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Return profile of debentures
Debentures typically give considerably higher yield compared to other fixed income options such as government securities and time deposits (fixed deposits). Debentures are generally subordinate unsecured debt issues, which prompt corporate issuers to give higher coupon.
The fact that the corporate debt market had been relatively dormant over the years also prompted corporates to give out a higher yield to attract investors (chart 1). The effective rates of yields of the outstanding debentures in Colombo Stock Exchange vary significantly and coupons can be as high as 20%.
Furthermore, the Budget 2013 exempted withholding tax on interest income earned on debentures listed in the Colombo Stock Exchange (CSE), giving tax free returns on the investments. Comparatively, fixed deposits and treasury instruments are liable for withholding tax.
Risk profile of the debentures
It is worthwhile to note that debentures are not risk free instruments. The main risk component of debentures stems from the credit risk of the respective debentures. That is the risk that the company will default on the debentures by failing to make the obligated payments.
The credit statuses of the issues are independently verified by the ratings issued by the credit rating agencies in Sri Lanka. All the debenture issues have such credit ratings accepted by the Securities and Exchange Commission of Sri Lanka (SEC), and two of the most common credit agencies are Fitch Rating Lanka Ltd. and Ram Ratings Lanka Ltd.
The credit rating and prevailing market interest rates are the two most important factors which will determine the interest payout of the debentures. When the companies’ credit rating is lower, the company will have to pay few basis points more to attract investors. It is also worthwhile to note that the company’s credit rating and the respective debenture’s credit may not necessarily be the same.
Since most of the debentures are subordinate debentures (the debenture payments have a less seniority compared to company senior debt), in a case of company’s liquidation, debenture payments will be paid after settling the senior loans.
Hence subordinate debentures are usually rated a notch down (for example if the corporate’s credit rating is A+ the debenture may get a credit rating of A) to reflect the additional credit risk of the debentures. However, the senior debentures which have the same priority as other senior debts may get the same credit rating.
Investing in debentures
Debentures are listed instruments in Colombo Stock Exchange. Therefore, investors also can buy debentures from the secondary market. However, unfortunately th
e secondary market is very illiquid at the moment and it will be very difficult to find the selling quantities of the outstanding debentures.
As of yesterday (14 November 2013), there were 113 debentures outstanding issued by 29 corporates. The average daily turnover is negligible with only about few thousand dollars. Therefore, subscribing for primary issues remains the main way of investing in debentures. But the secondary market liquidity is expected to improve significantly in the near future with rapid increase of corporates raising finance through debenture issues.
Liquidity issue
One of the main limitations of the debentures is the limited liquidity in the system or, in other words, low trading opportunities in the secondary market. The main reason for it was the limited amount of debentures listed in the market before 2013 because of the corporates’ reluctance to raise finance through bond market due to the lack of knowledge in the corporate debt market. Therefore corporates were uncertain about going for corporate debts, particularly when the cost of debentures was higher than the traditional banking finance. Furthermore, additional disclosure requirements in listing in the Stock Exchange may also have discouraged corporates from going for debentures.
Before the post-war fast economic activity took place, corporates were able to raise banking loans to meet their funding requirements. Generally when an economy grows, it will be difficult for the banking sector alone to cater to corporates’ financial needs. Especially when financial needs become more complicated in instances like funds with longer repayments, different mode of interest rate payments such as zero coupon bonds is required (especially in the case of project finance, the companies prefer to shift the interest payment towards maturity as projects has a long lifecycle in generating returns).
During 2010 and 2011, the economy saw rapid growth and there was an increased need of finance for the corporates. Accordingly, the Central Bank of Sri Lanka (CBSL) relaxed the credit environment, giving enough room for the banks to issue banking finance.
Also during the period equity markets took off with the post-war rally, which gave opportunities for corporates to look for equity finance at fairly cheaper cost as evident by the several IPOs took place. Therefore, despite the growth of economic activity, the corporate debt market remained stagnant during 2010-2012 periods as well.
Therefore very few companies opted for debenture financing and of the ones which have opted to go for debentures, the subscribers for the issues were institutional investors with long-term investment horizons. Therefore, there is very limited requirement for secondary market transactions, resulti
ng in very low liquidity in the debenture market.
Reasons for debenture market allure in 2013
Due to the credit controls implemented by CBSL during 2012 to control the rapid credit growth and pressure on balance payment on the widening trade deficit, there was a squeeze of credit available for the private sector, which could not be met by traditional borrowing finance. Therefore, the corporates found it increasingly difficult to finance their operations with lack of money.
The situation further worsened from the equity finance raising side due to the poor performance of the Colombo Stock Exchange and it became increasingly difficult for companies to go for equity issues.
Therefore, the option of corporate debt resurfaced and Government also understood the importance of developing the corporate debt market. (In the 2013 Budget, the Government removed withholding tax for debentures to attract more investors to corporate debt market). Accordingly, in 2013, the largest amount of fund raising through debentures for a year was witnessed, higher than highest equity finance raisings as well.
Interest rate direction
As discussed above, market interest rates are a key determinant of the coupon payout of the debentures and will play a key role in the demand for the instruments. Sri Lanka’s fixed income instruments have given considerably high yield even if we consider the currency depreciation (about annualised 3.5% for the last five years against the US Dollar) for a foreign investor.
During 2012, the interest rates picked up considerably, with monetary tightening measures taken by CBSL by increasing policy rates and adopting other credit control measures. But by the end of 2012, the Monetary Board of CBSL has become confident on the monetary outlook of the country and has seen the requirement to ease up the credit environment to stimulate the economic growth amidst stable inflation, adopting a dovish stance on the economy.
Therefore, market interest rates are on the decline and 364-day Treasury bill rates have come back to single digit levels. The down-trending interest rates will increase the value considerably of the current outstanding (yet to mature) high yield paying debentures in the market and investors may see strong buying opportunities if they can find the exposure to such debentures through the market.
Future direction
For Sri Lanka to achieve economic growth targets, capital market development will play a pivotal role in various ways. In Sri Lanka’s capital market context, the corporate bond market has long way to go as it still remains an insignificant proportion in terms of size compared with the listed equity market. But as discussed, the corporates are increasingly looking for the corporate debt with the benefits they offer for the companies’ balance sheets.
The Government is also actively promoting corporate debt market and systems are being improved to facilitate an active corporate debt market.
Therefore we believe we are still seeing an early stage of a corporate debt market, which will continue to attract investors at rapid pace, playing a much more significant role in the country’s overall capital market in the near future.
