Can an investor be assured that a bond backed by a letter of support from the government will not go into default sometime down the road? Case in point is Malaysian International Tuna Port Sdn Bhd (MITP), which defaulted on its bonds last November and is now likely to be bailed out by the government.

It is understood that some bondholders are expecting the government to honour the payment owed to them, as the bonds were backed by a letter of support from the Ministry of Agriculture and Agro-Based Industry (MOA) when the debt paper was issued in 2007.

“The letter of support indicates strong support by the government as the bond issuer is an entity that is owned by a government agency,” a source says. It is learnt that the letter was signed by Datuk Annas Khatib Jaafar, who was the director-general of the Fisheries Development Authority of Malaysia (LKIM) at that time.

An industry observer says it is likely that the government will repay the MITP bondholders, given that it had recently promised to pay the Port Klang Free Zone bonds, issued by Kuala Dimensi Sdn Bhd. The bonds were also backed by a letter of support from the Transport Ministry.

The recent bond woes have raised questions on why these bond issuers  deserve letters of support from the government.

Take for instance MITP, which was set up as a private-public joint venture in 2004 to manage a port for the processing and trading of tuna in Batu Maung, Penang. Its board of directors includes government representatives from the MOA, LKIM and the Department of Fisheries.

MITP’s two main shareholders are Bindforce Sdn Bhd, which holds a 60% stake in the company, while LKIM owns the remaining 40%.

According to information obtained from the Registrar of Companies, Bindforce, a port concessionaire, is majority owned by Datuk Annuar Zaini, who is also the CEO of MITP.

Incorporated in 1995, Bindforce’s last financial statements date back to FY2002 ended Dec 31, and show that the company did not have any operations but posted RM22,253 in net losses. No details were given on how Bindforce got involved in maintaining the tuna port.

The Batu Maung port, operational since 2005, was the country’s first deep-sea fish landing site. The government had ambitious plans to spearhead the development of the country’s fishing industry at that time and had earmarked three deep-sea fishing ports — the other two were the Fisheries Complex in Tok Bali, Kelantan and Fisheries Deep-sea Port in Tanjung Manis, Sarawak — for expansion.

When MITP issued a RM240 million Bai’ Bithaman Ajil Islamic Securities (BAIS) in May 2007, Malaysian Ratings Corp Bhd (MARC) assigned an A+ID with a stable outlook on the bonds.

The lead arrangers for the bond were OSK Investment Bank Bhd  and RHB Investment Bank Bhd. Both investment banks also subscribed for RM120 million each of the bonds when they were first issued. However, it is said that the institutions were able to sell down a significant portion of their holdings because of market confidence in the bonds.

MARC says its initial rating on MITP had taken into consideration the letter of support issued by the MOA to back the rated obligations, as well as the 40% shareholding in MITP held by LKIM.
The rating agency says the letter of support states that the government, through LKIM, would ensure that MITP is in a position to meet its liabilities in respect of all amounts borrowed for so long as they remain outstanding.

However, in October 2009, MARC downgraded MITP’s BAIS to BB+ID from A+ID, and maintained a negative watch on the debt paper due to MITP’s liquidity constraints.

According to MARC, construction at the Batu Maung port stalled for over a year following a stop-work order issued by the Department of Environment (DOE) in September 2007. The order was issued when the DOE found potential environmental impact from the sludge-dumping at certain sites by the contractor.

MARC says at that time about 18.5% of the construction had been completed, but the work did not resume although the order was lifted in September 2008. This was due to ongoing negotiation for a new construction contract, the rating agency says.

However, according to a source, the construction did not take off because the site overlapped that where the construction of the second Penang Bridge was supposed to take place. “Because of poor infrastructure planning, the development of the port was called off and the port became an abandoned project,” a source says.

By that time, some RM85 million had already been drawn down for its construction.

In addition, MARC says MITP had set up five units to carry out the operations of the tuna port. But none of the subsidiaries commenced operations as the development of the port was called off.  
“These units were expected to contribute as much as 97% of planned revenue. The profit from operations was also the main source of the BAIS repayment,” the rating agency says.

Deeply in debt and with no refinancing prospects, MITP’s financials deteriorated rapidly. MARC says MITP’s finance service reserve account 2 (FSRA 2) was already exhausted, even though the construction was not completed.

The FSRA 2 was for the purpose of depositing and maintaining funds for profit payment due and payable during the construction period, and was handled by OSK Trustees Bhd.

Hence, MITP had to come up with four half-yearly profit payments totalling RM40.83 million to service the payments during the construction period, says MARC.

MITP had intended to refinance the BAIS via bank borrowings and planned to bring in a government-related entity (GRE) as a new shareholder via a new share issuance. The GRE was supposed to take up a 40% stake in MITP, which was worth RM32 million.

But up till October 2009, the capital injection had still not been received as approval was pending from various ministries.

The bond defaulted in November 2009, but the problems that caused the damage in the first place still persist. The next question is, what really happened in MITP?

Bond issuer’s fundamentals should be the yardstick

The default of the Port Klang Free Zone (PKFZ) bonds and more recently, the Malaysian International Tuna Port Sdn Bhd (MITP) bonds, has opened a new can of worms for investors.

The bigger question is, are there more bonds issued with government letters of support that could default, which the investing community is not aware of?

No one is sure. As a banker puts it, usually it is only when there is a default in payment that the letter of support is highlighted as a basis for investors to obtain payment from the government.

In any case, even if there is no default of bond payments, having a government letter of support attached to a bond issuer does have some bearing on the security and quality of the debt paper.

However, from the example of the PKFZ and MITP bond defaults, letters of support may not be the best yardstick to determine the issuers’ track record and merit. Worse, the letters may give investors a false sense of confidence in the bonds.

Even if the bonds do come with a letter of support, does it necessarily mean that the debt paper is bound to be government guaranteed?

Recall that during the height of the PKFZ bond woes, then transport minister Datuk Seri Ong Tee Keat had said that the letter of support given to PKFZ bond issuer, Kuala Dimensi Sdn Bhd, was not tantamount to a government guarantee of the bonds.

However, his argument was shot down by Attorney General Tan Sri Abdul Gani Patail. The issue is still being debated today.

The government explicitly said recently that it would honour the payment owed to PKFZ bondholders. However, the promise made to PKFZ bondholders may have set a dangerous precedent.

In the future, if other bonds that have government letters of support default, should the government honour the payment owed to bondholders as well?

This is when the number of such bonds that could default becomes a concern. At the end of the day, when the government promises to honour such defaults, it is effectively the taxpayers who are footing the bill. This is hardly good news to us.

It is time to nip this problem in the bud. Letters of support should not be issued indiscriminately, and should be based on merit. Better still, it’s time to do away with letters of support for good. If a company has sound financials, good governance and is well managed, that would be the strongest guarantee investors can have.

This article appeared in Corporate page of The Edge Malaysia, Issue 815, July 19-25, 2010