Danareksa: Indonesian corporate bonds; not always the poor relation

In a recent movie about King Henry VIII of England, he talked about the difficulties of being less favored than his sibling who was considered to be smarter, braver, or more accomplished.

For a long time now, the fate of Indonesia's corporate bonds has been akin to that of a child whose sibling i.e. Indonesian government bonds - is better appreciated. Indeed, investors have tended to shy away from Indonesian corporate bonds.

Looking at the monthly market turnover ratio (that is the total value of bonds traded to the total value of bonds outstanding) for both corporate and government bonds in the period from January 2002 to October 2008, there were only three occasions when corporate bonds had a higher turnover ratio (that was in the months of April, June and September 2002).

Moreover, in the same period, the market turnover ratio for corporate bonds only managed to surpass the 10 percent level on three occasions - in June 2003, November 2006, and July 2007.

The low level of the market turnover ratio shows that most corporate bondholders prefer to hold their bonds until maturity.

As they have a much lower credit risk, it is natural that government bonds should offer lower yields than corporate bonds. However, this is not currently the case since the illiquidity of corporate bonds has resulted in a negative yield spread between the government bonds yield index and the corporate bonds yield index in every month since April 2008.

This phenomenon reflects weaker conditions in the financial markets which prompted investors to reduce their holdings of government bonds. This pushed bond prices down and yields higher. The consequence of this was to make it more difficult for the government to issue more bonds to raise funds to help plug the state budget deficit.

At the same time, bondholders tended to hold on to their corporate bonds rather than sell them.

As a result, the corporate bonds yield index does not reflect the current condition of the bond markets. In such a condition, investors will prefer to trade government bonds since they offer higher yields; hence, corporate bonds become even more illiquid, making them even less attractive to investors.

So does this mean that investors should avoid corporate bonds? Well, not necessarily.

By comparing the total year-to-date return indices for both government bonds and corporate bonds, we discover that corporate bonds actually give better returns than government bonds for most of the time.

Government bonds only provided better year-to-date returns in January 2005, for most of 2006, and then again in May-July 2007. As such, we believe that Indonesian corporate bonds offer some interesting opportunities - especially to investors who are looking for superior returns.

Another reason to consider investing in corporate bonds is that it allows for greater diversification of investment funds. Thus, rather than investing in the country as a whole i.e. in government bonds - we can instead choose to invest in business sectors that we believe will have bright prospects going forward.

Looking back to the early part of this year, we can see that corporate bonds in the business sectors we cover actually outperformed government bonds. In the year up to October 2008, the infrastructure sector is the worst performing sector (it has recorded four months of negative year-to-date returns). Also showing poor performance is the banking sector (with two months of negative year-to-date returns).

Meanwhile, the telecommunications, multifinance and property sectors have recorded only positive year-to-date returns so far.

Government bonds, however, recorded only two months of positive year-to-date returns in the year up to October 2008. Thus, by diversifying into corporate bonds we would have attained better overall returns than if we had invested in government bonds only.

In addition, we can make investments in bonds that match our risk appetite. By investing in corporate bonds we can choose to either invest in highly-rated bonds - in return for lower coupon payments - or in lower-rated bonds which pay out higher coupons.

Nonetheless, investors still need to be cautious. The main concern is definitely the credit risk. At the current time, with the credit crunch biting hard, highly leveraged (indebted) companies are much more risky. This is basically because they might find it difficult to get their maturing debts refinanced in the future.

Industry risk is another consideration for investors. The slowdown in the global economy will have far-reaching implications and some industries will be harder hit than others. The business environment for companies with operations in natural resources/commodities will be tougher. In addition, if interest rates remain high, the banking, multifinance and property sectors may face more challenging times ahead.

The third consideration is business risk. Having a good market share and a competitive advantage can help give larger sized companies the edge over their rivals.

Smaller companies, by contrast, will find it more difficult to raise funding - especially if there is less liquidity.

Finally, as we have mentioned before, corporate bonds are still illiquid. As such, it may be difficult to buy them at fair values.

In short then, it can be seen that corporate bonds can be attractive to investors. Just like in the movie, in which King Henry VIII left a bigger mark on history than his brother, corporate bonds deserve the attention of serious investors for their greater potential returns than government bonds. After all, it is not always the case that the less-favored should be less worthy!

The writer is an analyst at PT Danareksa Sekuritas' Debt Research