LEVERAGE HURTS: PALM OIL EDITION
Malaysia’s Sime Darby 2023 sukuk are little changed despite a ratings downgrade to A- from A with a negative outlook suggesting that investors largely expected the change. However, yields on the shorter dated 2018 sukuk tumbled back close to where they were when S&P initially put the company on ratings watch negative. The 2018 sukuk spreads dropped below where they were after the ratings watch negative announcement suggesting investors may have anticipated a sharper ratings cut following the acceleration of the debt-financed acquisition of New Britain Palm Oil Limited (NBPOL), continued low oil prices and weakness in the Chinese and Australian economies where much of the non-palm oil business is based.
In the ratings initiation in 2013 which gave Sime Darby a higher rating than the Malaysian sovereign, S&P highlighted its “increased appetite for debt-funding” which was tempered by its historical use of leverage in giving attractive pricing. The benefit from Sime Darby’s foreign assets has reversed with a slowdown in both China and Australia where its motors business is dependent for sales (the company was considering an IPO of this unit to reduce its leverage until postponing plans in February that may have now been put on hold indefinitely).
CHALLENGES IN CORPORATE SUKUK
There are two ways to look at the failure of the longer-dated Sime Darby sukuk to move in response to a ratings downgrade or the amplified moves in the shorter-dated Sime Darby sukuk. One could either use the movement in the shorter sukuk as confirmation that liquidity is building in corporate sukuk in Malaysia or highlight the unchanged spreads on longer-dated sukuk as evidence that corporate sukuk markets are inefficiently pricing changes in the risk because supply so far outstrips demand that few investors that get allocations of sukuk are willing to sell.
A recent Reuters article covered the issue of sovereign dominance in the sukuk sector with the lede:
Sukuk issuance by governments around the world is expanding, helping to bring Islamic finance into the mainstream. But in one respect, the sovereign issues are proving a disappointment: they are not encouraging sukuk sales by companies.
Legal and product design issues as well as pricing – it can be considerably more expensive for companies to issue sukuk than conventional bonds – are deterring corporate activity.
The issues facing Sime Darby are not due to legal, product design or pricing issues, but one of the trading activity of different maturities of sukuk. A study from a researcher at INCEIF in 2013 looked at the relationship between conventional bonds and sukuk in secondary markets and conducted empirical tests to try to determine causality. The results of his study found that there was not a causal relationship either way between bonds and sukuk but that they were not identically priced either. This study considered situations where a single issuer had similar securities outstanding which is not possible to do for Sime Darby since it uses sukuk nearly exclusively.
The pricing impact from the ratings downgrade, in fact, was different at the shorter end of the curve where sukuk traded tighter than conventional bonds than at the long end where sukuk priced wider. One explanation for the difference in reaction for Sime Darby sukuk pricing impact from the news of the ratings analysis is that a combination of greater illiquidity and higher volatility caused by the bond having a lower coupon directed more activity towards the shorter-tenor sukuk compared with the longer-tenor sukuk.
Please Note: The information contained in this article has been prepared solely for informational purposes from sources believed to be reliable, and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or investment product. The opinions expressed in this article do not constitute investment advice.