Even before it had any business, 1Malaysia Development Bhd or 1MDB’s first move was to raise money, issuing RM5 billion in bonds, subsequently taking it up to RM20 billion. The deals caused a fluster because of attractive yields. Preliminary calculations indicate 1MDB could have lost as much as RM4 billion through mispricing. Question is, was it deliberate?
Preliminary calculations by KiniBiz with the help of bond specialists show that mispricing of 1Malaysia Development Bonds could have been as high as 20% of the total bonds involved, or some RM4 billion on bonds issued or in the process of issue of some RM20 billion
Bond issues made by 1Malaysia Development Bhd (IMDB) have raised substantial interest because of their attractive interest rates. But investors have found to their chagrin that they are unable to subscribe and the bonds are issued to a select club instead through private placements.
“I would have loved to get my hands on those bonds,” one bond trader said.
Basically what happen is that the bonds are priced to yield more than the market rates. And because these bonds are long term, they yield higher interest rates over many years. Once they are on the market, the prices adjust to yield returns with comparable securities, giving windfall gains to those who got in on the first floor.
It’s just yet another example of financial shenanigans that routinely take place in the world today with big name investment banks associated with them and working hand-in-hand with the issuers.
For this to happen, the transactions need to take place in private with as little of the terms as possible coming into public hands so that few notice the mispricing. The secondary trading too often takes place under veils of secrecy to stop prying eyes from discerning how much the players have made.
Bonds are financial instruments that need to be handled with care because there is one variable that can send their values tumbling – or rising. That is interest rates. If a bond is priced to yield more than comparable yields, the value of the bond can be considerably different.
Just altering the effective interest rate to yield two percentage points more than comparable bonds can result in a RM5 billion 10-year bond being mispriced by RM1 billion or more.
And the longer the term of the bond the greater the possibility of mispricing the bonds. If you misprice the bonds, the value can be off by 20 percent or more. On RM5 billion that amounts to one billion ringgit. On RM20 billion, it could account for as much as RM4 billion or more.
1MDB raised RM5 billion in Malaysian currency bonds in May 2009, US$1.75 billion (RM5.55 billion) in May 2012 and US$3 billion (RM9.3 billion) to make a total of RM19.85 billion, just shy of RM20 billion (see table).
The first was arranged by local investment bank AmInvestment Bank Group.
The second, arranged by Goldman Sachs, was issued to part finance 1MDB’s RM8.5 billion acquisition of Tanjong Energy, which holds power ventures, from tycoon Ananda Krishnan. It was jointly guaranteed by 1MDB and International Petroleum Investment (IPIC), a unit of the Abu Dhabi government. The last is yet to be confirmed but was reported by Bloomberg.
When 1Malaysia Development Bhd, then Terengganu Investment Authority or TIA, raised money via bonds in May 2009, it did with a real bang. Two things stood out – the effective interest rate was considered rather attractive for the buyer and it had the longest tenure of any local bond at 30 years. And it was safe because it was explicitly guaranteed by the Malaysian government.
Just as it got local investors excited, it disappointed them. Bond traders said the bonds were privately placed and no local institution had access to them. This mouthwatering bond was apparently not accessible to most. The list of those who took the bonds were never disclosed.
The coupon rate of the RM5 billion bonds was 5.75% a year payable semi-annually. On top of that, the bond was issued at roughly a 12 percent discount to its par value, which increased the yield. According to the 1MDB annual report, the yield was 6.71%.
There was one problem with this bond though. There was no comparable bond with that tenure. Even government securities went out only as far as 20 years. Cagamas bonds, which have no explicit government guarantee, traded at around 5.28% then, with Malaysian government bonds trading at around 50 basis points less, at about 4.8%.
Bond analysts say a 25-30 basis point premium to government bonds is okay for a bond with an explicit government guarantee. Adding another 30 basis points for 10 years more in tenure would give a fair yield of around 5.4%. Instead, the effective annual rate was 6.71 per cent while the coupon rate was 5.75 percent.
Using a bond calculator, the bond price would have been undervalued by about 20% (see table on mispricing). That means those who obtained the bond at that price and then subsequently sold it on the secondary market would have made about RM1 billion on the RM5 billion face value of the bond.
In its books, 1MDB as at Mar 31 2010, some 10 months after the deal, listed the carrying value of the bonds at RM4.39 billion while the fair value was listed at RM5.26 million, a valuation gap of RM870 million.
Trading on these bonds are thin, but the last trade done earlier this month was at a yield of 4.5 per cent which prices the bond at around RM1.20 for a RM1 par value bond. This is an increase of more than a third over the 88 sen that it was issued at in May 2009.
Similarly, we can do the same for the other bonds and the indications are that pricing is off by about 20% in each case, leaving a total mispricing loss of about RM4 billion.
The second bond for US$1.75 billion attracted international financial media attention when it was issued in May last year and was described as a “mysterious private placement” by respected financial review IFR Asia, a unit of Thomson Reuters.
“The jumbo US$1.75 billion deal is one of the biggest privately placed US dollar bonds on record from Asia, and a big payday for sole arranger Goldman Sachs. The few available details, however, have posed more questions than they answer, with rival bankers quick to suggest that 1MDB overpaid for the deal.
“With Malaysian oil major Petronas, which is lower rated at A1 (Moody’s) trading at Treasuries plus 185 basis points on May 21 (2012), this means the 1MDB paper was priced 240 basis points back of its nearest comparable in the Malaysian sector,” it said.
A Financial Times blog posed this question: “Bankers are wondering why an Abu Dhabi government investment fund would guarantee what is essentially Malaysian sovereign debt. After all, 1MDB has secured a Malaysian state guarantee in the past. Why is a Gulf emirate, many miles away, guaranteeing this bond?”
Since 1MDB has not revealed pricing and other details for the third and largest bond for US$3 billion or RM9.3 billion, it is only possible to make estimates but the order of magnitude of the losses are likely to be correct, analysts said.
Where does the money come from when a bond is mispriced and how is it possible to make so much upfront, virtually at the time of the issue?
Essentially what happens is that a mispricing of just 200 basis point or two percentage points is reflected in the cash flow that comes back to bondholders over a long time. The mispricing represents the value in current price terms of this stream of cash flows and is an upfront realisation.
If we take the RM5 billion bond, two percent works out to RM100 million a year and over 30 years that amounts to RM3 billion in all
Who makes the money? At the end of the day it will be the intermediaries. But if it is deliberately done, everyone gets a share with the biggest share going to those who initiated and masterminded it.