Banks overlooked as firms turn to bonds

This year has been a boon for the Government and local companies, especially banks and insurance companies, looking to borrow money from the public to fund their growth.

Just like in times of agricultural surplus when the supply of fruits or vegetables exceeds demand, investors are spoilt for choice.

The bond market — where the Government and companies come to borrow money from institutional investors and the common investor — has had near-perfect conditions over the last 10 months.

For a start, there has been a lot of money in circulation, interest rates (the price of money) have been low and stable, and inflation has remained at single-digit levels.

Positive sentiment

This cocktail of figures and positive sentiments about the country — including the news that the Kenyan economy has grown in size by 25 per cent to $55.2 billion (Sh4.91 trillion) after rebasing — have aroused a sense of excitement in the debt market.

As a result, ‘bond madness’ appears to be taking centre stage on the Nairobi Securities Exchange (NSE), providing a rare opportunity for investors and dealers to cash in on these securities and bolster their earnings.

What is more, market analysts are upbeat that this is just a tip of the iceberg.

A bond is debt security under which the issuer (borrower) owes the holders (lenders or investors) a debt. The borrower is obligated to pay investors an interest and repay the principle sum at a later date.

It is argued that the flourishing middle class, prospects of lower interest rates after the Government’s decision to slow down its borrowing from the domestic market, and increased cash in the economy as a result of increased spending have made the bond market a viable investment destination.

The prospects of an economic turnaround and the fact that bonds provide a cheaper funding option for companies have added to their attraction.

And what makes the bonds even better investments is that they can be traded freely at the NSE, meaning investors who wish to adjust their portfolios can easily exit their positions at minimal costs.

“The economy is getting vibrant and the cheapest way of raising funds is through the bond market,” said James Wangunyu, the managing director of Standard Investment Bank (SIB), one of the key players in the bond market.

“The interest rates are coming down and the funds are available. We are seeing a lot of liquidity in the market. The economy is taking shape and there are a lot of activities taking place, including foreign direct investments (FDIs) coming in.”

Massive appetite

According to John Ngumi, the head of investment banking for East Africa at CfC Stanbic, Kenya’s middle class is driving the growth of the economy.

“Granted, the economy has been growing sluggishly over the last two years or so, although all signs point to economic activity gradually picking up, a trend we believe will feed through into 2015,which is perhaps why companies are looking to raise capital,” he said.

This year alone, the bond market has entertained four new corporate bond issuers in quick succession.

The bond issues by NIC Bank (Sh3 billion), CIC Insurance Group (Sh3 billion), Britam Investments (Sh3 billion) and UAP Insurance Holdings (Sh2 billion) were all oversubscribed, meaning that the appetite for these debt instruments by investors is massive.

All four firms are in financial services, and their expansion plans are an indicator that they are anticipating rapid growth in the sector. And if the financial services sector is bullish that the coming year or so will be good, then this is likely to be picked up by players in other sectors, such as manufacturing.

The oversubscription meant that NIC bank, Britam Investments and CIC Insurance Group exercised their green-shoe options by taking part of the excess cash and in the process avoiding the costs of coming back into the market for subsequent tranches.

FUNDING KEY PROJECTS

“Well, for starters, it is cheaper to issue capital through debt than equity, plus bond covenants are less restrictive than, say bank-style covenants that tend to restrict borrowing,” said Mr Ngumi.

“Most bonds are also issued on an unsecured basis, which makes them more attractive to the issuers, while compensating investors for the risks that they are taking. There is also a dearth of tradable fixed income products on the Kenyan market, so when the products are made available, and provided they present a good credit story, then you should expect demand from investors.”

The uptake of the issues has also seen the Government accelerate its fund-raising drive to finance infrastructure projects.

So far this year, the Government has raised and listed Treasury bonds valued at Sh89.1 billion, while the corporate bond market has generated Sh13.5 billion, according to data from the NSE.

Last month, the Government, through its fiscal agent Central Bank, issued a 12-year bond valued at Sh15 billion to fund key projects in transport, energy and water.

The bond guarantees a return of 11 per cent to be paid every six months, with investors being given the chance to invest as little as Sh100,000.

“On the issuer side, we cannot speculate on the rationale for the use of the bond markets, but it will be linked to reasonable lower funding costs and no security required, unless a company doesn’t meet Capital Market Authority [CMA] eligibility requirements,” said Ngumi.

“Last year, Government rates were all over the place and were very high at times given the liquidity challenges the markets witnessed due to problems around devolution. It is, therefore, not surprising that firms at that time opted to raise capital through equity rather than debt. Plus, it was an election year and there was an obvious risk of fiscal slippage that could cause rates to rise.”

According to Ngumi, Government debt tends to be the price benchmark for corporates to borrow. Thus, with the Government keen to not borrow excessively from the domestic market, there is minimal risk of unstable rates in the near to medium term, which could see more firms opt to borrow through debt.

John Kirimi, an executive director at Sterling Capital, added that bonds have become even more attractive now that they can be traded freely at the NSE.

“The bond market has developed and has become more attractive,” he said.

According to Mr Kirimi, the growing middle class and the reforms in the bond market, including the introduction of electronic bond trading, have played a key role in the rebound of activities in the fixed income market segment.

“I expect this trend to continue as people realise there are more ways to invest than through bank savings accounts,” he said.

Individuals, commercial banks, pension funds, insurance companies and other investors putting money in a bond enjoy attractive interest returns, plus the added advantage of exemption from paying a withholding tax of 10 per cent on the interest income.

The fears

There are, however, fears that the increased issuance of bonds could have an adverse impact on the cost of living through inflation

“Increased issuance of local currency corporate bonds will have minimal impact on the currency, but increased issuance tends to lead to an increase in money circulation, which will typically have a lag effect on inflation,” said Ngumi.

He added that companies may continue to invest in anticipation of growth in their respective sectors a year or two or three down the line, even if an economy is experiencing a reduction in gross domestic product (GDP) growth.

“Each company has its own growth forecasts and these would have informed their expansion plans. The plans are usually reflective of strategic plans that a company is implementing, which would typically span more than three years.”

According to CMA, the ratio of corporate bond market capitalisation, or value, to GDP is expected to rise to 40 per cent from the current two per cent.

The percentage of county financing through capital markets is anticipated to increase to 30 per cent over the next 10 years.

Similarly, the ratio of corporate bond turnover to total bond market capitalisation is projected to hit 50 per cent from 0.1 per cent in the next decade as the country strives to become the gateway of financial services in the middle African region.

According to the authority’s 10-year plan (2014-2023), the percentage of infrastructure investment financed through the capital markets in Kenya will increase from the current 18 per cent to 80 per cent.

The cost of infrastructure investment to be financed through equity and bonds will rise to $10.67 billion (953.4 billion) from $3.6 billion (Sh321.7 billion).

Data from CMA shows that in the last two decades, the capital market has raised more than Sh2.4 trillion through issuances of bonds and equities.

The capital markets play a key role in providing long-term funding for large infrastructure projects such as the development of transportation networks, extractive industries, technological connectivity and utilities infrastructure — all projects that form part of the Vision 2030 development agenda.

The National Treasury has already tabled a National Priority List of 47 public-private partnership (PPP) infrastructure projects.

These have a requirement for private sector funding of at least $27 billion (Sh2.4 trillion) over the next 10 years, indicating an infrastructure-funding need of $2.7 billion (Sh241.2 billion) a year over this period.

Ideal channel

The size of the required investments for these infrastructure projects makes the capital markets an ideal channel for mobilising international financing.

It is hoped that the share of infrastructure investment financed through private capital markets, by means of listed equity, private equity or bond issues will rise to 25 per cent by 2023.

The NSE, in conjunction with other stakeholders in the capital markets, completed and launched the automation of the bond market by making real-time data on trends in the bond market available.

This has allowed market players, investors and potential issuers to make informed decisions, not only in the secondary market but the primary one as well.

The availability of information to all market participants through the Automated Trading System has also ensured information symmetry and the ability to complete a trade within three days of a transaction.

Plans are underway for dealers in the bond market to exercise the choice of trading the bonds on or away from the bourse after key stakeholders agreed to introduce a hybrid model of trading.

The implementation of this over the counter (OTC) market is among measures the regulator is undertaking to reform the bond market to attract more issuers.

OTC is basically a negotiated market between two parties where participants in the bond market trade debt instruments directly without going through market intermediaries — brokers and dealers — in the secondary market.

This is expected to spread the benefits of the bond market to a larger pool of investors, which include less restrictive covenants, long tenures, and in some cases, cheaper funding because of the disintermediation factor (borrowing funds directly from the providers of funding rather than using, say, a bank, which is an intermediary).

In addition, no security is required for bonds compared to bank loans and there is no dilution of ownership or shareholding as would happen in a rights issue if main shareholders do not take up their rights.

REVIEW PROCESS

Further, equity funding is riskier than bond funding, so the returns projected for equity investors must compensate them for risk, and would need to be higher than the returns investors would expect on less risky investments.

“The bond market has always been an easier option to tap into than an equity capital raise. Because the risks are lower, the review process is much easier for investors,” said Ngumi.

“Having said that, the issuer of a listed bond does need to meet specific CMA requirements, while bank covenants could be tailored to meet the situation of a particular company.

“In more developed markets, bonds are issued on a disclosure basis, so there are disclosure standards that an issuer has to meet and the investors then make the decision as to whether to invest. The investor undertakes a credit review of the issuer and determines the risk premium they would receive for taking that risk.”

According to Ngumi, developed markets also have a credit rating culture that makes it easier for investors to review credits.

“We are hoping that our market will move to more disclosure-based issues going forward,” he said.

janyanzwa@standardmedia.co.ke