Shafkat Mahmud,Senior Manager, Corporate Advisory, IDLC Asset Management Limited

Current Status of the Domestic Bond Market As Bangladesh aspires to be a developed nation by 2041 with success stories in infrastructural development expected to continue for years to come, a well-developed financial market with active role of corporate and government bonds has become a dire necessity. The Global Infrastructure Hub estimates that a cumulative total of USD 600 Billion of investments would be required in infrastructure sector alone from 2016 to 2040. But if you expect the current trends of actual investments to continue, a gap of USD 200 Billion long-term financing with no visible source of funding still needs to be addressed. Developing of a well-functioning and sizeable bond market that caters to the needs of both investors and issuers alike can be potential long-term fund mobilization alternative. Moreover, even if you look at the current trends, Bangladesh has invested billions of dollars in mega infrastructure projects that are expected to start operation within a few years. But, rolling these hard infrastructures on a consistent basis is only possible when the country simultaneously pursues development of soft infrastructures like developing of financial markets such as the bond markets. The long-term nature of bonds investments with flexible structuring mechanisms & repayment structures are ideal for supporting the investment and cash-flow needs of these long-term projects and capital expansions for a fast growing economy like ours.

Cumulative Infrastructure Investment 2016-2040 (USD Billion)

The current market for bonds is Bangladesh is somewhat lop-sided as almost all outstanding bonds lie with the government bonds.

At present, the government bonds outstanding would be worth about $17.2 Billion whereas corporate bonds outstanding is only $0.3 Billion. If we look at other countries, we shall see how corporate bonds act as one of the most stable source of financing for the public sector -being 149 % in the US, 60 % in China, 16 % in India, 60 % in Malaysia and 59 % in Thailand on GDP. The root cause of this lack of interest could possibly be some of the dent left by some of the issuer’s performance in the larger number of defaults that took place in listed corporate bonds past decade in the 90’s. This raised questions of the enforcement of rules and regulations. Post- 1999, a long pause too place for issuance of corporate bonds. Interestingly, from 2014 to 2016, few corporate also successfully raised commercial paper but this also did not reach scale. The private bond market is currently largely comprised of the commercial banks issuing and subscribing to each other’s subordinated debt to meet their minimum capital adequacy requirements as its considered part of their Tier II Capital. Despite all the setbacks, the recent issuance of a Taka denominated bond by Pran Group in the international market and locally listed bond by Ashuganj Power Limited are showing promising signs that our private bond has already started taking a new dimension and upholding this momentum can easily translate into a vibrant bond market in the foreseeable future.

Absence of bond markets puts excessive dependence of the banking system causing systemic risks. The absence of a sufficiently large corporate bond market has resulted in an overdependence of large corporates depending on the banking system for their long-term financing needs. Banks themselves are have capacity constraints in terms of providing long-term financings. A view of the deposit structures of banks shows most of their collections are in the form of short-term deposits (3 months to less than 1 year), accounting roughly 70% of total deposits and the rest 25% in the 5 years and above bucket. Thus, the presence of short-term liabilities and long-term assets in the banks books causes mismatch, which they tries to address by booking more and more deposits. This also leads to increases in non-performing loans (NPLs) and repeated res-scheduling requests by the corporates as corporates commits to short-term loans with high cash-flow burdens which often does not match the cash-flow requirements of these project loans. Moreover, it is also surprising how banks lend in the growing housing project for 20 years depending on the short-term deposits in the banking system.

Bond markets are part of the capital markets and hence needs corporates to take permission from the Bangladesh Securities and Exchange Commission (BSEC). As more and more corporates seek alternative debt financing to banks, they must be aware that bond is a long-term debt capital, and prior regulatory approval for the issuance is required. Bangladesh Securities & Exchange Commission (BSEC), under the “Securities and Exchange Commission (private placement of Debt Securities) Rules, 2012” provides regulatory approval to the institutions for issuance of privately placed debt securities. In case of convertible bond or publicly offered bond, Bangladesh Securities and Exchange Commission (Public Issue) Rules, 2015 is applied. In addition, the issuer also needs to take approval from its primary regulator before any such issuance. For banks and NBFIs, Bangladesh Bank acts as the primary regulator and provides approval for such issuance.

Benefits of a Robust Bond Market for Developing Economies

Banks dominate the financial sector in South & South-East Asian economics where bonds can effectively manage the mismatches in the economic scenario of an emerging financial market. Bonds in Asian market are either denominated in USD or local currency. All countries have their own principles for issuance of bonds. In South East Asia, bonds came into highlight after the financial break down during late 90s. It was understood by many that large dependence of financial sector in commercial/scheduled banks is not a good idea, where problems such as liquidity and mismatch always increases. The bond market in India with the liberalization has been transformed completely. The opening up of the financial market at present has influenced several foreign investors holding up-to 30% of the financial in the form of fixed income to invest in the bond market in India. he diversification of the market, has to a large extent contributed to the economic stability of the country, as it provides immense potential in raising funds to support the infrastructural development undertaken by the government and expansion plans of the companies. Developing economies can benefit in multiple ways from a well-developed bond market as it only incentivizes financial market and its players to be more efficient and spreads risks across investors and intermediaries. Some of the key benefits are as follows:

• It can potentially supplement the existing banking system in mobilizing funds to enterprises (both government and corporates) as doing so reduces vulnerability of the financial system to external shocks by diversifying the funding basket of the economy. Looking at the previous financial crises would reveal how systematic problems in the banking sector has interrupted the flow of funds from savers to investors for a significant long period of time.
• It can provide alternative investment options for institutions such as insurance companies and pension funds, which by their very nature seeks long-term assets to match their long-term liabilities.
• It allows for the development of credit derivative products, thereby allowing efficient credit risk transmission.
• Bond financing lowers funding cost for high quality borrowers by way of credit rating based instrument pricing and advantage of lower intermediation costs compared to bank financing.
• A well-developed bond market also introduces a healthy competition to the banking sector in providing corporate financing.
• Efficient bond markets can also help spreading the risk among ultimate savers rather than getting concentrated in the intermediaries.

How Bonds can potentially be better alternatives to available instruments

The wide spectrum of fixed income securities that are currently available in our financial markets can benefit both the issuers (supply-side) and investors (demand-side) alike, depending on their investment requirements and appetite. Some of the key benefits are highlighted as below-

Supply Side Benefits:

• Matching Funds: Funds with long-term repayment nature can be raised for the long-term financing needs of infrastructure projects and capital expansions of government and corporates.
• Intermediary by-passing: Bonds can be priced at a lower rate than bank loans as bonds issued by a corporates can easily be subscribed by other corporates, easily bypassing the requirement for a financial institution as an intermediary.
• Fixed Interest Rate: Some bonds such as zero coupon bonds can be offered at a fixed discount rate, i.e. similar to a fixed interest rate instrument. Hence, bond issuers can protect themselves against variable interest rates through issuance of zero-coupon bonds.
• Flexible Repayment Structure: Issuers can structure repayment mechanism of bond payments in whatever manner they desire as long as it matches the investors’ appetite and ensures the repayments matches with the issuer’s projected cash-flows. This can greatly enable the issuers from avoiding default in payments from the available off the shelf bank’s long-term financings which often are constrained from being customized to borrower’s requirements.
• Convertibility Option: The options to convert bonds to equity can enable issuers to raise debt at a lower rate in comparison to other debt instruments due to the equity sweetener, i.e. giving the investors the option of participating in any potential capital gains through converting their bonds to equity in secondary markets.

Demand Side Benefits:

• Tax Exemption on Zero Coupon Bond: The interest income derived from investment in Zero Coupon Bond is 100% tax exempted for corporates and individuals.
• Institutional Portfolio Diversification: Bond provides an opportunity for investors (provident fund, gratuity fund, insurance companies etc.) seeking higher return and long term investment options and enables them to diversify their portfolios.
• Collateralized Bonds: Bonds can be collateral or guarantee backed that can increase assurance of certain principal and interest payment from the project’s income streams, collateral liquidation or repayment guarantee by a higher rated agency - such as a banks or even government.
• Regular Income Source: Investors with need for regular income streams can generate through the periodic coupon payments from bonds over investments in equity market which does not guarantee such payments and by nature is much more volatile as return in equity market is mostly generated through dividends and capital gains.
• Higher Income Potential: Coupon/Discount rates from bonds are usually higher than those from regular savings deposits offered by financial institutions, as issuers can afford to pay a higher rate due to by-passing the financial intermediaries.

Market Barriers to Sectoral Development

Despite the multi-varied ways our growing economy and its participants can benefit from a vibrant bond market, various market barriers still exist which restraints the sectoral development.

• Lengthy issuance process & high issuance cost: The issuance of a bond is quite lengthy compared to the alternative options (i.e. bank loans) for the issuers. In general, bond issuance takes a total of 4-6 months whereas the scenario is quite different for bank loans. Moreover, the application issuance process of bonds is much more complex than commercial loans. The initial cost of issuance cost for bonds is also much higher as there are several additional fees/costs (i.e. registration fee, stamp duties, consent fee, credit rating cost, audit cost, trustee fee, arrangement fee etc.) that are not required for commercial loans.
• High return offered by government Sanchay Patras: The Bangladesh Sanchay Patras from the Government of Bangladesh already offer lucrative rates of return, which are higher than most term deposits offered by scheduled banks. Since these instruments are risk-free, it is necessary for corporate bonds to offer higher rates of return (to compensate investors for their additional risks), which makes issuing bonds quite unfeasible. Moreover, this high cost of borrowing is also causing the government to bleed through its fiscal budget every year.
• Absence of a vibrant & liquid secondary market: The absence of a vibrant & liquid secondary market is partly caused by the absence of a significant number of retail bond investors that has made it difficult to properly price the bonds in the primary market and also impacting easy exit of the holdings.
• Limited number of prospective investors due to focus on capital gains: The investor base in the bond market is very insignificant compared to the investor base in capital market as the capital market offers higher return but at the cost of higher risk. In addition, investors are reluctant to invest in the bond market as they prefer short term deposits products offered by financial institutions over long term investment in Bonds. The majority of investors in Bangladesh prefer capital gains over regular interest income; this is reflected by their preference for stocks over bonds.
• Lack of trust on credit rating provided by rating agencies: The quality of the credit rating provided by the rating agencies to the issuers below standard and mostly inflated. This has happened due to existence of too many ratings agencies and price competition amongst the agencies to acquire clients. Hence, risk-based pricing of bonds on the basis of ratings provided by these rating agencies would be quite unreliable.
• No tax incentive for Banks, NBFIs and Insurance Companies: The Zero-Coupon Bonds, which offers tax exemptions for corporates and individuals, unfortunately puts no mercy on Banks, NBFIs and Insurance Companies.

A Road-map for development of the Bond Market

In order to develop a flourishing bond market, we must develop a clear road-map to ensure a vibrant market exists for the benefits of all market participants. The following key measures could potentially open doors for substantial fund-flow through bonds from savers to investors.

• Prioritize development of the secondary bond market over the stock market: Investors in the stock markets are only entitled to dividends and capital gains, which to a large extend depends on how the company performs over the period. Hence, prices of stocks shows greater volatility and by nature are riskier investments, especially for retail investors. On the other hand, when a bond issuer commits to a pre-determined cash flow to the investors through coupon and principal redemptions at maturity, it becomes a much less risky investment vehicle and hence show less volatility. Thus, for investor groups which appetite for regular cash-flow requirements and institutions such as insurance companies, provident/pension funds, endowments and other institutional investors with rigid cash flow requirements to meet their own obligations to the policy holders or beneficiaries, listed bonds can offer a much better investment matching over stocks. This is why many countries developed their bond markets before creating their stock markets. Similarly, for Bangladesh as well, this should be the case forward as retail investors are yet to develop the investment know-how to analyse stock investments. It would be better if they can get used to investing in capital market with bonds that are less risky than stocks. The bond market also helps fund managers in diversifying their portfolio and managing risk. For example, if a fund manager considers that the stock market is over-valued, he can increase his fund allocation to bonds. Other than the corporates, the secondary market for government debt securities in Bangladesh is still in a very growing stage. For example, in the DSE, 221 treasury bonds are listed with a maturity of 5-20 years. The bonds are traded in the secondary market through Over the Counter (OTC) and Trader Work Station (TWS). Both the procedures are the integral parts of Bangladesh Bank initiated Market Infrastructure Module (MI Module)-the automated auction and trading platform of government securities. If the transaction is allowed in the secondary market through stock exchanges, it will increase participation by individuals and corporate houses.

• Corporates to be made mandatory to raise bonds before raising equity in the secondary markets: At the absence of a corporate bond market, corporates have historically relied on bank borrowing, hence finding it difficult to manage their bank borrowings and are often left with no option other than defaulting or rescheduling their BSEC may take the initiative of making it mandatory for corporates to develop the track record of issuing bonds in the secondary market before seeking to raise capital through equity. This would also make it easier for BSEC to protect the interest of bond investors as bond investors are entitled to fixed cash flows from issuers and taking remedial actions to potential non-compliance or events of defaults by issuers would be quicker and more objective.
• Government support through faster regulatory approval, credit enhancement facilities and tax incentives: As already mentioned, the BSEC approval process of 4 -6 months for corporate bonds is too high for issuers to consider it worthy to pursue fund-raising through bonds. BSEC must do its own capacity enhancement to ensure a faster approval process is ensured. Additionally, under some government investment authority, a standard practical payment guarantee may be offered by a government agency for enhancing the rating of bonds to channelize long term funds for infrastructure projects. A budget allocation from the Government would be beneficial for such initiative. The tax incentive for zero coupon bond is currently available for the corporate houses and individuals. However, most of the investment done in this sector are by the Banks, NBFIs and Insurance Companies. Some incentive in the tax structure for these institutions shall ensure greater participation and help create depth and breadth of the market.
• Establishment of a market reflective reference rate: Currently, the bond market lacks a proper market reflective reference rate or reference yield. Currently, Bangladesh Bank publishes a yield curve of government securities of different tenor. However, the yield curve is not market reflective for corporate bonds. Without the proper benchmark, all other fixed -income instruments, including corporate bonds shall lack the required reference rate for pricing. Currently the structure of corporate bond in Bangladesh market uses average fixed deposit rate of Banks as reference rate. A market reflective reference rate shall ensure proper risk premium and shall attract long term investment in bonds.

• Structuring of bonds with flexible repayment and stronger recourse mechanisms: Compared to the economies in other neighboring countries, it is essential that financial market of Bangladesh also structures innovative bond transactions through matching bond’s cash-flows with issuers’ requirements. There is still an untapped market where bonds like municipal bond, green bond, sukuk (Islamic Bond) etc. can be offered. Involvement of all relevant stakeholders including government authorities in this regard is essential for the development of this market. Moreover, since investor’s trust in this sector is yet to be at a desired level, trustees in bonds can play a greater role by devising recourse mechanisms such as step-in rights, collateralizing bonds and holding other fiduciary responsibilities that can potentially give confidence to the investors for investing in bonds.