The Growth Of The Malaysian Bond Market Finance Essay - Free Essay Example

Malaysia bond market is one of the fastest growing bond markets in Asia. The bond market reached a whopping amount of RM730.0 billion as at September 2010 compared with RM634.8 billion as at end year December 2009. Both public and private sector contributing a balance mix amount of 53% and 47% each. Ringgit was the best performing Asian currency against the US dollar. Thus this will cause the increase of the demand on Ringgit denominated bond. The bond is rated base on its strong performance and the ringgit is expected to further appreciate on speculation of Yuan appreciation. The ringgit has gained 7.0% against the USD as compared to other Asian currencies. With the unpredictable volatility of stock market; investors have begun searching for an alternative investment. Malaysian investors should look forward in holding ringgit denominated bonds while avoiding global bonds. Currency Year to date (YTD) basis Currencies Performance VS USD. Ringgit 7.0% India R upee 4.6% Korean Won 4.6% Indonesia Rupiah 4.1% Thai Baht 3.2% Singapore Dollar 2.4% Taiwan Dollar 2.1% China Yuan 0.0% Source: Bloomberg, iFAST Compilations, date as at 26Apr 2010 Malaysia posted 4.5% GDP growth as at year 2009 was backed by the improvement of external and domestic demand with support of better economic fundamental. The global recovery since the 2007 Financial Crisis has yet to see double digits of year on year growth recorded in exports and manufacturing sales growth. The New Economic Model (NEM) is a plan to transform Malaysia into a high income economy country has somehow influence the recent surge in Ringgit. Malaysian government plans to cut its budget deficit from 7.9% of GDP in 2009 to 5.4% of GDP in 2010 by reducing the supply of bonds. On the other hand, as a result of some of the developed nation such as Portugal, Italy, Ireland, Greece, Spain, UK, US and Japan see their debt to GDP ratio soar. These have ca use an increase in demand for Ringgit denominated bonds as it perceived their sovereign debt risk would continue to rise. Investors look at developing nations debts as an alternative source to provide them a safer alternative investment. The rise of bond yields will cause the fall in bond prices when the economy improves because investors will withdraw money out of safe or government backed bonds and opt for riskier investments. Investors will search for better opportunities in the stock market to gain potential bigger returns. Generally a recovery of a countrys economy or a good economy expectation will be the typical reason for bond yields to go up. However, the perceived of higher risk default on a country could also be a reason of the rise on bond yields. Example the recent Greek bond yields sore up to 7% recently due to its meltdown on fiscal deficit. When bonds are issued the issuer will compensate investor with periodic interest payments for the use of money. Bonds carr y coupon rates that are close or similar to the prevailing market interest rate. There is an inverse relationship between the interest rate and bond prices. The reason that causes the inverse relationship between interest rate and bond price is due to the opportunity cost of investors investment alternative. Investors will compare the returns on their current investment to what they can get in other market. Market interest rates changes will affect the attractiveness and preference of investors on bond market. For an example, suppose XYZ Company will to issue a bond carrying a coupon rate of 5%. This means the bond will pay RM50 a year in interest and you decided to purchase the bond at its par value of RM1000. Lets assume that if the interest rates in general go up. New bond being issue at RM1000 now will be paying 6% coupon. Investors will be reluctant to pay a face value of RM1000 for the previous XYZ bond. You cant change the interest rate on the bond. However you can change the price you are willing to take for the bond. In order to sell the bond, XYZ Company has to offer the bond at a lower price or a discount. The annual payment of the XYZ at RM50 (RM1000 x 5%) must equal a 6% payment. Doing a simple calculation you can find that the face value of the bond must be discounted to RM833 so that the RM50 fixed payment equals a 6% yield on the buyers investment (RM833 x 6% = RN50 ). Similarly, if the rates dropped below 5% of the original coupon rate the bond would be worth more than RM1000. Therefore it would be price at premium since it would be carrying higher interest rate than what currently offers on the market. This example is to illustrate the relationship between the interest rates and bond price at 10 years maturity. It does not represent the actual computation of a bond price. The following example will go in-depth on computing the bond price base on the present value formula. The basic present value formula for calculating a bonds price stated below: P = Market price of bond C = Coupon Payment M = Value at maturity, usually equals to face value i = Market interest rate or required yield N = number of payments Referring to the above example the increase of interest rates at i = 6%, C = RM50, M = RM1000, N = 10. The price of the bond will price approximate at RM926 lower than the face value of RM1000. The bonds yield relates the relationship of the ringgit price to its cash flow. The bond cash flows consist of coupon payments and return of principal. The principal is normally returned at the end of the bond terms known as the maturity date. The bond price is the sum of the present value of every cash flow consists by the bond. Inflation causes a big stir in bonds market. When there is a rising expectation in inflation it will cause direct impact in interest rates rise, bond yields rise therefore a fall in bond prices. The market bond price will normally be priced relative to a benchmark, usually base on a government security. If the bond is a good rated bond it has a smaller spread between its required return and the yield to maturity (YTL) benchmark. Bond Pricing Agency Malaysia (BPAM) Ringgit bond index includes bond types of zero coupon, fixed coupon, bullet and bonds with secondary notes. The indexes also consist of treasury, government related and corporate sector. It has 732 bonds with a total market capitalization of RM524 billion. The bond index is the weight of a security in the index the market value of that security on issue divided by the total value of all securities on issue. BPA Malaysia Bond Index: Source: Bond Pricing Agency Malaysia Sdn. Bhd date as at 26Oct 2010 Source: Bond Pricing Agency Malaysia Sdn. Bhd date as at 26Oct 2010 The accumulation index will increase due to the interest earned on the bonds in the index portfolio. The primary source of movement due to the rise in yields implies a fall in prices and the index. While a fall in c urrent yields holding all other factors equal implies a rise in the index. Therefore there is a positive relationship between the prices change on the index. The shorter the maturity period of the bond the weaker the impact of differences between bonds yields and coupon rate. Bonds priced at discount will cause an increase of value over the time by holding other things being equal, while bonds priced at a premium will decrease in value. The price changes of bonds will automatically balance the index. The increase in weighting in proportion of the rise in market value would have cause by the rise in the price of a particular bond. The following table shows simple average returns with a graph of the total return index: Simple average return 1 Month 0.57% 3 Months 2.11% 6 Months 3.83% 12 Months 5.83% 18 Months 7.71% 24 Months 13.61% Source: Bond Pricing Agency Malaysia Sdn. Bhd date as at 26Oct 2010 The BPAM values bond portfolios through providing a price that is market relevant and may be done via fair valuation or taking the market price through mark-to-market. BPAM provides prices for all the bonds in the market the cope with the lack of bonds price due to not being traded. By using the last traded price can be use when the market price is reliable only in an efficient market. It also uses the fair valuation that a methodology is used to provide a rational and unbiased estimate of the potential market price. To estimate the current price it uses the arms length market transactions and relative comparison. The pricing process of BPAM is base on a daily yield adjustment exercise whereby the adjustment is done on pre and post data. Other factors that affect the price calculations include credit rating changes, micro and macro economic factors and changes in the bond terms and condition. BPAM chief executive officer Meor Amri Meor Ayob claims that the BPAM Reference Pricing Service (RPS) could reduce price discre pancies between primary bond issues and secondary market trades and provide an alternative to issuer for prices negotiated by investment bankers or bond arranger. This is to aimed at giving the fair price of a proposed bond issue, based on the current interest rate and economic environment. The difference between the prices should not be a different in when it is issued and when it began trading therefore whether it is at the primary or secondary level there should not be a change in price. The risk interest rate environment, the credit rating, the risk exposure and the asset should not be a discrepancy in price. The following graph shows the correlation analysis between the Bond Market Index level VS Equity Market Index level: Source: Bond Pricing Agency Malaysia Sdn. Bhd date as at 26Oct 2010 The above chart shows the performance of bond market index perform better than the FBMKLCI from the beginning year. In year 2010 it shows a better economic sign compared to the previ ous year causes the increase issuance of financial related bonds. Government bonds were oversubscribed by 6 times while issuance of commercial paper by Private Corporation such Kinsteel Bhd being oversubscribed by 1.3 times. This clearly indicates that there is good liquidity and institutional interest in bonds and other fixed income instrument. Investors should consider their interest in the bond market as the effect on bond pricing provides a great opportunity for steady and safer returns. A few European countries have causes the downturn of the European region economy. Besides the quick recovery of stock market since 2007 financial crisis have increase the doubt of most investors in the stock market performance. The issuance of bond in Malaysia has been increasing from both government and corporate sectors to meet the demands of interested parties. Therefore with the active bond market that has a good pricing prospect in the future provides a safer ground for risk adverse investo rs.