Establishing a vibrant bond market can help attract foreign portfolio investors
Since the start of my career in the capital market, I have been hearing about the importance of a vibrant bond market.
Now, why is it important? Bonds are known as fixed income securities. Unlike stocks, bonds offer a fixed coupon over the maturity period and principal payment at maturity.
If it is a zero-coupon bond, you will be buying the bond at a discount from the face value and receiving the face value upon maturity.
A bond is a very beneficial instrument for both the issuer and the investor. The issuer will get the money needed by issuing a bond and the investors will receive interest and the principal amount.
Our country is heavily dependent on bank financing. Even the stimulus packages offered for combating the impact of Covid-19 is based on bank financing.
Banks are already in a bad shape with rising non-performing assets and for implementing the 6 percent-9 percent rule.
Banks are getting too much pressure and we must keep in mind that in the process of combating Covid-19, a bank failure is the last thing we want.
In addition to that, the government is borrowing heavily from banks and the borrowing amount has risen to TK 81,000 crore already, for meeting the budget deficit, due to dismal revenue collection amidst the novel coronavirus outbreak.
The revised target of government borrowing for this fiscal year was TK 72,953 crore.
This will have a significant crowding-out effect, where private borrowers may find themselves side-lined.
We must also keep in mind that the 9 percent maximum rate offered to lenders will also make bankers more cautious in disbursing loans in the coming days.
The plausible effects of 9 percent lending rate on private borrowers will be:
- More cautious lending practices, hence decline in private sector credit growth (which has already been observed since January 2020, as private sector credit growth dipped below 10 percent to 9.2 percent)
- Fund will be directed towards selected borrowers only, since the lending rate is low
- Demand for loans will increase relative to supply of loanable fund since banks will not be able to charge a higher interest rate for risky projects as well
- Since demand for loans will increase, the need for capital rationing will increase as well and this may create a lemons problem
- Increase in shorter maturity loans with stringent terms to cover for the loss in low lending rate
- Overall lending might come down even more and this will affect the economy adversely if less creditworthy borrowers with good projects are excluded from getting access to finance
- Current 5 year maturity T-Bond rate is 8.12 percent and 10 year maturity T-Bond is 8.74 percent, so it makes more sense to invest in those instead of lending at 9 percent
Keeping in mind all of the above, we must seek other alternatives and here is where an active bond market can play an important role.
The corporate bond market in Bangladesh is almost non-existent, with only two bonds listed in the prime bourse at present.
But the market needs to expand and now is the time to start working on the issue.
The opportunity we have here is we do not have any established bond market at present. We can start afresh.
In FY 2020-21, the government is going to have a larger fiscal deficit due to Covid-19 and Amphan.
As per the Global Infrastructure Hub report, Bangladesh needs $608 billion of investment in infrastructure sectors - water, electricity, telecom, ports, airports, rail and road - from 2016 to 2040.
However, current trends indicate $417 billion of investment is possible in the aforementioned sectors, thereby leaving a gap of $192 billion in investments in the period 2016-2040.
This gap in the top three sectors, power, telecom and water sectors, is $100 billion, $41 billion, and $40 billion respectively.
These projects are mostly financed through the government's own fund and multilateral and bilateral funding agencies.
But if the government can develop a framework for meeting the funding gap of those projects by issuing long term infrastructure bonds, a new asset class can be created.
This might also attract foreign portfolio investments which specialize in infrastructure finances. A new category of mutual funds can be created in the country, which will invest in that type of bond.
Instead of allocating funds for public sector utility companies, the government can develop a framework so these companies can issue bonds and raise funds for funding their various utility projects.
All in all, the government can stop relying so much on bank borrowing by issuing bonds, where global investors can participate as well. Insurance companies and pension funds can be other large institutional investors for these type of bonds.
Apart from the government, corporations can also issue bonds for various financing needs.
Commercial banks of Bangladesh are fairly active in the private market of bonds, mostly for meeting their capital adequacy ratio as per Basel III.
In recent years, many other companies except banks have also participated in the private market of bonds.
Now, why should corporations issue bonds? Bonds have some advantage to taking bank loans, such as bonds can be issued at the floating rate, zero-coupon bonds can be issued, bonds can be issued with call option and put option, convertible bonds can be issued.
The central idea is that the issuer can issue and structure a bond keeping in mind their financing need and cash flows to be generated.
Different types of bonds can be issued based on the need of the issuer and such flexibility may not always be possible with bank loans.
On the investor front, bonds will offer a lucrative investment vehicle. Currently, large institutional and HNI investors with liquidity find it difficult to invest the excess liquidity elsewhere, except for banks.
Different types of bonds will allow investors to participate in the growth of a company and economy, as well as directly, and enjoy the fixed return over the maturity period.
Now the question comes, if bonds are that good for both issuer and investor, why is the sector not growing?
There are a few reasons such as those mentioned below:
- It is easy to obtain loans from banks: It does not take much time to get a loan from a bank, whereas the current bond ecosystem is such it will take at least 6 months to 1 year to raise fund by issuing bonds. By the time the issuer receives the money, the viability of the project to be undertaken may not remain the same.
- Cost consideration for the issuer: The cost of issuing a bond can be 1.5 percent to 2 percent of the issue size. Relevant costs of bond issuance as per Private Placement of Debt Securities Rule 2012, Public Issue Rules 2015. In addition to those abovementioned fees, there are other fees such as credit rating fee, auditing fees, printing and publication fees of the prospectus, notice fee, lottery conduction fees etc. Due to these high cost issues along with the time needed to raise fund from bond issuance issuers shy away from issuing bonds.
- Higher return alternatives with low risk government securities: Currently, government savings certificates offer interest rate as high as 11.76 percent. But we should also keep in mind that savings certificates are mostly for individuals and pension funds. There is a maximum limit of TK 3 Million for an individual account and TK 6 Million for a joint account but no limit for pension funds. Pension funds can emerge as a large intuitional investor for bonds if such a market can be created.
- Lack of familiarity as an asset class: For this reason, nationwide awareness programs have to be conducted.
- No digitization: Currently the bond market is not automated. The market has to be automated by establishing a bond trading platform for all investors. In India, general investors can participate in the primary bond market via non-competitive bid using NSE goBID, which has both a web version and a mobile application.
Corporate bonds and government bonds are very popular among institutional and HNI investors worldwide.
If we can successfully establish a vibrant bond market, we will be able to attract foreign portfolio investors.
A reference interest rate point can be established for our country as well, which is non-existent at present and also misrepresentative due to the cap issue.
Considering the current interest rate scenario and the current state of capital market, the bond market can emerge as a knight.
Banks, NBFIs and merchant banks can enhance their fee-based income by working on bond issuances and cover for the losses they are likely to suffer from the lower interest rate in the market and the loss suffered in the capital market.
Those with surplus money who have already met the limit of investment in the capital market will be benefited from the new asset class.
Investment in bonds allow tax rebate for general investors, although for institutional investors there is no such incentive.
But investment income from zero-coupon bond is tax free for both individual and institutional investors, according to the sixth schedule section 40 of Income Tax Ordinance 1984.
Lowering bond issuance cost and time to raise money from bonds, increasing incentives for institutional investors who are typically the large investors of bonds and increasing the familiarity of bonds can help develop the bond market.
Shahriar Azad Shashi, is a Fund Manager at LankaBangla Securities Limited