Government retail bonds a safer option for investors

Jakarta Post
August 02, 2006


Kahlil Rowter, Jakarta

I was pleasantly surprised to find that the Indonesian
government is offering a retail bond. I can now expound on bond
economics to my friends ad nauseum, and they will listen. Gone
are the days when bond terms like yield, maturity and coupon
were considered arcana. Unsophisticated investors can now boast
that they will receive net after tax coupon greater than deposit
rates.

Aside from this simple pleasure and its educational value lies
something more fundamental. This is the shift from a reliance on
official financing to cover fiscal deficit to reliance on the
market. The government is now behaving like a supplier of debt
instruments, which means it must cater to the market appetite.
As deposits look like low-hanging fruit the issuance of a retail
government bond is aimed at this.

Substitute for what?

The proposed Rp 2-3 trillion government retail bonds pale in
comparison to the about Rp 600 trillion in time deposits, 57
percent of which belong to individuals. Therefore I view this
retail bond not as a substitute for any existing market
instrument but as an additional type of asset to enrich the
choice of investors. Did I say investors? Yes, that is the
proper term from a behavioral standpoint, although most deposits
are short-term and the average maturity of all deposits is
currently only 2.3 months.

As retail bonds are aimed at this group, does it make sense to
offer a three-year instrument in lieu of deposits maturing in
2.3 months on average? The answer is yes, due to interest rate
differentials and direction. In the average investor's mind
buying this retail bond is like locking up money for three years
to get 12.05 percent per annum interest as opposed to 9-10
percent that banks now pay. As most investors like to receive
regular interest income this is exactly what the government is
offering.

But what if you need to cash in before maturity? As with
time-deposits you will also have to incur some penalty. But with
bonds it is a bit more complicated, considering its price moves
about. The main driver, of course, is interest rates. If we can
be certain that in the near future inflation will taper off to
single digits it is reasonable to expect interest rates will
also continue their way down and remain low. Consequently bond
prices will likely remain strong. But this is only the general
trend. Bond prices have refused to behave in the past. And
individual bond prices can buck the trend. One major risk is
offshore investors in Indonesian government bonds making a huge
turnaround.

From the government's standpoint adding retail bonds to its
array of issuing channels is appropriate. The potential Rp 2-3
trillion in retail bonds may look small compared to total
government debt at about Rp 400 trillion. Furthermore, domestic
debt is only 36 percent of total public debt. But this trend is
reversing. In the last few years additional fiscal deficits were
increasingly financed by going to the market. Therefore, it is
important to add instruments to further develop the market.

In addition to conventional instruments, tapping the sharia
market is now a major global trend. Part of the rationale is
liquidity in the Middle East, stemming from oil revenues. The
other is that avoiding interest rate volatility opens up
additional investor and issuer segments.

The government issuance of sharia instruments will at the same
time add issuance channels, add investor target groups and
potentially generate a benchmark for corporate issuances. The
upshot is an impetus for domestic Islamic products. Such is the
interest in the sharia market that Thailand and the Philippines
are working hard to tap into it. Therefore we laud recent
government initiatives in this area.

Institutional overhaul is the other cornerstone of market
development. Price discovery and dissemination have been vexing
impediments to efficiency and transparency in the corporate bond
market. Presently fund managers-generated data is the main input
to price benchmarks. Another shortcoming is that many
transactions are simply not reported, so valuable price
information is lost. The capital market authorities will now
force all bond deals to be reported shortly after transactions
and then put out the information for the market to see and use.

What of those bonds not traded in any particular period? For
this, the authorities will create a bond pricing agency to
manufacture prices which can then be used for benchmarking.
Certainly no one system can satisfy all players, but any system
is better than none. And in the long run any system will be fair
insofar that it is not revised too often.

Government retail bonds increase investor choice but will not
cannibalize existing instruments. From the government's
standpoint this may not be a major source of income but will,
more importantly, develop the market and cater to investor need.
Retail government bonds should be viewed as a bridge to extend
investor horizon toward the longer term. At the same time
developing sharia products and revamping the domestic bond
market will open up a wider investor base and support the
creation of a vibrant bond market.

Meanwhile, what should you do with the Indonesian government
retail bonds you buy? My advice: Hold them to maturity!

The writer is chief economist at CIMB-GK Securities Indonesia.
The views expressed here are personal.