Sparkling Future for Corporate Bonds

The stage is now set for Sri Lanka to rapidly move from a bank driven economy to a market driven one, that is, if corporate debt issuers step forward

By Echelon.

Published on January 05, 2013 with 2 Comments

Ravi

The stage is now set for Sri Lanka to rapidly move from a bank driven economy to a market driven one, that is, if corporate debt issuers step forward

Guest Column by By Ravi Abeysuriya, CFA

After years of painful trying and a number of false starts, the corporate bond market got the massive fillip their promoters had been waiting for when the budget announced major tax incentives for investors in listed corporate debt. Finally corporate treasurers and Chief Financial officers can start plotting their way out of the clutches of banks, which have been the only real option for most private companies so far.

The listed debt market in Sri Lanka is anemic, with issues to the equivalent of 0.6% of GDP. For example in Malaysia, the listed corporate debt is the equivalent of 43% of the GDP and in Korea local currency bonds outstanding is 60% of GDP. The corporate debt market in Sri Lanka is also illiquid, there is hardly any trading and mostly corporate bonds are held to maturity. The overall volume in the corporate debt market is a small fraction of the trading of the government securities market and the equity market.
For potential bond issuers the budget announcement on November 12th by President Mahinda Rajapakse proposing to exempt income tax including withholding tax on any interest yield from corporate debt instruments, where such instruments are quoted on a licensed exchange approved by the SEC with effect from 1st January 2013, could not have come at a better time. Companies, for the lack of other options, have been bank funding their investments in new capacity and increasing business volumes. It’s presumed the exemption will apply to both resident & non-resident individuals and corporate bodies. This proposal, when implemented, will put the listed bond markets on a new trajectory.
Tax incentives have played a major role in the growth of listed corporate bond markets worldwide. For example, in Malaysia, withholding tax exemption on listed debt was a catalyst to widen the issuer and investor base. Malaysia has one of the most developed domestic debt markets in Asia, with many of the essential building blocks already in place.
Like in any time of change there are a number of challenges market participants have to appreciate and start adapting to before Sri Lanka can develop a robust new alternative source to fund companies and achieve greater risk diversification for investors.
Listed bonds tend to lower borrowing costs for issuers than wholesale and over-the-counter markets because of the greater transparency and liquidity. Because investors don’t need to be compensated for these concerns, yields can be lower. New Zealand is another example of the success of listed corporate bonds. Issuers there prefer the cheaper option of listed bonds and only those that cannot issue listed bonds use the wholesale market. New Zealand’s institutional investors also prefer to buy listed bonds because of the greater liquidity that retail investors bring.
The impact of the Budget proposal on Sri Lanka’s corporate debt markets and the larger economy will be felt for years to come. Robust local currency bond markets help diversify funding sources to support long-term investments and sustain high economic growth. Greater disintermediation will improve capital productivity. Companies and investors will move away from a bank-driven economy to a market-driven one. Companies and infrastructure projects will be able to raise long-term funds allowing them to match their asset-liability profiles.
SEC relaxing rules on pension, provident, gratuity, unit trust and insurance fund investments in the capital market will increase depth and breadth of the market, broaden the institutional investor base and increase the number of participants willing to take risks and actively trade. Because professional fund managers adopt a multitude of investment strategies to achieve various asset liability objectives, bond investing Unit Trusts will be attractive for retail investors to diversify risks and seek higher returns. The push to lower costs will encourage issuers to obtain credit ratings where greater disclosure of information is a requirement.
Regulators and market participants will have to seek a new equilibrium allowing market forces to efficiently set prices while protecting investors by discouraging unfair market practices. This can be done by emphasizing greater professionalism, good corporate governance, high standards of due diligence among company directors, investment banks and investment advisors and market intermediaries specializing in fixed income securities, with clear legal provisions against any misconduct.
The launch of NDBIB-CRISIL bond indices for Government securities is a step in the right direction. Due to the increased transparency in the listed universe, when the listed corporate bond market develops, NDBIB-CRISIL would be able to introduce indices for corporate bonds in the future. Bond indices play an important role to measure and benchmark performance of fixed income funds by facilitating attribution analysis and make it possible to take asset allocation decisions for investors.
A liquid, default-risk free, benchmark yield curve and a well-managed government bond issuance program that ensures a supply of sizable issues in a range of tenors is imperative for a corporate bond market to thrive. A robust debt-trading platform with adequate infrastructure for custody and settlement with relatively low issuance and trading transaction costs is also necessary. The market should be liquid and of course have universal values i.e. fairness, efficiency, integrity, liquidity and transparency.

Bonds vs. Fixed Deposits
Sri Lankans are accustomed to investing savings in banks and finance company deposits to earn interest with capital preservation in mind. However, fixed deposit accounts have scarcely paid a real return, enabling them to buy more goods and services for the sacrifice made by saving. For example, if one saved the cost of a loaf of bread in 2002 (i.e. Rs.11.15) in a term deposit paying average weighted deposit rate (AWDR) as interest annually over the ten years, he or she cannot even buy a half loaf of bread with the principal plus compound interest received (i.e. Rs.23.20) in 2012.
Those who looked for higher returns without understanding risks ended up losing all their money by investing in Pramuka Bank, Golden Key Credit Card Company, Sakvithi-Danduwan Mudalali swindles, etc. Some savers unwisely believe they can avoid paying taxes on interest income by investing in multiple finance company deposits. Inland Revenue has computerized their systems and is gradually roping in those who have large deposits in to the tax net. Listed Bonds now offer a legitimately tax-free alternative for savers where risks are clearly identifiable through credit ratings.
It’s useful to look at some of the differences between investing in bond funds offered by Unit Trusts, and fixed deposits. Firstly, a bond fund is a diversified portfolio of investments, so it effectively spreads the investment risk while a term deposit is not diversified. Secondly, a bond fund provides two types of return: interest income and the potential for capital gains through appreciation of the market value of the underlying bond. Of course, value can also depreciate, except when an investor holds the bond to maturity. Term deposits don’t generate capital gains. It’s also possible to earn higher returns from bonds than with bank term deposits, which is why bonds are attractive to investors.

Bonds vs. Equity
Retail investors in Sri Lanka are somewhat familiar with equity investing. Those who ventured into equity investing during the Bull market in 2009 & 2010 and were advised by brokers such as Heraymila or were smart enough to exit on their own before the bubble burst in 2011 have made significant tax-free capital gains. However a vast majority, who joined the bandwagon driven by irrational exuberance and with a weak understanding of investing fundamentals and or were wrongly advised by their brokers, lost a lot of money. Today, the loss of investor confidence and trust in equity markets is evident with the volume of trading, where only 9,000 CDS accounts have had any trading in November 2012 although CSE counts over 700,000 CDS accounts under its supervision.

Apart from being held to maturity, fixed income securities- such as Treasury Bills and Bonds and corporate bonds are tradable as an asset class. However rarely do individual investors here recognize bonds as a tool for risk diversification and a safe bet during volatile times. Fixed income securities come in various types i.e. bonds & debentures, callable bonds, convertible debentures, municipal bonds, mortgage-backed securities, preference shares, etc. Understanding this asset class is important. Unless investors are confident about the intricacies of bond investing, they should leave it to professional fund managers such as Unit Trusts.
Bonds don’t have the same appeal as equity and rarely make headline news. Usually they are long-term investment products with little short-term volatility, so a long term investment attitude helps. The bond-investing lingo is also far more complicated and can be outright confusing to a retail investor. Today’s bear equity market is perhaps just the backdrop for investors to appreciate the virtues of safety and stability that bonds can provide. In fact, for many investors it makes sense to have at least part of their portfolio invested in bonds. Bonds are debt, whereas stocks are equity, this is the important distinction between the two securities. By purchasing equity (stock) an investor becomes an owner of a company. Ownership comes with voting rights and the right to share in any future profits. By purchasing bonds an investor becomes a creditor to the company. Bondholders have an early claim on a business’s remaining assets, in the case of bankruptcy.
Generally, bonds are issued at a discount to face value and the investor profits from the difference in the issue and market price. With Bonds, the total return on investment is denoted by its “yield” which depends on four factors. Firstly the face value of the bond or how much an investor paid for it. Secondly the rate of interest paid which is called the coupon value. Thirdly it’s the duration, when will the security be redeemed if it’s held to maturity and lastly the market price or how much will an investor receive if a security is sold.
While the face value, coupon rate and duration of a security cannot change once the bond is issued, market price fluctuates in listed bonds, which in turn affects the yield. Rising market interest rates make the prices of listed bonds fall, whereas when market interest rates are falling, the market prices of listed bonds rise. Attractive capital appreciation opportunities arise from active portfolio management when market interest rates fluctuate whereby investment professionals generate high returns by aggressively trading bonds. This is done by smartly identifying possible future changes in market interest rates and credit risks of companies, which gets reflected in the market price of listed bonds.

Diversification
Investors should maintain a diversified portfolio and change the weightings of asset classes based on market conditions and individual circumstances. The benefits of diversification, by having stocks and bonds in a portfolio is shown in the table, where the investors are able to mitigate the negative returns of one asset class with positive returns of the other.

Conclusion
Whether the Government policy would foster a vibrant listed bond market, would depend on the dynamism of issuers and investors of bonds, if the Colombo Stock Exchange would facilitate bond listings cost effectively & efficiently and how the market intermediaries behave. Market conditions are ripe for a vibrant and liquid bond market in Sri Lanka. Let us hope the opportunity will not be squandered.

Risks of investing in Bonds

Similar to any other asset class, investing in Bonds are subject to risks that may include but are not limited to the following:

Market or Interest Rate Risk
When market interest rates rise, bond values fall and when market interest rates decline, bond values rise. For an investor planning on holding a bond to maturity, the change in its market price prior to maturity is not a concern. However, for an investor who may have to sell the bond prior to maturity, an increase in market interest will mean the realization of a capital loss.
Since a Bond fund mainly consists of bonds as its underlying assets, the value of the units of a fixed income fund will also react in a similar manner to market interest rate changes. However, since a fixed income fund is a diversified portfolio of bonds of varying maturities and coupon rates, bond funds are subject to less interest rate risk compared to an individual bond.

Reinvestment Risk
The variability in returns due to reinvestment of interim cash flows due to changes in market interest rates is called reinvestment risk. The risk arises because of having to invest interim cash flows at lower interest rates due to fall of market interest rates. Reinvestment risk is greater for longer holding periods.

Credit or Default Risk
The risk of a bond issuer failing to repay the principal and interest in a timely manner is known as credit or default risk. In Sri Lanka, three credit rating agencies provide rating services. A credit rating agency evaluates the credit risk of a company or financial institution considering a variety of factors such as their interest coverage, financial gearing, asset quality, parent company support, etc. and publishes credit ratings.

Ratings Downgrade Risk
It’s important for an investor to keep track of the credit ratings issued by rating agencies because a change in perceived credit risk or the spread demanded by the market for any given level of risk can have an immediate impact on the market value of a bond.

Yield Curve or Maturity Risk
The yield curve is the relationship between the cost of borrowing and the maturity of the bonds of equal credit quality. The expected yield of bonds of a particular credit quality is expected to follow the yield curve. The risk here is depicted by the steepening or the flattening of the yield curve because of changing yield among comparable bonds with different maturities. The shifts in a yield curve risk characterize the way the fixed income fund managers react to market interest rate fluctuations.

This reaction is indicative of the returns achieved by a portfolio. When we have rising market interest rates, investors prefer short-term debt instruments in comparison to long term. At the same time, the issuer would try to sell long-term instruments before the increase in market rates. This results in an increase at the long end of the curve resulting in steepening the curve. When the market rates are expected to fall, investors prefer long-term instruments in order to safely lock in their money. Therefore, the price of longer term instruments rise-eroding yields. Similarly, the issuer wants to sell short-term instruments so that he has to pay the higher interest rates for a shorter duration. This results in a flattened yield curve.

Marketability or Liquidity Risk
The primary measure of marketability/ liquidity is the size of the spread between the bid price and offer price quoted by a dealer. The greater the spread, the greater the marketability/ liquidity risk.

Ravi Abeysuriya is Chief Executive Officer at Heraymila Securities Ltd., a subsidiary of Heraymila Investments Ltd. (HIL) UAE. HIL directly manages over 290 million dollars of private and public investments on behalf of Abdulaziz Al Mashal’s family office.
email

2 Comments

There are currently 2 Comments on Sparkling Future for Corporate Bonds. Perhaps you would like to add one of your own?

  1. Its great to see providing debt market information to the nation.

  2. I appreciate your focus on transformation from banked based economy to market based economy. Further, it gives a message to those who allocate resource among different assets.

Leave a Comment