Fixed Income Portfolio Management Workshop
18 April 1996 |   By : Dato' Dr. Mohd. Munir Abdul Majid, Chairman, Securities Commission, Malaysia

The Securities Commission (SC), in its three-year Business Plan (1995-1997), has identified the development of the Ringgit Bond Market as one of its main developmental activities, together with the development of the derivatives market and the fund management industry. This in itself is reflective of SC's recognition of the fact that these different aspects of the capital market need to co-exist symbolically. The lack of a hedging market for instance, has been identified as one of the factors impeding the development of the corporate bond market. This will be addressed by the impending introduction of interest rate derivatives and subsequently bond derivatives into the Malaysian market. Furthermore, developments in the bond market would also complement the equity and derivative markets as it would bring with it greater industry sophistication in the use of bonds and interest rate derivatives to hedge interest rate movements, maximize returns through arbitrage transactions, manage systematic and unsystematic risks effectively and to value equities and derivatives more efficiently.

A developed fund management industry, on the other hand, would address yet another factor that is impeding the development of the bond market ¾ the shortage of institutional investors. Presently, there are insufficient pension funds, unit trust funds and closed-end funds pooling together the funds of individual investors and managing those funds using sophisticated portfolio diversification strategies and thus, assist in making market for bonds. To be able to do all these however, the mere increase in the number of institutional investors is just the beginning. The fund managers managing these institutional funds must be well equipped with the necessary skills and techniques to adopt sophisticated portfolio management strategies. It is in recognition of this necessity that the SC has invited the Ratings Agency of Malaysia (RAM) to jointly organise today's workshop with BARRA.

The corporate debt market in Malaysia, as with many other countries within the region, had a late start compared to the equities market. The size of the ringgit bond market is still small compared to equities ¾ total outstanding debt in 1995 was in the region of 50% of GDP compared to KLSE's market capitalisation which was some 280% of GDP. In the early 1980s, the debt markets were primarily in the hands of the government, the banks and the provident funds. The Government issued bonds progressively in the late 1970s and 1980s mainly to finance public sector development expenditure. The investors were mainly Employees Provident Fund and Commercial Banks who hold these papers for their statutory and reserve requirements. The corporate bond market was almost non-existent as corporations relied on bank borrowings for short term working capital and project financing and the equity market for capital raising. All this changed in the late 1980's. These changes were driven by measures introduced by the government authorities.

The first move was the establishment of Cagamas, the national mortgage corporation in 1986. It was established to function as an intermediary between banks and finance companies, the prime lenders and investors seeking long term investments. The securitisation of the housing loans has contributed to improved liquidity in the banking system and provided liquid, high quality paper to the market.

This was followed in 1988 by the issuance of the Private Debt Securities guidelines by the central bank to provide a regulatory framework for issuance of corporate bonds. Then the first rating agency in the region, RAM was established in November 1990 to provide independent rating services for the issue of corporate bonds. As we are aware, the Minister of Finance has, in June last year, announced the intention to establish a second rating agency.

These institutional reforms have resulted tangible results. More corporations began to tap the local bond market to finance their operations. Debt securities are being viewed as alternative sources of financing to traditional bank borrowings. New instruments are being developed. International institutional investors now have a keen interest. The statistics themselves are impressive. Comparing equity and debt issues in the capital market, the equity market raised RM10.3 billion in 1995, and the debt market raised RM11.5 billion, (of which RM3 billion are Cagamas issues). The raising of debt through the capital market has exceeded equity issues each of the past three years.

The progress achieved hitherto should not, however, mask the reality that we are still in the early stages of development. The challenges ahead are indeed many. Much remains to be done to establish systems and infrastructure that would facilitate the issuing process in the primary market and the development of an efficient and liquid secondary market.

With the reduction of government borrowings since the late 1980s largely due to the government's privatisation programme, as well as its prudent economic management programme, a shortage of new sovereign issues has arisen. Redemptions through maturities have exceeded new issues of government bonds for the past three years. To compound the problem, the demand for papers keeps increasing. In 1995, loans in the banking sector alone increased by RM55 billion. Hence banking institutions are forced to compete for the limited supply of papers for their reserve and liquidity requirements. In addition, there are demands from Insurance Companies, Unit Trusts and Employees Provident Fund, who are traditionally the largest holders of government bonds, because of the relevant statutory restrictions imposed on them.

Related to the supply issue is the need for benchmark mid-term to long-term bonds upon which corporate bonds can be priced. A benchmark would greatly facilitate the pricing of bonds in both the primary and secondary markets. Benchmark securities must be actively traded so that market quotes are available at all times. To facilitate a proper benchmark, there must be a planned programme of frequent benchmark bonds of various maturities. Indeed, in countries with successful bond markets such as in the US, Australia and France, there are pre-determined dates for regular issues of Treasury or government securities. In Canada, for instance, regular issues with different maturities are auctioned quarterly in an attempt to create liquidity in addition to raising target sizes for benchmark issues.

Now, you would say to me, these countries make a virtue of a necessity. Their governments need to finance their deficits, and creating a bond market on the back of this need makes sense. But what about a country that is running a budgetary surplus?

In response to that question, the SC has been studying the experience of the Hong Kong Government. Although it does not need the funds, the Hong Kong government has implemented a programme to issue, on a regular basis, a series of Exchange Fund bills and notes of maturities extending from three months to seven years with the aim of building a liquid, risk free yield curve. The size of each issue is determined upon consultation with industry participants to ensure that there is sufficient demand in primary market and liquidity in the secondary market. Through this programme, as well as other supporting measures, the Hong Kong yield curve has been taken out to seven years, and secondary market trading of Exchange Fund bills and notes has been about one-third of the issued volume in the last two years. So, yes, it is possible to have a liquid bond market and a budget surplus at the same time.

Regulatory reform is yet another area for developmental initiatives. Currently, all bond issues require approvals of BNM and RAM. If bonds are intended to be offered to the public and listed on the KLSE, approvals of the Registrar of Companies, SC and KLSE are also required. This results in a comparatively long time taken for the approval process. This exposes the issuers and the underwriters to the risk of interest rate movements and other risks such as the issues becoming less attractive to investors. The regulators are working towards addressing this problem and it is hoped that the soon-to-be launched interest rate futures market would, to a certain extent help issuers and underwriters hedge their interest rate risk.

In the development of the secondary market, the primary focus will be to increase liquidity. It is hoped that the liberalisation of the requirements imposed on Employees Provident Fund with regards to investment in government bonds (from 70% to 50%) will be followed by similar liberalisation's for other institutional investors such as pension and provident funds. This will reduce the need for these institutions to keep these papers as 'captive instruments'. This has been and still is the main factor contributing to an illiquid secondary market. At the same time, the increase in the number of non-statutory funds such as unit trust funds and closed-end funds would also add liquidity to the secondary market.

Our efforts to develop the ringgit bond market must address all of the above challenges and more. It must build upon the pioneering efforts of Bank Negara in introducing asset-based securities, a scripless custodial system, and a mandatory rating system for all issuers of debt, with the SC now also playing its developmental and statutory role. It must bring together the concerted efforts of all market participants in building up the market, and making it efficient, secure, open and transparent.

Most importantly, these reforms will only bear fruit if investors and issuers are willing to take on greater responsibilities, to assess the risks and returns of new issues that are being brought to the market. Too many issues today are premised on the guarantees of financial institutions. Not only is this inefficient for the issuer, it also provides too ready a cushion for investors, albeit at a cost to them as well.

To heighten the sensitivity of issuers, investors and intermediaries to market forces, the education of all market participants must be enhanced. In the 1970s and early eighties, bond dealers did not worry about duration or convexity; they used rules of thumb to access risk. As long as interest rates remained relatively stable, this approach seemed to suffice. With increased volatility in the interest rate environment bond dealers and management have now to grasp with the mathematics of bond pricing and volatility. We should not stop here. New instruments demand new analytical skills. Convertible loan stocks are bonds with embedded call options. Coming our way are asset backed securities. And our fund managers are beginning to venture abroad to invest in bonds in the more advanced markets.

The Securities Industry Development Centre (SIDC) feels it timely that we bring to you a workshop that will improve your skills in the areas of analysing bond price volatility, constructing yield curves, modeling credit spreads, applying risk models in global bond investing and bond portfolio management and for that purpose, we have selected BARRA to conduct the workshop. I am confident that this two day workshop will give you a flavour of the state of the art in analytics and bond engineering technology.

May I take this opportunity on your behalf to welcome Stan Beckers, who is currently president of BARRA International, who will be your main instructor, as well as their team from Hong Kong, Eugene Chen, Mark Adams and Wayne Pushka. I would also add a note of thanks to RAM for their effort in jointly organising this event with the SIDC.

Ladies and gentlemen, it is my pleasant duty to declare this Fixed Income Portfolio Management Workshop open.
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