The Economic Council is contemplating the establishment of an entity to guarantee bonds with low ratings.
The Economic Council, a high-level advisory body chaired by the Prime Minister, has proposed to set up an entity to guarantee bond issues with lower ratings.
Economic advisers to the government said the entity can help bolster the domestic bond market, which is expected to shrink 10 per cent to RM25 billion next year from an estimated RM28 billion this year.
It can also eventually help stimulate the local economy by guaranteeing debts raised by companies in key sectors like infrastructure and services to finance viable projects. [Bond guarantee plan. Zuraimi Abdullah. Business Times. December 25 2008]
Suppose that the plan goes through and lowly rated bonds are now guaranteed.
Consider the fact that lowly rated bonds — it could be junk bonds for all we know — offer high yield rates to compensate the inherent default risk any purchaser of the bonds face. Therefore, the issuers’ cost of borrowing is high.
Consider the fact that highly rated bonds offer low yield rates due to high repayment certainty it offers. The cost of borrow for highly rated issuers are low.
Now, if the junk bonds are guaranteed, which between the lowly rated bonds and the AAA-type would you choose, with all else being equal?
It should be the junk bonds. You get higher yield compared to the AAA while enjoying the guarantee, assuming the yield does not incorporate the guarantee.
Yup. It would turn the world upside-down.
The bonds with high default risk become the safest bonds in the local market by virtue of sovereign guarantee. With sovereign backing, the risk of default is practically zero, making badly rated bonds to be better than the AAA-type. The AAA then would have to seriously compete with the junk bonds for funds despite the obvious difference in risk profile.
Worse, the AAA would have an incentive to lower their ratings to qualify for the guarantee so that people buy their bonds. In fact, the AAA would have to offer higher yield rates to compete with the junks which are supposed to be crawling at the bottom of the table.
In other words, the guarantee would punish those with good records while rewarding those with bad or unproven standings.
If the yields are adjusted to incorporate the guarantee, risk-adverse purchasers would still prefer badly rated bonds to goods ones by the virtue that it is safer than the better rated ones. Meanwhile, the cost of borrowing for the highly rated ones become more expensive than that of the junks’.
Either case, eventually, it would open encourage many to undertaken risky investments because the state would reward bad behavior and punish good behavior.
Blow up the bubble, please. And when it finally burst to cause untold damage, please blame it on free market philosophy.
And yes, do it with our retirement funds collected by forced saving too:
Shareholders of the proposed entity could include Bank Negara Malaysia and large institutional investors like the Employees Provident Fund, he said. [Bond guarantee plan. Zuraimi Abdullah. Business Times. December 25 2008]