What Does A Bond Or Sukuk Default Mean For Malaysian Investors?

Bonds, and their Sharia-compliant equivalent, sukuk, are a way for governments or businesses to raise funds.

When you invest in bonds or sukuk, you are essentially lending money to these institutions. In return, you will receive periodic interest or profit payments over the life of the bond or sukuk. When it matures (i.e. reaches the end of its term), you will get back your initial investment.

Bonds and sukuk are low risk investments because they offer stability and consistent returns. But they’re not without risk – you could lose money if your bond or sukuk defaults.

What is a default of surety or sukuk?

If a business can’t generate enough revenue (or collect enough taxes, in the case of governments), it may have difficulty paying down debt. If he cannot repay his deposit or the interest or principal on his sukuk on time, he is said to be in default. When this happens, you could lose some or all of your initial investment.

What happens if a bond or sukuk defaults?

According to the Bonds + Sukuk Information Exchange (BIX), one of the following can happen when a bond or sukuk defaults:

  • Debt restructuring. As part of a debt restructuring, the borrower can negotiate lower interest rates on the loan. This process could also involve extending payment due dates, so that the borrower has more time to make their payments. Alternatively, there could also be a debt-for-stock swap, in which the debt is forgiven, and in return investors will receive shares of the company.
  • Liquidation. This is when a business closes its operations and its assets are sold or distributed to its creditors. This process can be triggered voluntarily by a company’s shareholders or by force through a court order.
  • Judicial management. Instead of liquidation, a judicial manager is appointed for the company. The court manager will run the business for the purpose of its survival, or to sell its assets to pay creditors. During this period, the company is protected against claims from creditors, so investors are unlikely to receive interest or principal repayments.

How do you know if a bond or sukuk is likely to default?

In Malaysia, there are two credit rating agencies, RAM and the Malaysian Rating Corporation Berhad (MARC). These agencies assess a bond / sukuk to give it a credit rating, which reflects the financial strength of the business or government and its ability to repay the bond / sukuk.

Credit scores are represented by letter ratings. For example, the higher AAA rating indicates that the bond / sukuk issuer is very likely to honor repayments on time. A BBB rating indicates a moderate ability to make repayments. At the end of the scale, a rating of C indicates a high probability of default, while D means that the issuer has already defaulted.

These ratings are useful for assessing the risk rating of a bond / sukuk before investing. But they’re also handy for tracking your portfolio, as these ratings are updated quarterly. A downgrade could mean that your bond / sukuk is at risk of default. For example, MEX II Sdn Bhd recently defaulted on its RM 1.3 billion sukuk, which was anticipated by credit rating agencies who have downgraded its rating several times since 2019.

How many cases of default on bonds or sukuk have there been in Malaysia?

The number of bond and sukuk defaults over the past decade has been quite low. Bond research platform Bondsupermart points out that Malaysia experienced an increase in defaults during the global financial crisis, but experienced single-digit defaults from 2010 to 2020.

Malaysian bond defaults graph

Image via Bondsupermart

How to reduce your risk as an investor?

Here’s what you can do to reduce the risk of losing returns or your initial investment:

  • Invest in high quality bonds / sukuk. Sticking to bonds / sukuk with high credit scores can reduce the risk of default, although you will also receive lower interest / profit rates in return.
  • Invest in shorter term bonds / sukuk. The longer the maturity of a bond / sukuk, the greater the likelihood that a negative event (such as bad market conditions or a global pandemic) will occur, increasing the risk of default. Investing in bonds / sukuk with shorter maturities means less interest / earnings returns, but you also reduce the risk of default.
  • Diversify with different bonds / sukuk. You might consider holding bonds / sukuk of different types (such as corporations or governments), sectors, and maturities. Having multiple investments means that you won’t have to rely on a single bond / sukuk to generate returns.
  • Invest in bond / sukuk trust funds or exchange traded funds (ETFs). These products help you instantly diversify your money across many different bond or sukuk investments. They are also much more accessible than buying bonds / sukuk directly. Buying bonds / sukuk through a bank costs at least 250,000 RM, but you usually only need to invest 1,000 initial RM to buy bond / sukuk mutual funds, or 100 stocks if you invest in ETFs via shares. Marlet.

On top of that, you could diversify into other low risk investments. For example, money market funds invest in short-term debt that is loaned to banks and the government. These funds carry less risk than bonds, but they also generally generate lower returns.

You can even make additional contributions to your Employee Provident Fund (EPF) account, which has generated annual returns of 5-6% in recent years. For classic accounts, it also guarantees a minimum annual dividend of 2.5%.

But remember that reducing risk is not the end goal. Rather, it’s about aligning the risk in your portfolio with the level of risk you can take, which may depend on your age, when you want to retire and your financial obligations.

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