A few months ago, the establishment of a government-backed financial institution to facilitate credit enhancement for companies seeking to raise money in capital markets may seemed like the correct thing to do in an uncertain economic climate.

But deeper scrutiny suggests that this is not necessarily a good idea. While a credit enhancement agency is important, in its present form, it is subject to abuse and does not help the bond market in the long term.

The proposed RM15 billion Financial Guarantee Institution (FGI), to a certain extent, helps prevent a systemic risk to the capital markets. It can and should be utilised to help companies refinance debt papers that are due to mature in the next few months or by the end of next year.

The prime target should be companies that have issued corporate debt papers with low ratings such as single “A” and “BBB” ratings. Until May this year and December next year, the amount of single “A” and triple “BBB” corporate bonds up for maturity is some RM2.8 billion.

Most of these papers face huge refinancing cost not because the companies are bad or that they are unable to repay the debts.

Rather, the reason is single A-rated papers are generally not well received by financial institutions, even when the going was good and the companies backing them were credible.

Perhaps, another cause is that the Malaysian bond market has been traditionally pampered with “AAA” papers to the extent that institutions do not want to look at anything less than a “AA” rated paper.

Against such a backdrop and with the lending environment tight, the coupon payments demanded for refinancing for single “A” papers would be high.

This is where the FGI can play an effective role to lend some degree of guarantee to ensure the papers are refinanced, if that is what the companies concerned want to do, at an acceptable rate. Companies cannot afford to be burdened by extra financing cost during a recession. This is what the FGI should offer because the alternative is for the companies to seek conventional bank borrowings, which are expensive and difficult to obtain.

In a worse-case scenario, the facility will go into default and cause a systemic risk to the entire banking system, which is something we do not want to see. That’s why some support from government in terms of credit enhancement would be good for the companies that are already in the bond market and which traditionally get low ratings.

But to open up the facility to companies seeking to raise fresh funds from the capital markets is something else.

The government has stated that one of the objectives of the FGI is to help companies with sound management and good projects obtain cheap financing. But in the first place, if the projects are good and the management sound, why would the company require the government to help with a good credit rating?

On the broader bond market, the FGI would inevitably see a slew of triple-A rated papers coming into the market as compared to now, when there is a mixture of both high and low-rated issues.

A bond market loaded heavily with triple A rated papers is not what we want to see. The ideal situation is a bond market with a good mix of papers ranging from the much sought-after “AAA” to the risky “BBB”.

As it is, the supply of single “A” and “BBB” rated papers is getting tight because of the high cost of issuance. In other markets, any paper with an “A” rating would be sought after. But not in Malaysia, where the bond market is largely confined to sophisticated and high-net worth individual investors.

With the FGI coming into place, would the supply of single A rated papers, not to mention the BBB rated ones, fizzle out?

Almost certainly it would, which means the local bond market will be heavily dominated by only “AAA” rated papers.

Is this good for the long-term development of the bond market? Certainly not.

Another reason the FGI should not be extended to companies raising fresh funds is that it opens up the facility to abuse.

Who or what mechanism is there to stop some well-connected but ill-managed company from raising cheap funds to finance a project that is not financially viable?

The backing from the government would be the only reason the papers command a high rating, lower cost of funding and lower coupon payment. It would not be because the company has a well-recognised name, strong management and a good track record in delivering.

If the credit enhancement facilities are provided to less-deserving companies and projects, the government will eventually face a backlash.

Whether we like it or not, the RM15 billion credit enhancement facility would be a contingent liability on the government. If projects associated with the credit facility are not sufficient to repay the papers, the liability would eventually fall on the government.

No matter how cheap the financing cost is, a project that does not generate enough returns for repayment will eventually rear its ugly head in the bond market.

An example is the Port Klang Free Zone project where bonds were issued with “AAA” ratings but are currently trading at yields reflecting a single “A” paper because the underlying asset is not generating returns as projected.

Bond market players are waiting eagerly for the government guarantee facility to be up and running to facilitate the flow of papers into the bond market. This is where caution is needed.

The guarantees should only be limited to ensuring there is no systemic risk to the financial system. If it is confined to such needs, the contingent liability on the government is less than RM3 billion, based on the amount of lower rated corporate papers expiring between now and end of next year.

Extending the facility to allow companies to raise new money, opens the facility to abuse, something which taxpayers will probably have to bear a few years down the road.

This article appeared in The Edge Malaysia, Issue 754, May 11-17, 2009