the perceived success of Covid-19 containment policies that will bear significance to both consumer and investor confidence in the economy.”
Commenting on the risk of WGBI exclusion, Areca’s Toh says it is an event that bond investors are keeping an eye on. “We would be susceptible to foreign investment withdrawal if the exclusion were to happen. There would be an immediate selldown in the bond market.
“However, foreign holdings of our debt, including government and corporate bonds, add up to about RM180 billion — less than 12% of the market. Our market is resilient enough to withstand this.”
Default rate could hit 7% at peak, though unlikely
Denise Thean, deputy CEO and chief rating officer at RAM Rating Services Bhd, says the default rate of the Malaysian bond market could peak at 7% in a worst-case scenario. “Assuming that all entities currently rated non-investment-grade (BB and lower) in RAM’s portfolio — of which there are fewer than 15 — were to default concurrently, the default rate would peak at about 7%.
“However, we do not think this scenario will pan out. Even so, investors’ losses may be limited as all but two of the issuers are either bank- or Danajamin-guaranteed, or are supported by entities rated at least AA.”
Danajamin Nasional Bhd, established in 2009, is the country’s first and only financial guarantor in charge of stimulating and further developing the Malaysian bond and sukuk markets. It is jointly owned by the Minister of Finance Incorporated and Credit Guarantee Corporation Malaysia Bhd.
Thean points out that the peak default rates during the 2008 global financial crisis and the 1997/98 Asian financial crisis were 1.6% and 9% respectively. The default rate last year was a mere 0.6%, she adds.
As at March 31, only 6% — or 10 rated issuers of RAM’s portfolio — had a high risk of credit impairment, which means a downgrade in their credit rating. Three out of 10 of these issuers are guaranteed issues, says Thean. “The entities in the high-risk band are mainly those directly exposed to the hard-hit tourism and leisure sector.”
She notes that almost half of RAM’s portfolio has been assessed to have a low risk of credit impairment. “Having said that, this may not further preclude higher negative rating actions in the event of a deep and prolonged economic downturn beyond 2020.”
As a comparison, Thean says up to 10% of RAM’s portfolio suffered downgrades with an average quantum of two notches during the global financial crisis. During the Asian financial crisis, when the Malaysian economy contracted by about 7%, 60% of its portfolio suffered downgrades with an average quantum of three notches.
“Since then, the structure of the Malaysian corporate bond market and the financial profile of issuers have substantially changed, with corporates that are less leveraged and have minimal offshore borrowings. Also, a large proportion of bond issuers are from the project financing segment (related to independent power producers) and public-private finance partnerships,” she says.
“Financial institutions are the other major bond issuers. While they are not spared from the current challenges, we believe our banking sector is well capitalised to absorb the impact.”
Meanwhile, Thean expects corporate bond issuances this year to come in at RM80 billion to RM95 billion, a deceleration from RM132.8 billion in the previous year. Such a number is also weaker than the RM124.9 billion and RM105.4 billion in 2017 and 2018 respectively.
“The dimmer issuance outlook is primarily due to the widely expected economic contraction and potential project delays, as well as reduced capital expenditure by companies. The demand for financing will be dampened this year along with a potential hold up in the rollout of new bond programmes as issuers take a more cautious stance,” she says.
As at May, corporate bond issues were led by Prasarana Malaysia Bhd, which supplied RM4.85 billion worth of bonds to the market, says Thean. This constituted 15.1% of the total corporate bonds issued during the period.
DanaInfra Nasional Bhd is another major issuer, with a year-to-date issuance of RM2.8 billion. “The relatively robust issuance is in line with the ongoing infrastructure financing needs amid the gradual recommencement of big-ticket construction projects in the second half of the year,” says Thean.
Government bond issuances are expected to come in higher at RM155 billion to RM165 billion, compared with RM115.7 billion last year, taking into account the wider budget deficit due to the increased development expenditure following the recently announced stimulus package by the government, she adds.
Meanwhile, the yield spread between Malaysian Government Securities (MGS) and corporate bonds across all rating bands has been on a widening trend since the start of the year amid heightened market volatility triggered by the Covid-19 outbreak. This shows that the global risk-off sentiment has significantly reduced the market’s appetite for credit risk, says Thean.
“While bond yields generally rose for both benchmark MGS and corporate bonds, risk aversion placed significantly larger upward pressure on corporate bond yields. It shows that investors demand a higher risk premium to invest in riskier corporate debt paper over ‘risk-free’ government bonds,” she adds.
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