Fixed Income Securities

Identify the fixed income securities found in MALAYSIA CAPITAL MARKET and analyze their features on RISK and RETURN.



Introduction:
In the immediate aftermath of the 1997-98 financial crisis, efforts to strengthen the Malaysian capital market were mainly focused on regaining investor confidence, facilitating the raising of funds, supporting debt and corporate restructuring, and rehabilitating the securities industry.

As recovery mounted, work increasingly focused on positioning the Malaysian capital market to more effectively meet the future needs of the Malaysian economy. With this in mind, the Securities Commission (SC), in close consultation with the industry and government, formulated the Capital Market Master plan to provide strategic clarity for this positioning and framework for the future direction of capital market development. One important aim of the Master plan, which was released in February 2001, is to provide capital market stakeholders with a clear point of reference, especially in relation to many on-going areas of work.


Major Products traded in the Capital Market:
Equities:
• Share capital: Ordinary shares, Preference shares
• Fixed-income securities: Debenture stocks, Loan stocks
• Others: Warrants, Property trusts, Closed-end funds
Derivatives:
• Crude palm oil (CPO) Futures
• Kuala Lumpur Stock Exchange Composite index (KLCI) Futures
• Kuala Lumpur Stock Exchange Composite index (KLCI) Options
• Three-month Kuala Lumpur Inter bank Offered Rate (KLIBOR) interest rate Futures
• Five-year Malaysian Government Securities (MGS) Futures
Corporate Bonds:
• Long-term private bonds: redeemable, non-conventional secured and unsecured
• Short-term bonds – Revolving Underwriting Facility (RUF), Note Issuance Facility
(NIF)

• Fixed Income securities:

Fixed income security is a claim on a specific periodic stream of income. Fixed income securities have advantages of being relatively easy to understand because the level of payment is fixed in advance. Risk considerations are minimal as long as the issuer of the security is sufficiently creditworthy. That makes those securities a convenient starting point for our analysis of the universe of potential investment vehicle.

There are two types of bonds available for the investors, government bonds and corporate bonds. Let’s discuss more on the bond features and risk as well as the taxation on it.





BOND

Feature of Bond:

A bond is a security that is issued in connection with a burrowing arrange. The burrower issues or sells a bond to the lender for some amount of cash. The bond is the “IOU” of the borrower. The arrangement obligates the issuer to make specified payments to the bond holder on specific dates. A typical coupon bond obligates the issuer to make semiannual payments of interest to the bond holder for the life of the bond. There are called coupon payments because in earlier days, before the computer are not so common, the bonds had coupon that investors would clip off and mail to the issuer if the bond to claim interest payment. When bond matures, the issuer repays the debt by paying the bondholder the par value or the face value. The coupon rate of the bond serves to determine the interest payment. The annual payment is the coupon rate times the bond’s par value. The coupon rate, the maturity date, and par value of the bond are part of the bond indenture, which is the contract between the issuer and the bond holder.

Bonds usually are issued with coupon rates set high enough to induce investors to pay par value to buy the bond. Sometimes, however zero coupon bonds are issued that make no coupon payments. In this case, investors receive par value at the end of the maturity date but receive no interest payment until then. The bond has coupon rate of zero. These bonds are issued at prices considerably below par value. And the investor’ return comes solely from the difference between issue price and the payment of par value at the end of the maturity.

The Malaysian bond market is the second largest in Asia ex Japan. There are over 2000 bonds issued as of January 2006 with a total value exceeding RM 140 billion. However on any given day less than 2% are traded. The valuation of the remaining 98% therefore becomes an issue.


Corporate bond:

Like government, corporation borrows money by issuing bonds. Both domestic and foreign investors can buy and sell conventional and Islamic corporate debt instruments through the exchange and over-the-counter markets.
Here are the bond instrument found in Malaysia and there summery


Bonds found in Malaysian market:

Cagamas Bonds:
Cagamas Bonds were introduced in October 1987 with the establishment of Cagamas Berhad, a National Mortgage Corporation, in 1986 to promote the secondary mortgage market in Malaysia by providing financial products that would make housing loans more accessible and affordable to Malaysians, particularly the lower income group.

Cagamas Berhad borrows money by issuing debt securities and uses the funds to finance the purchase of housing loans from financial institutions, selected corporations and the Government. The provision of liquidity at a reasonable cost to the primary lenders of housing loans encourages further financing of houses at an affordable cost.

Besides housing loans, the Company’s other products include industrial property loans, hire purchase and leasing debts (conventional and Islamic), and credit card receivables.

Cagamas Bonds and Notes Cagamas fund its purchases of loans and debts primarily through the issuance of Cagamas debt securities. The five types of debt securities issued by Cagamas to fund its portfolio of loans and debts purchased under the facilities for housing loans, industrial property loans, hire purchase and leasing debts and Islamic house financing debt, as follows:





Cagamas Fixed Rate Bonds


These bonds have tenures of 1.5 to 10 years and carry a fixed coupon rate which is determined at the point of issuance, based on the tenders submitted by the Principal Dealers. Interest on these bonds is paid half-yearly. The redemption of the bonds is at nominal value together with the interest due on maturity date.


Cagamas Floating Rate Bonds


These instruments have tenure of up to 10 years and an adjustable interest rate pegged to the 3-month or 6-month KLIBOR. The interest rate is reset every 3 or 6 months while interest is paid at 3 or 6 monthly intervals. They are redeemed at face value together with the interest due upon maturity.

Cagamas Notes


These are short-term instruments with maturities between 1 to 12 months issued at a discount from the face value. The other features of these notes are similar to those of the Malaysian Treasury Bills. They are redeemable at their nominal value upon maturity.


Sanadat Mudharabah Cagamas

These are Islamic bonds issued under the Islamic principle of Mudharabah (profit-sharing) to finance the purchase of Islamic house financing debts which were granted on the basis of Bai Bithaman Ajil and the purchase of Islamic hire purchase debts which were granted under the principle of Ijarah Thumma Al-Bai. Dividend based on a pre-determined profit sharing ratio is payable semi-annually. They are redeemable at par on maturity date unless there is principal diminution. These instruments may have a tenure of up to 10 years.



Sanadat Cagamas


These are Islamic bonds issued under the Islamic principle of Bai Bithaman Ajil to finance the purchase of Islamic house financing debts and Islamic hire purchase debts. Dividend on these bonds is payable semi-annually. The bonds are redeemable at par together with the dividend due on maturity date. These instruments may have tenure of up to 10 years.


Short-term fixed-income securities found in Malaysia:

REPURCHASE AGREEMENT (REPO)

A Repurchase Agreement (REPO) is an undertaking by a financial institution to repurchase money market instruments initially sold to a REPO customer at an agreed price on a specified future date.

A bank would enter into a REPO agreement as a source of funding during temporary liquidity shortfalls where securities are available on bankbooks. REPO can also be used for gapping opportunities against longer dated securities. The maturity period of REPO will be less than a year.



MONEY MARKET INSTRUMENTS ISSUED BY GOVERNMENT.

a. Bank Negara Malaysia Bills (BNB)
b. Malaysian Government Treasury Bills (MTB)


Types of government debt securities are listed below:

Bank Negara Bills (BNB)
Bank Negara Bills (BNB) is short-term instruments issued by Bank Negara Malaysia (BNM) and is an additional capital market instrument utilized to influence the level of liquidity in the economy.
• Issued for tenures of up to one year.
• Issued on a discount basis by tender through appointed Principal Dealers and payable at face value on maturity date.
• Classified into bands by remaining maturities, e.g. Band 1 (up to 21 days), Band 2 (22 to 43 days), etc.
• Traded actively in the secondary market under the Scrip less Securities Trading System (SSTS).



Malaysian Treasury Bills (MTB)
Malaysian Treasury Bills are short-term securities issued by the Malaysian Treasury to finance its working capital requirements.
Malaysian Treasury Bills (MTB) characteristics:
• Issued and managed by BNM on behalf of the Malaysian Treasury.
• Tenures of up to one year.
• Issued on a discount basis by tender through appointed Principal Dealers and payable at face value on maturity date.
• Sovereign debt securities those are virtually risk-free.
• Classified into bands by remaining maturities, e.g. Band 1 (up to 21 days), Band 2 (22 to 43 days), etc.
• MTB's are scripless securities and held in Authorized Depository Institution (ADI) accounts with BNM acting as the central depository. ADIs are appointed by BNM and generally are approved financial institutions.
• Being a negotiable instrument, MTB are highly liquid and freely traded in the secondary market through transfers under BNM's SSTS.

Government Investment Issues (GII)
Government Investment Issues (GII) are non-interest bearing government securities based on Islamic principles, issued by the Government of Malaysia and placed on a competitive tender with maturities of one year or more. Funds are used for development expenditures.



Commercial paper

Commercial papers are short term promissory notes issued by corporate borrowers to raise short term funds for seasonal and working capital needs and for bridge financing of long term projects or corporate takeovers. Commercial paper is unsecured and usually issued by corporations with strong capital and credit standing.

Commercial papers provide a liquid short-term investment for savers and source of funds for the corporations. The default risk for CP is low since the borrowers are mostly credit-worthy, yet the return in terms of interest rate is higher than that for Treasury Bills.


Two most popular shot term commercial papers available in Malaysia are:
a. Revolving Underwriting Facility (RUF)
b. Notes Issuance Facility (NIF)




Notes Issuance Facility

NIF is a basic short term debt instrument issued by corporations. Borrowers issue short term notes of less than a year maturity under an issuance facility provided by a banking syndicate. NIF typically has a tenure ranging from three to 5 years. The notes are subscribed by financial institutions and have maturities up to one year, the common ones being 1,3 and 6 months and allows the borrower to renew his facility at a different rate when a fresh issue takes place. NIF are issued in specific denominations up to RM500, 000 and sold at a discount to face value.


Revolving Underwriting Facility

If an underwriting is included in NIF, the securities are RUF. The underwriters are committed to take up the remaining amount at a pre-determined rates should the notes be under-subscribed. These facilities which are continuously renewed or revolved give borrowers long term continuous access to short term money underwritten by banks at a fixed margin.




Bond Rating:


The Malaysian bond market is still developing. The level of market maturity has not yet reached a point where voluntary fair valuation has been adopted as in the US. Given this fact, the SC has determined that a BPA (Bond Pricing Agency)-based approach would be most suitable and effective.
The BPA generates its valuations via a consistent and transparent methodology that uses data such as observed trades, rating information, historical behavior, yield curves and issuer financial data. With this methodology, fair valuations can be generated for EVERY individual bond in the market on a daily basis, even though these bonds are illiquid or un-traded.

• Determinants of Bond safety:

Bond pricing agencies base their quality ratings largely on an analysis of the level and trend of some of the issuer’s financial ratios. The key ratios used to evaluate safety are:

1. Coverage ration: Ratio of company earnings to fixed costs. Fir example the times-interest-earning-ratio is the ratio of earnings before interest payment and taxes to interest obligations. The fixed cover ratio adds lease fund payments and sinking fund payments to interest obligation to arrive at ratio of earnings to all fixed cash obligations. Low or falling coverage ratio signal possible cash flow difficulties.
2. Leverage ratio-debt-to-equity ratio: A too high leverage ration indicates excessive indebtness, signaling the possibility the firm will be unable to earn enough to satisfy the obligations on its bonds.
3. Liquidity ration: The two common liquidity ratios are current ration and quick ratio. These ratios measure the firm’s ability to pay bills coming due with cash currently being collected.
4. Profitability ratio: Measures of rates of return on asset or equity. Profitability ratios are indicators of a firm over all financial health. Return on assets is the most popular of these measures. Firms with high return on assets should be better able to raise money in the security markets because they offer prospects for better returns on the firms’ investments.


Cash flow-to-debt ration: this is ration of total cash flow to outstanding debt.




Bond Pricing:


The formula used for pricing bond is sum of all the coupons from the bond and the price of the bond. All of those are discounted back to find the price of the bond.
The formula for calculating the bond value is





Market Price (P) =



Where
P  The current market price of the bond
T  The number of annual period to maturity
YTM  The annual yield to maturity to be solved for
c  Annual coupon in dollars
F  The face value of the bond


It is calculated by adding risk free rate (T-bills rate) to risk premium. Risk premium is the additional return given for having additional risk. Here T-bills are considered risk free since the government is most likely to repay its debt in the mean of tax or burrowing again by issuing T-bills.
Different definitions and classifications can be used in classifying risk. A general classification may use physical, social and economic sources. But an in-depth investigation of the problem of risk identification may need classification that can cover all types of risk in more detail. Therefore the sources of risk can be represented depending on the environment in which they arise as follows:
• physical environment;
• social environment;
• political environment;
• operational environment;
• economic environment;
• legal environment;


Junk bonds

Junk bonds, also known as high yield bonds, are nothing more than speculative-graded (low rated or unrated) bonds. Buying those bonds is not advisable since those promises are not feasible and it can’t be trusted at all.


Preferred Stock.


Preferred stock is classified as fixed income securities because its yearly payment is stipulated as either a coupon (for example, 5% of the face value) o stated Ringit amount (for example RM5 Preferred). Preferred stock defers from stocks because its payment is dividend and therefore not legally binding. For each period the firm’s board of directors must vote to pay it, similar to a common stock dividend. Even if the firm earned enough money to pay the preferred stock dividend, the boards of directors theoretically vote to with hold it. Because most preferred stock is cumulative, unpaid dividends would accumulate to be paid in full at a later time.

Although preferred dividends are not legally binding as the interest payment on a bond are, they are considered practically binding because of the credit implication of a missed dividend. Because corporation can exclude 80% of inter company dividends from taxable income, preferred stocks have become attractive investment for financial corporations. For example, a corporation that owns preferred stock of another firm and receives RM100 in dividend can exclude 80% of this amount and pay taxes on only 20% of it. (RM20). Assuming a 40% tax rate the tax would be RM 8 or 8% verses 40% on other investment income. Due to this tax benefit, the yield on high grade preferred stock is typically lower than that on high grade bonds.





Valuation of Preferred Stock.

The owner of a preferred stock receives a promise to pay a stated dividend, usually each quarter, for infinite period. Preferred stock is perpetuity because it has no maturity. As was true with the bond, stated payments are made on specified dates.

Because preferred stock is a perpetuity, its value is stated annual dividend divided by the required rate of return on preferred stock(kp) as follows:-

V= Dividend /kp

Assume a preferred stock has a RM 100 par value and a dividend of RM 8 a year. Because of the expected rate of inflation the uncertainty of the dividend payment and the tax advantage to you as a cooperate investor, your required rate of return on this stock is 9%. Therefore the value of this preferred stock to you is

V = Rm8 /.09

=RM 88.89

Given this estimated value, you would inquire about the current market prove to decide whether you would want to buy this preferred stock if the current market price is RM95, you would decide against a purchase, where are it is RM80, you would buy the stock. Also, given the market price of preferred stock you can derive its promised yield. Assuming a current market price of RM85, the promised yield would be

kp = Dividend / Price

= RM 8 / 85.00 = 0.0941

An introduction to risk and return:


Selecting the appropriate portfolio of assets in which to invest is an essential component of real estate fund management. Although a large proportion of portfolio selection decisions are still taken on a qualitative basis, quantitative approaches to selection are increasingly being employed. Markowitz (1952) established a quantitative framework for asset selection into a portfolio that is now well known. In this it is assumed that asset returns follow a multivariate normal distribution or that investors have a quadratic utility function. This approach shows that characteristics of a portfolio of assets can be completely described by the mean and the variance (risk) and so is described as the mean-variance (MV) portfolio model. For a particular universe of assets, the set of portfolios of assets that offer the minimum risk for a given level of return form the efficient frontier. The portfolios on the efficient frontier can be found by quadratic programming and such problems can now be solved easily in spreadsheet programs.





The solutions are optimal and the selection process can be constrained by practical considerations, such upper and lower bounds, which can be written as linear constraints. The weakness of the MV approach, however, is that the underlying assumptions of multivariate normality or that investors have a quadratic utility function are not sustainable. This has led researchers to develop portfolio asset allocation models using other measures of risk that have many theoretical and practical advantages over MV. Even so, the MV approach remains the most popular approach to the asset allocation problem.






The total risk (variance) of an individual investment or portfolio is thus in two parts. The risk which is associated with market influences is called systematic risk and that which is unique or specific to the investment itself is called unsystematic risk.



The figure below shows a clear view of systematic risk and Un-systematic risk.

Fiqure1.1
Measuring risk:



Unsystematic risk is associated with an individual property’s characteristics such as location; regional and local economic conditions affecting demand and the comparative supply of similar properties; physical design and construction; tenant’s credit worthiness; lease structure etc. These factors, and more, contribute to the performance of the asset and to its volatility. Such risk factors are perceived as being different from property to property. In principle careful or clever investors can construct portfolios which by virtue of diversification tend to cancel out the unsystematic risk element. By spreading the investments of the fund across locations and property types, a fund manager hopes that the unsystematic risk will largely disappear as an influence on the return of a well diversified property portfolio.

In contrast systematic risks are the external factors that are not specifically related to a property, but affect all investments in the market. Factors such as national economic policy; budgetary and other financial uncertainties; inflationary pressure; business and property cycles and demographics influence the market’s overall risk and return profile.

The factor determines the return in the risk. Higher the risk the return expected is higher and visa versa. The interest rates (return) on fixed income securities changes over the years due to inflation and speculation of those securities in the market. The longer the period the higher is the changes. The bond rate exceeds the bond rate because the extra risk involved in the bond.

The Risk (variance) of the investment can be given by the following equation




Finding the mean of the return over a period of time and then finding it variance help use to find the risk factor associated with the asset.






Conclusion:



Fixed income securities are those guarantee a fixed rate of income over a period of time. For an investor point of view this could not be the best alternative for investment thought it guarantees a fixed income. Investor might be willing to accept greater risk and get high return at the end of the day.

The rates calculated for measuring risk is based on the theorem and it is not totally reliable. In long term we don’t know exactly what will happen. So human can predict them to some extend. But still we considered it as the best yard stick for measuring the risk.

The risk of the securities could be minimizing when you take a mixture of portfolio. According to the research it is advisable to take at lease 20 stocks so that the risk could be diversified and the risk is evenly distributed among the securities.




References:

• www.oecd.org
• http://asianbondsonline.adb.org
• http://www.bondweb.com.my