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Interest
rates have come off, and those with loans can breathe a huge sigh of relief.
For the investor, however, lower interest rates also mean that they are
receiving less than attractive returns from their cash fixed deposits
(FDs), the hottest investment vehicle in the past year.
And, as they look for investment alternatives, one option that has been
suggested is debt. Not taking a loan, but investing in them.
Bonds -- basically government or corporate debt -- are a middle-of-the-road
investment instrument that appeal to conservative investors who want higher
returns than FDs but don't want the volatility of the stock market.
As the over-the-counter bond market requires huge amounts of money for
bond investments, the best way for the individual investor to access bonds
is through bond funds managed by unit trust companies, says Lee Kiew Ying,
general manager (money market) of Amanah Short Deposits Bhd.
Bond funds are a viable option, especially for those not keen to enter
the equity market or anything of higher risk. Fund managers say that bond
funds should be able to beat term deposit rates over the long term of
three to five years.
Lee says that generally, bond funds are less risky than equity funds,
and are popular among the more conservative investors with a lower risk
appetite who are looking for a more stable investment that provides a
regular income (see story on bond pricing on Page iii).
"When you invest in equity, you can lose everything if the company
goes broke. With bonds, you are guaranteed repayment before any equity
holder as you have first rights to the company's assets," says Jason
Yetton, chief executive officer of Commerce-BT Unit Trust Management Bhd,
which manages the Malaysian Bond Fund.
"Furthermore, bonds are typically guaranteed either by banks or by
some form of security like a sinking fund," he says.
Low risk, however, does not necessarily mean no risk. "Bond funds
are a good diversification tool but as an investment vehicle, it still
has an element of risk. There are a spectrum of bond funds with different
levels of risk, depending on their investment portfolios and objectives,"
Yetton explains.
Bond fund investors need to consider two very important types of risks
associated with bonds: credit risk and interest rate risk. Particularly
in the past year, these risks have become major challenges for bond fund
managers.
Interest rate risk arises due to the inverse relationship between bonds
and interest rates; when interest rates rise, the value of bonds drops.
Conversely, when interest rates drop, the value of bonds rises.
As such, the high interest regime in the past year pre-September 1998
would not have boded well for a lot of bonds.
"A lot of them were originally sold at yields of between 8.5 per
cent and 9.0 per cent, and obviously, short-term interest rates have increased
significantly higher than that," says Yetton, who adds that this
caused a drop in demand for bonds as investors were getting better returns
from cash deposits.
Credit risk is also a major factor, as it usually becomes greater during
a recession when companies face cashflow problems and may not be able
to service their loans, says Amanah's Lee. Companies facing financial
and cashflow problems mean that debt quality has also deteriorated significantly.
Therefore, the market yield on bonds would have significantly risen in
line with higher risk premium and higher interest rates, and bond prices
would have come down, Yetton explains.
"Credit risk has increased; people are worried that the bond issuers
would not be able to repay their debt upon the bond's maturity,"
he adds.
The increasing number of financially troubled companies filing for protection
from creditors under Section 176 of the Companies Act have not helped
either, particularly given that the protection was also extended to the
financial institutions which had acted as guarantors for these companies'
bond issues.
As the effectiveness of the bank guarantees were affected, many bonds
had their ratings drastically downgraded to non-investment grade papers
by independent rating agencies. Prior to the Section 176 issue, bank-guaranteed
bonds were considered attractive investment grade papers.
Chong Chang Choong, Kuala Lumpur Mutual Fund Bhd general manager of investment
says, however, that it is encouraging to see the recent amendments by
the authorities to tighten this section from gross abuse.
"One of the amendments is that 50 per cent prior creditors' approval
must be obtained before the court can grant protection to the borrowers.
This will give creditors the leverage to ensure a fair and meaningful
restructuring scheme.
"The company must also produce a list of assets and liabilities to
ensure that during the protection period, there will not be abuse of movement
of assets, and also appoint an independent director to protect the assets
and to verify whether or not the scheme is fair," he adds.
All three fund managers agree that a company filing for protection under
Section 176 does not necessarily signal default on a particular bond issue.
Neither does it mean that investors won't see their money again.
"It is more of a timing issue; I don't think that the court's ruling
absolves banks from the guarantees on those bonds.
"The concern is more of whether or not the bond issuers are going
to be able to repay their principal upon the bond's maturity; whether
or not that maturity date has to be extended," Yetton explains, adding:
"We will certainly hear of more Section 176 cases, but at some point
those risks are going to go out of the market as well. Companies are going
to be restructuring and looking to raise equity, and as those cashflow
problems dissipate, credit risk will dissipate and bonds are going to
do very well."
According to Yetton, the job of the bond fund manager is to try and manage
risk. "The bond manager's job is two-fold: to conduct risk or credit
assessment to determine if the corporate borrower has the ability to meet
its obligations and repay its debts; and to try and get the interest rate
cycle to the fund manager's favour."
Given the challenges faced because of the state of the economy, most bond
managers would have been quite proactive over the past one year.
Yetton says there is a misconception that bond funds buy bonds to hold
to maturity. "It is difficult for fund managers to add value by just
simply holding to maturity. Although the illiquid secondary market for
private debt securities makes it hard to trade, it does not mean you can't."
How do fund managers add value to bond funds?
"To manage interest rate risk, when interest rates are going up,
fund managers want to get short and reduce the duration of the bond portfolio
so that they can catch high interest rates as they go up. Conversely,
when rates are going down, fund managers would want to increase the duration
of the bond portfolio to lock in at higher rates," Yetton explains.
(To diversify its risks, bond funds invest not only in bonds but also
short-term debt papers such as banker's acceptances and negotiable certificates
of deposits.)
Bond fund managers can also take advantage of arbitrage opportunities
that have come up over the past six months when the market was so volatile.
KL Mutual's Chong says that while he tends to hold better bonds to maturity,
he does trade when there is an unjustifiable, excessive premium.
"For instance, two companies have single A ratings, but one company's
bond is trading at a yield of 15 per cent while the other is trading at
12 per cent, usually due to perceptions of different companies.
"What we would probably do is to sell the bond that gives lower yield
and buy the one that provides the higher yield. Based on our expertise
and familiarity with credit quality, we are prepared to ride that kind
of risk and take the opportunity to arbitrage," he says.
He also adds that the indiscriminate dumping of bonds by investors in
the past year have resulted in some good bargain hunting opportunities
as better issues were similarly discarded at fire-sale prices.
So is now a good time to invest in bond funds, particularly now that interest
rates have come off? In the current environment with interest rates trending
downwards, it is beneficial for bond funds investors to remain with their
funds to take advantage of the higher yields locked in and the prospect
of capital gains as bond prices improve, says Chong.
Moreover, the current bond yields are also superior to fixed deposit rates
which have plunged sharply following Bank Negara's massive liquidity injection
into the banking system since the implementation of capital controls on
Sept 1.
"In a downward trending interest rate scenario, bond fund investors
would have some capital appreciation opportunity, because the prices of
bonds will go up. The lock-in yield of the bonds should give you a higher
return than fixed deposits," he adds.
Chong says interest rate risk over the next one year looks pretty low,
as interest rates will bias downwards rather than upwards. Credit risk,
however, is still volatile.
Yetton believes that as credit risk becomes less of an issue, there will
be significant capital gains to be made through bonds. "Bonds are
a case of short-term uncertainties but probably long-term opportunities
right now."
Another plus point for bond funds is the expected increase in corporate
bond issues as the economy picks up.
Amanah's Lee believes that as the market stabilises and the country's
economy is put on firmer ground, there will be a lot of companies coming
in to raise long-term funding through corporate bond issues. Furthermore,
the government is keen to develop the capital market for financing long-term
projects.
"Everyone has learnt that you cannot fund through short-term borrowings;
a lot of companies have been caught because they have been borrowing short-term
to fund long-term," she says.
All three fund managers agree that for diversification purposes, investors
should have some bonds in their investment portfolio.
"The biggest mistake people can make is to invest in just one asset
class, whether it be all equities or all cash. The key to investment decisions
is getting your asset allocation right for your risk profile," Yetton
adds.
1998. All rights reserved. The Edge
Communications Sdn Bhd
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