Indonesia's bond market: Dark clouds with silver lining

Neda Tanaga ,  Danareksa analyst   |  Thu, 07/17/2008 10:10 AM  |  Business

The Indonesian corporate bonds market is very illiquid compared with the Indonesian government bonds market. In June 2008, average daily trading for corporate bonds only amounted to Rp 241.5 billion (US$26 million) compared to Rp 3,752.17 billion (US$403 million) for government bonds (Surat Utang Negara or SUN).

This means the average daily trading volume for corporate bonds is only 6.44 percent of the daily trading volume for government bonds.

The Indonesian corporate bond market often does not reflect their fair value. The proof of this is the negative spread between the Indonesian corporate bonds yield index and the Indonesian government bonds yield index during 2008. Indonesian government bonds were traded more, but yielded relatively less, while Indonesian corporate bonds were traded less, but yielded relatively more, taking into account their very different volumes.

Since March 2008, the government bonds yield index and corporate bonds yield index both rose to double digits. This is a reflection of the increasing returns anticipated by investors given a higher risk profile.

From April to June 2008, there was a significant increase in crude oil prices. Bloomberg recorded that the West Texas Intermediate (WTI) crude oil spot price surged from $101.58 per barrel on March 31, 2008, to $140 per barrel on June 30, 2008, an increase of 37.82 percent. This soon translated into higher inflation.

For the first time since October 2006, we had double digit year-on-year inflation in May 2008 -- as the government decided to increase domestic fuel prices -- and this higher inflation persisted into June 2008. Bank Indonesia was forced to raise the benchmark lending rate three times sequentially in May, June and July 2008 by 0.25 percent (25 bps) each time.

The liquid government bonds yield index fully echoes the macro environment. The corporate bonds yield index rose as well, but it moved at a relatively slow pace compared with the government bonds yield index, because of its illiquidity. Hence the negative spread between the two yield indexes.

Another factor that drives corporate bonds to stray from their fair value is the REPO transaction. With previously agreed-on prices, the transactions that take place in the future will not reflect current conditions in the bond market or for the company. Instead the agreed-on price is the reflection of the view of the transacting parties on future conditions, at the time the contract is signed.

It is a no-brainer for new investors to take positions on Indonesian government bonds because as sovereign debts, theoretically speaking, these bonds have next to zero default risks, though they bear higher market risks because of their liquidity. If government bonds (SUN) offer higher yields, then their price is relatively cheaper than that of corporate bonds.

Therefore, SUN popularity among investors might well increase further and in time make government bonds even more liquid than corporate bonds.

For investors who have already taken positions, the climbing yields of government bonds (SUN) will cause the value of their investments to go down, hence negatively affecting portfolios.

On the other hand, steadier corporate bond yields will partially dampen the negative impact of increased SUN yields. Therefore, diversifying your portfolio with Indonesian corporate bonds will strengthen your overall portfolio performance.

Our first argument for this is because we believe that Indonesian macroeconomic conditions are fundamentally sound. Despite skyrocketing oil prices, increasing inflation and rising interest rates, Indonesian GDP has grown 6.2 percent so far this year. The Finance Ministry says the government will strive to maintain economic growth at 6 percent to the end of this year. This is higher than IMF-projected global economic growth projected at 3.7 percent. As of June 30, 2008, our official reserve assets have strengthened to $59.5 billion, the highest level ever.

In addition to that, we are not directly exposed to the US subprime mortgage debacle. Consequently, the global subprime crisis is having limited impact on the performance of Indonesian companies. Pefindo, the ratings agency, has made no rating downgrade this year, in its report released May 31, 2008.

At a time like this, we might want to take a look at sectors with limited exposure to oil prices in their cost structure such as property, telecommunications and infrastructure.

The three have performed relatively better compared with interest-rate sensitive businesses like banking and multifinance. In June 2008 property, telecommunications and infrastructure recorded total returns of 1.07 percent, 1.20 percent and 6.28 percent, respectively. Meanwhile, multifinance company bonds recorded a loss of 0.58 percent and banking 0.09 percent.

During this past year property, telecommunications and infrastructure recorded returns of 11.45 percent, 13.47 percent and 14.80 percent, respectively, whereas multifinance and banking were only 8.85 percent and 5.14 percent.

Fuel-sensitive sectors such as consumer goods surprisingly managed to record positive returns. In June 2008, the consumer goods total return index went up 4.41 percent. The sector has also had a positive return of 11.62 percent during the past year.

With big names such as HM Sampoerna, Indofood and Mayora leading this sector, institutional investors are holding the bonds until maturity. The transaction data for June 2008 shows that most of the issues traded were from short term to maturity, which automatically limits the price range.

In conclusion, as the negative spread persists in the short term, we predict that investing in property, telecommunications and infrastructure company bonds will be beneficial for portfolios, as this gives higher returns than for government bonds. Using the total return index in January 2005 as the benchmark, the three sectors' total return index has showed that they outperform the government bonds total return index most of the time.

The total return index of those three sectors also offers higher spreads compared with those of multifinance, banking and consumer goods.

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