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Unrated bonds to test investor buy-in
Lifting of rating requirement to broaden corporate bond market
Chito Santiago 3 Sep 2014


Chong: Another milestone for Malaysian bond market  

Today, it is a regulatory requirement that all tradable corporate bonds in the Malaysian bond market be rated. But come January 1 2017, this mandatory requirement will be removed and that could open the issuance flood gates as more issuers and borrowers access this pool of liquidity. At the same time, the international credit rating agencies with full foreign ownership would be allowed to operate in Malaysia.


The measures, announced in June by Prime Minister Najib Abdul Razak, are designed to further promote investments in a broader spectrum of assets in the country. He explains the lifting of the requirement for credit ratings will broaden the corporate bond market and enable investors to further diversify their portfolios.


A gradual approach is being adopted to provide industry players sufficient time to further refine the mechanisms necessary to operate under the new regime. From January 1 2015, the flexibilities will be accorded on credit ratings and the tradability of unrated bonds and sukuk.


“Ultimately, this liberalization will enable the Malaysian bond market to become a more cost-effective and attractive long-term financing platform,” says Najib.


Bankers and other market participants agree. “The removal of the mandatory rating of bonds will spur the growth of the Malaysian bond market, providing investors with greater investment choices and enable unrated bonds to be traded in the secondary market,” says John Chong, CEO of Maybank Kim Eng Group and Maybank Investment Bank. “The eventual lifting of the rating requirements marks yet another milestone in the development of the Malaysian bond market, bringing it closer to some of the international bond markets, including the US dollar bond market where there is no mandatory rating requirement.”


For Hanifah Hashim, head of Malaysian fixed income and sukuk at Franklin Templeton Investments, the rating liberalization is what the market needs. “Though our bond market has grown in recent years, it is still dominated by high quality bonds – the AA and above rated ones,” she notes. “We need diversity of bond papers in the market and by that, it means having both the high yield and high grade securities.”


Thomas Meow, senior managing director and head of credit markets and banking at CIMB Investment Bank, also lauded the lifting of the rating requirement, saying it will enhance the accessibility of corporates to the Malaysian corporate bond market. And as a result, there will be a range of new captive names typically tapped by the loan market turning to bonds, thus adding depth and breadth to the market. “This helps to offer an opportunity for investors to further diversify their portfolios with a wider set of risk profiles,” he adds.


Currently, investors subscribing to unrated bonds are required to hold these securities until maturity given their non-tradability and non-transferability. “We expect the regulatory change to increase the investor appetite and spur demand in the unrated bond market in Malaysia and in the long-term, increasing the sophistication of investors in the market,” notes Meow. “The removal [of the rating requirement] is likewise expected to enhance the competitiveness of the ringgit bond market to foreign issuers looking to diversify their investor base and put it on a level playing field with the other bond markets. These issuers will also be able to avail themselves of a vast sukuk investor base given the central role currently played by Malaysia as a regional Islamic hub.”


Indeed, as Norfarasha Abdullah, senior vice-president for debt capital markets at RHB Investment Bank says, the non-rated borrowers may now benefit from a bigger subscriber base of their capital – such as loans from banks/syndications to bond issuance to large institutions, including pension funds, mutual funds, insurance companies and perhaps retail investors.

 

Mixed views from investors

 

 
Abdullah: Issuers will continue to look for cheaper source of funding  

The immediate beneficiaries, she points out, could be the companies that are (1) frequent issuers which have been previously rated; (2) exchange-listed companies whose credit quality could be easily monitored with greater governance and transparency; (3) small issuers with “quality assets” as securities and (4) companies with strong parents as the main subscriber to the papers.


However, Abdullah reckons there was a mixed view from the local players as some investors are still very much comfortable with rated papers and most organizations would have an internal investment policy that requires a rating from a local rating agency.


“Liberalization is a good step forward by the government, however, the other half of it will have to be from the investors,” says Hashim. “We need buy-in from the investors as our investable universe depends on our client’s mandate. At present, most of the mandates do not allow investment into unrated bonds. Once investors warmed up to the idea of investing in non-rated bonds, we will have more assets to choose from.”


She expects change to happen, but gradually, where clients slowly allow its mandate to invest in non-rated bonds at a certain percentage before its limit is eventually removed altogether over time to allow investments in non-rated bonds. “I am positive this will happen. It is only a matter of time,” adds Hashim.


Chong also expects corporates with strong credit ratings and frequent issuers to benefit the most from the rating liberalization as they may now be able to tap the bond market on either a rated or unrated basis. “If they choose to issue bonds which are unrated, they may do so but enjoy the benefits of having their instruments traded in the secondary market as well,” he says.


With the removal of the mandatory bond ratings, the issuers will now have to be more transparent to the public as investors would demand greater access to information to carry out their own credit assessment in the absence of an external independent credit assessment by rating agencies.


For bonds without a rating, the onus for investors to perform their own credit analysis and evaluation of the risks associated with a particular bond is greater. “The old adage of “caveat emptor” is more imperative than before,” stresses Chong. “However, the lifting of the rating requirement will have successfully created a new instrument in the Malaysian bond market, that is, the unrated bonds that are tradable. Thus, investors can enjoy a broader bond market with increased investment choices.”

 

 
Hashim: We need diversity of bond papers in the market  

As for the rating agencies, it is believed the new ruling will not have a significant impact on the credit rating industry, according to Chong. Rating agencies, he says, will continue to thrive as certain investors will still see the value of independent third parties to monitor and analyze the credit risks of any investment, including providing early warnings on changes in the credit profiles of the bond issuers.


Indeed, Rajan Paramesran, acting head of ratings at the Malaysian Rating Corporation (MARC), remarks their business will not be impacted by the lifting of the rating requirement. “Rating services will still be in demand, driven more by investors,” he asserts. “Given our extensive experience in rating a wide spectrum of conventional bonds and sukuk issuances close to two decades, we are in good stead to meet the challenges. It will be business as usual for the local credit rating agencies come January 2017.”

 

Fresh mandate for unrated bonds


What the rating liberalization also brings to fore is a more pronounced role of an investment bank as principal adviser/lead arranger/lead manager for a bond transaction. “The adviser will have a greater responsibility to advise their client on the suitability of a rating, especially in the context of pricing, marketing and distribution of a bond offering,” comments Chong.


But are the investors ready for the new asset class in the form of unrated bonds? At present, the buy-side in the Malaysian bond market is dominated by institutional investors such as pension funds, insurance companies, fund managers and banks whose investment mandates are to buy high quality, investment grade paper.


“Given the investment trend in recent years where we have seen a risk appetite favouring strong rated bonds – AAA and AA – investors such as fund managers will not be able to invest in unrated bonds unless their clients are willing to loosen their mandates,” says Chong.


And even if the mandates are procured to buy unrated bonds, he reckons the investors would initially limit their portion of such bonds, rather than allowing an open-ended policy due to the liquidity risk associated with unrated bonds. The liquidity risk in this case refers to the risk associated with these bonds, which although tradable, may not be as liquid as their rated counterparts.


As it stands, Paramesran does not think institutional investors are ready to buy unrated lower-tier companies. “Certain markets have allowed the issuance and tradability of unrated bonds of all types, but their disclosure standards may be different which may have allowed for the practice,” he says, adding, “Issuers here would need to be more transparent by providing investors timely and continued access to information. Greater transparency on financial accounts, cash flows, corporate plans, etc. would be the key to facilitate the reception of unrated bonds as it would enable accurate investment decisions to be made.”


For Abdullah, most of the local investors may need to obtain a fresh mandate to invest in the unrated bonds or loosen the existing one. “As a result, the take-up for the unrated bonds may not be as great in the early stage of implementation – except for those issuers that fall under the four categories, which are the immediate beneficiaries – compared to the other market with mature unrated universe such as Singapore.”


Chong says firms with lower credit ratings typically face uncertainty on the pricing they can achieve through a bond issuance. “Without a rating, investors will have an incentive to price the bonds higher than their rated peers to compensate for the lack of liquidity for the unrated bonds vis-a-vis the rated bonds,” he notes. “There remains a possibility that there will be insufficient take-up as investors might not have the confidence to take up bonds without a credit rating attached to it. This is further exacerbated when investors are unable to access the information they need to evaluate the company’s financial strength and creditworthiness.”


From another perspective, the removal of the mandatory rating requirement for bonds will help reduce the cost for the bond arrangement, while saving the potential issuer time, effort and administrative cost to undergo the rating process. “At present, the lower-rated issuers and borrowers are not tapping the bond market partly due to the additional cost and effort in getting and maintaining a rating,” notes Meow. “By doing away with the compulsory rating, many of these issuers and borrowers may find that it may be cost-effective for them to issue bonds, especially in the smaller amount of financing that they require.”


Adds Chong: “Issuers will no longer have to contend with upfront rating exercises, annual rating reviews and their associated fees. This will not only make bond issuances more cost-effective to potential issuers in terms of fees, but also save potential issuers time, administrative costs and commitment of resources.”

 

 
Meow: Enhancing the competitiveness of the ringgit bond market  
 
Paramesran: Rating fees are not prohibitive factor for bond issuances  

Cost of rating


A typical rating exercise for a ringgit-denominated bond can indicatively cost a potential bond issuer up to 0.06% initial upfront fee on the bond programme size, subject to a cap of 450,000 ringgit (US$141,607) to 500,000 ringgit, according to Chong. The rating agencies also charge an additional fee of up to 0.05% to the total programme size with a cap of 300,000 ringgit to 450,000 ringgit for the annual rating review exercise throughout the tenure of the bond programme. “The upfront and annual rating review fees represent some of the biggest components of the bond issuance costs, and in some cases, even exceed the fees paid to legal advisers and other transaction parties,” says Chong.


Paramesran argues, though, that from MARC’s observations and experience, rating fees have never been a prohibitive factor for bond issuances. He says: “A key factor has always been the investor appetite. Following the 2008 global financial crisis, we have seen a steady decline in investor interest for A and lower-rated papers – BBB or below. This is largely due to concern on credit quality of these bonds and, as the crisis had demonstrated, are highly vulnerable to rapid credit deterioration.”


But while it is widely believed that the fees charged by the rating agencies may be one of the factors in making it challenging to attract foreign issuers into the Malaysian bond market, a credit rating can also be seen as a means to help the marketing and distribution of bonds issued by foreign issuers in Malaysia.


Observes Chong: “Malaysian investors tend to be name- and credit-rating sensitive, and may not be familiar with foreign issuers who seek to tap funding through the ringgit bond market. A rating may assist investors to understand the credit profile of the issuer and provide a foundation for their own assessment of the issuer’s credit profile.”


Amid the cost saving in the absence of a rating, an unrated bond issuance may entail an additional risk premium in the issuance yield. “This might be the case for bond issuers who are new to the market and an expectation of investors who demand a risk premium as a compensation for their lack of familiarity with the issuer’s name and/or credit profile,” adds Chong.


Meow concurs: “It is worth noting that cost savings could also be nullified by the higher yields demanded by investors for relatively new or lesser-known names in the market. For these issuers, investors may be comforted by a credit rating instead.”


Meanwhile, the lifting of the rating requirement is not expected to have a negative impact on the loan market – through a shift of borrowers into the bond market. “Although the lifting of the rating requirement automatically increases the attraction of the bond market as a funding avenue – as a result of potential cost savings from not having to undertake a mandatory rating exercise – the loan market still offers multiple benefits for the borrowers,” argues Chong.


He continues: “By weighing the funding options between accessing the loan market or the bond market and taking into account other considerations such as the level of disclosure required under a capital market instrument, regulatory approval required and longer execution time frame to issue a bond, the bond market may not be for everybody. The loan market and bond market still have their respective merits, which make each individually attractive as a funding avenue.”


Meow likewise notes that while lifting the rating requirement will make it easier for corporates to raise funds from the bond market, the loan market may remain appealing for some issuers as there is more flexibility to negotiate on the loan terms, and the execution process is quicker.


Comments Abdullah: “We do not think the emergence of non-rated bonds will cannibalize the growth of the loan market in the short to medium term as the issuers will continue to find cheaper source of financing.”

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