By
Usman Hayat
Mar 11 - 17, 2002
Term Finance Certificates (TFC) represent the
corporate bond market in Pakistan. They are issued under Section 120 of
the Companies Ordinance 1984, which allows companies to issue securities
and redeemable capital not based on interest. Although largely similar
to a conventional bond, TFC repay principal by large payments in the
last few years to maturity rather than making a single principal
repayment in the end.
TFC are very young. The first TFC was issued in
Pakistan by Sapphire Textiles in 1995, but it was entirely privately
placed. The first ever TFC with a public offer was made by Packages Ltd
in 1995. Till 2001, there have been a total of 33 TFC issues with a
public offer. Out of these, 17 issues raising 12 billion came in 2001
compared to only 6 issues raising Rs 1.2 billion in 2000, displaying a
phenomenal growth in the last year.
But despite the growth of TFC, the corporate debt
market in Pakistan is still dominated by bank loans. Since bonds are
both a compliment and substitute to bank loans in channeling the savings
of an economy to the producers of goods and services, it is worthwhile
to understand the barriers and triggers to their growth. The discussion
that follows would be confined to the TFC issues that have a public
offer for little is known about the issues that are entirely privately
placed.
Barriers: Despite their increasing number, size,
and sophistication, there still exist substantial barriers to the growth
of TFC.
Liquidity: TFC are not liquid even though they
are listed. In the absence of large trading volume, a small investor is
forced to hold his TFC to maturity, making it more of a debt rather than
a debt security. Due to their highly risk averse nature, small investors
would rather not invest in an illiquid asset. TFC are largely said to be
traded by institutional investors in the telephone-based over the
counter (OTC) market. Eventually, it would take a screen based OTC
market to provide the desired level of liquidity, but in the meanwhile
it is important to generate exchange based trades.
Lack of enough issues: Growth in TFC is also a
function of itself: the more issues are made, the more developed would
be the market, thus paving the way for even more issues. To get into
this virtuous circle, the number, size, and share of public offering
would have to increase manifold before TFC become an established
investment vehicle. The simple average of public offer component of all
33 TFC issues to date is 31%, i.e. bulk of the issue goes to the
institutional investors.
Source: Prospectuses
Competition from NSS: The current SBP discount
rate is 9% while the current rate of return (IRR) for investor who buys
an A rated TFC is about 14% gross, i.e. a premium of 5% above the
discount rate is being offered to the investors on a high credit quality
instrument. Since inflation is reported to be below 6%, investors in TFC
are all set to earn a high real return. Trouble is that a common
investor can invest in the National Saving Schemes (NSS), which provide
12% to 14% gross return on 3 to 5 year maturity. One can argue that NSS
offer more value to the investor because they are free of default risk
and more liquid. NSS also have a relatively favorable tax treatment. The
rates offered on NSS have been reduced but for TFC to successfully
compete with NSS, the profits on the latter would need to be brought in
line with the market rates. Note that NSS are essentially domestic debt
and Government does not invest NSS proceeds in projects that would pay
back these sums. The interest and principal of investments in NSS would
inevitably come from the taxes of the people of Pakistan, including
those who invested in NSS! Unlike NSS, TFC make economic sense because
their proceeds are invested in creating goods and services that are
enough to pay everyone involved.
Investor ignorance: Pakistanis are largely
unaware of the investment opportunity provided by TFC. Even when TFC
provide an attractive risk-return trade off, investors shy away from
them because they are far more familiar with bank deposits and NSS. To
target the small investor, TFC are being offered in denominations as
small as Rs 5,000 but more needs to be done. Creating awareness among
small investors is a long and slow process. In the meantime it is up to
the bankers to the issue to make their depositors invest in TFC.
Low per capita income: The per-capita income of
Pakistan at Rs 25,000 is very low. Due to low income, the demand for
insurance and investment in pension fund is also low. After all, it is
the income and wealth of the people that generates individual as well as
institutional demand for corporate bonds. Low income is a long-term
demand side barrier and its affects would only be mitigated by overall
economic development.
Institutional environment:
State of development
of accounting, audit and disclosure, sophistication of property rights,
and the ability of the government to enforce contracts are institutional
fundamentals to creating the right environment for developing a bond
market. Pakistan has weak institutions and due to a number of financial
scams in the past, investors are unlikely to put faith in the
institutions to protect their investments. Improving the institutional
environment is an area in which we have a long way to go.
Expenses & lead time:
The average estimated
initial expenses to the issue in 2001, as declared in the Prospectuses,
was 1.5%, ranging from 0.7% to 2% — a significant ratio with a
substantial variation. This excludes the issue by First International
Bank Limited, which was entirely publicly offered and therefore very
expensive. Some of the major expenses are set as a fraction of the size
though they may not be variable or at least proportional to it. In case
of Pak-Arab Refinery's TFC issue, the credit rating fee alone was
reported to be one million. Often a lot of expenses are lumped together
in the Prospectus so one cannot make specific comparisons across issues.
Detailed costing needs to be done to rationalize these expenses before
they become an established 'market rate.' A long lead-time to the issue
is another barrier. It can take as long as 6 months from the time a
company sets off to issue the TFC to the time it actually receives its
proceeds. However, often time taken is a question of the skills and
resources of the advisors.
The ambiguity on riba: Supreme Court in its
judgment in Dec 1999 declared all forms of interest as "riba"
— unIslamic — and asked the government to take necessary actions to
bring the economy in line with Islamic principles. A technical
evaluation of the structure of TFC would make it clear that it is but
difficult to justify that TFC are not based on interest. However, the
judgment is not said to have affected the TFC growth.
The demand & supply side to bonds
Within the debt market, why do companies issue bonds
(supply side) when they can borrow from a bank and why do investors
invest in a bond (demand side) when they can make a bank deposit? First,
many investors are involved in corporate bonds so they can assume and
diversify more risks and therefore provide relatively big, longer-term
high-risk projects that the banks may not be willing to finance to avoid
a maturity mismatch etc. Thus bonds may act as a complement to bank
loans. Second, some companies are large enough and enjoy good credit
reputation. They can go to the public by replacing an expensive
intermediation by commercial banks with a relatively cheaper
intermediation by investment banks. This is how bonds act as a
substitute to the bank loans. The same is true for the investors. On one
hand, corporate bonds provide investors with risk-return opportunities
not provided by bank deposits, government bonds etc and on the other,
they are an opportunity to diversify within debt. A competitive and
complete market requires both substitutes and complements. Bonds exist
because they are both, to the borrowers as well as investors.
Triggers: Having seen the barriers, we move on to
see the triggers to the TFC growth.
An unblemished past: Publicly offered TFC are
always credit rated and listed, and usually secured and underwritten.
This subjects the issue to multiple scrutinies and reduces risk for
every one. So far there hasn't been any default on a TFC with a public
offer. The average over-subscription of public offers is 54% and all but
three issues were oversubscribed. This unblemished past is increasing
the confidence of the investors. At the same time, it also means that
any one default is likely to have a major adverse impact on both
outstanding and new issues. This spillover of a default is a negative
externality imposed by one defaulter on others but it is very difficult
to internalize it, i.e. confine the overall costs of the default to the
defaulter. The best move is to adopt very strict vigilance to avoid any
disaster.
GOP bonds: An important factor behind lack of TFC
growth had been the lack of government bonds to make a complete yield
curve. The interest rate offered on the 'default-risk free' GOP
securities act as a benchmark for issuing corporate bonds. They also
provide the trading volume that makes the secondary bond market active.
Now with different outstanding bond issues, including the new Pakistan
Investment Bonds (PIBs) issues of 3, 5, and 10 years maturity, at least
the problem of not having a benchmark government bond has been largely
solved.
Credit rating: Credit rating in Pakistan is being
done by PACRA and JCR-VIS. The extracts from their credit rating reports
are prominently displayed in every TFC prospectus and rightly so. For a
common investor, it is but the credit rating that provides a sense of
issuer's ability and willingness to pay. It is also a key input in
determining the coupon rate. Even institutional investors rely on the
credit rating to decide whether or not to invest. One can safely say
that it is but difficult to exaggerate the importance of credit rating
in the bond market and there is a strong need to comply with highest
professional and ethical standards in this area.
Benefits to the issuer: TFC are turning out to be
significantly cheaper than bank loans; it is possible to retire debts
costing as much as 18% with TFC costing 14 to 15%. This also shows
rigidity on behalf of banks that despite the drop in interest rates,
they are not cutting their prices and virtually forcing the companies
into the bond market. TFC make it easier for the issuer to avoid
maturity mismatch that is of particular relevance to financial
institutions, such as leasing companies — the most active issuers in
the TFC market. With the permission of the SBP, commercial banks are
also about to join the TFC issuers for similar reasons. Issuing TFC also
brings market recognition to the issuer and it pays to be known and
visible. Moreover, TFC increase the internal knowledge and skills of
corporates and improve their way of going about financing. Companies
should also consider TFC to diversify their financing mix.
Change in institutional parameters:
Institutional
investors have been barred from investing in the NSS. With this policy
change, an unfairly advantaged competitor of TFC in the institutional
investment has been eliminated. The interest rates on NSS are also being
brought in line with market forces, which would generate demand from
small investors. Moreover, recently SBP has also allowed banks to issue
TFCs. Rated and listed TFC have become eligible for the Statutory
Liquidity Reserves (SLR), which was being demanded for some time. These
regulatory moves have radically increased the demand for TFC.
Features
TFC are becoming sophisticated with time. In the
beginning issues came with a fixed return and without any options. The
new issues are using a floating rate, with a floor and a ceiling,
usually set a certain percentage points above the SBP discount rate.
Issuers are keeping a Green Shoe Option — a right to retain a
percentage of over subscription. The tenure is usually around 5 years,
though there has been one perpetual issue. Some issuers are even adding
a partial or a full Call option — the right of the issuer to recall
some or all of the TFC outstanding (say the issuer can get cheaper
debt). While some issuers made sinking funds — a reserve for paying
off the bonds — most of the issues have come without one. The issue
size has varied from Rs 100 million to Rs 2500 million. The new features
are to the issuer's benefit but they make valuation complex because
concepts like yield to call, option adjusted spread, duration, convexity
etc are not well understood.
Improving disclosure: Pakistani capital markets
are characterized by lack of disclosure, which is anti-investment. But
things are changing. With the new breakthrough requirement of quarterly
accounts and implementation of more international accounting standards,
the hold of banks on privileged information regarding the credit worth
of a company would be loosened that would pave the way for more bond
issues.
Number of issuers & advisors:
Even though
Pakistan does not have many large companies, the number of companies
that can but have not issued TFC is large. It is up to the advisors to
aggressively sell the idea of TFC to these potential clients. The
knowledge and skills of the advisors to the issue are also improving
with every new issue. No more a few brokerage houses or banks dominate
the market. Admittedly, the new advisors and arrangers move down the
learning curve at the cost of the issuers, but their increasing numbers
is good news for the overall market.
Conclusion
Corporate debt channels the savings to the producers
of goods & services, an essential for economic progress. But despite
their role as substitute and compliments to bank loans, TFC have only
begun to make their presence felt in the corporate debt market. The
objective here was to identify the various barriers and triggers to the
TFC growth, a summary of which is given in the following table.
|
|
Supply
Side |
Demand
Side
|
Institutional
|
|
BARRIERS
|
Short
Term |
•Lack
of enough issues
•Expensive
•Long
lead time |
•Lack
of Liquidity
•Competition
from NSS for small investors |
•Weak
legal, audit, and accounting systems
•Poor
record in preventing and handling past financial scams
•Small
size of insurance and pension funds
•Established
Credit Rating
•Increasing
number and •know-how
of Advisors Improving Disclosure
|
|
Long
Term |
•Ambiguity
on the issue of Riba |
•Investor
Ignorance
•Low
Per Capita Income
|
|
TRIGGERS |
Short
Term |
•Large
number of potential issuers including banks |
•Unblemished
Past Consistent Over- subscriptions
|
| Long
Term |
•Cheaper
funds to issuers
|
•Bar
on Institutional investment in NSS
•TFC
eligible as SLR
•Attractive
returns to investors
|
Major barriers
to the TFC growth are established and longer-term such as investors'
ignorance, low per capita income, and weak institutions. Major triggers
are relatively recent but also long-term in nature, such as a bar on
institutional investments in NSS and eligibility of TFC as SLR. Further
eradication of short-term barriers is likely to provide another boost to
the number of issues, but eventually long term demand side and
institutional barriers would cap the growth of the bond market. However,
in the near future, the tide of TFC would remain on the rise, providing
new economic choices to everyone and helping the economy to progress.
The first TFC issue of 2002 by Reliance Weaving Mills has been offered
for public subscription in the first week of February and many more are
expected to follow.
|
All
TFCs with a Public Offer |
|
Sr
# |
Issuer |
Tot.Offer
Rs M |
Tenure |
Credit
Rating |
Public
Offer |
Return (IRR; if bought at face value)
Floor
Ceiling |
Over/Under
Subscription |
|
2001 |
|
33 |
Security Leasing |
200 |
4 |
A-* |
20% |
For Year 1 & 2 = |
14.75% |
17.50% |
1%
|
| |
|
|
|
|
|
For Year 3 & 4 = |
14.00% |
17.50% |
|
32 |
Cres. Lease |
250 |
5 |
A+ |
30% |
|
14.50% |
18.00% |
16% |
|
31 |
Pak-Arab Refinery |
2,500 |
3 |
AAA |
20% |
|
13.00% |
15.00% |
8% |
|
30 |
Engro Chemicals |
500 |
5 |
AA- |
20% |
|
13.00% |
17.00% |
190% |
|
29 |
First Intl. Invt. Bank** |
100 |
5 |
A , A |
100% |
12.5% for R1 |
|
|
93%
|
| |
|
|
|
|
|
15% for M1 |
|
|
|
28 |
Nishat Mills Ltd |
600 |
4 |
A+ |
25% |
14.5% for Y 1 |
|
|
-93% |
| |
|
|
|
|
|
For Y 2 to 4 |
13.00% |
17.00% |
|
|
27 |
Dawood Leasing |
250 |
5 |
A+ |
30% |
|
13.50% |
17.50% |
4% |
|
26 |
Gulistan Textile |
300 |
5 |
A- |
33% |
|
14.00% |
17.50% |
21% |
|
25 |
Atlas Lease |
100 |
5 |
A |
25% |
15% Fixed |
|
|
4% |
|
24 |
Packages Ltd |
700 |
P*** |
AA- |
21% |
|
13.50% |
17.00% |
174% |
|
23 |
Pakistan PTA Ltd (ICI) |
1,600 |
5 |
A- |
31% |
16% Fixed |
|
|
-54% |
|
22 |
Deewan Salman Fibre Ltd |
1,800 |
4 |
A+* |
11% |
16% Fixed |
|
|
8% |
|
21 |
Engro Asahi |
500 |
5 |
A |
20% |
|
13.00% |
17.00% |
7% |
|
20 |
Sui Southern Gas Corp. |
1,000 |
5 |
AA |
20% |
|
13.00% |
18.00% |
15% |
|
19 |
Shakarganj Mills |
250 |
4 |
A-* |
28% |
|
15.00% |
18.75% |
1% |
|
18 |
ORIX Leasing |
700 |
4 |
AA |
21% |
14% Fixed |
|
|
28% |
|
17 |
Pak Ind. Leasing Corp |
325 |
3 |
A- |
46% |
15.6% Fixed |
|
|
6% |
|
2000 |
|
16 |
Nishat Mills Ltd |
350 |
4 |
A+ |
27% |
14.5% for Y 1 |
12.00% |
14.00% |
-8% |
|
15 |
Al-Noor Sugar Mills |
200 |
4 |
BBB+ |
38% |
|
16.50% |
18.50% |
5% |
|
14 |
Network Leasing |
100 |
5 |
BBB+ |
40% |
16.25% Fixed |
|
|
71% |
|
13 |
Atlas Lease |
200 |
5 |
A |
25% |
15% Fixed |
|
|
218% |
|
12 |
Paramount Leasing |
250 |
4 |
A+* |
20% |
16.25 Fixed |
|
|
231% |
|
11 |
Sigma Leasing |
100 |
3 |
A-* |
20% |
17% Fixed |
|
|
230% |
|
1999 |
|
10 |
Pak Ind. Leasing Corp |
250 |
5 |
A- |
30% |
18% Fixed |
|
|
135% |
|
9 |
NDLC |
330 |
5 |
A+ |
30% |
17% Fixed |
|
|
170% |
|
8 |
Dewan Salman Fibre Ltd |
700 |
5 |
A+ |
29% |
19% Fixed |
|
|
82% |
|
7 |
Saudi-Pak Leasing |
250 |
4 |
AA- |
20% |
18.25% Fixed |
|
|
68% |
|
1998 |
|
6 |
First Intl. Invt. Bank |
300 |
5 |
A |
100% |
17.5% Fixed |
|
|
9% |
|
5 |
Garton Industries |
250 |
5 |
A+ |
20% |
18% Fixed |
|
|
49% |
|
1996 |
|
4 |
ICI |
1,000 |
5 |
AA |
25% |
18.7% Fixed |
|
|
50% |
|
3 |
Nishat Tek |
250 |
3 |
A+ |
30% |
18% Fixed |
|
|
1% |
|
1995 |
|
2 |
Sui Southern Gas |
500 |
5 |
AA |
20% |
18.25 Fixed |
|
|
17% |
|
1 |
Packages Ltd |
210 |
5 |
A+ |
48% |
18.5% Fixed |
|
|
22% |
*Rating by JCR-VIS/DCR-VIS; rest by
PACRA; Rating is for instrument at the time of Issue
**First Intl. Invt. Bank issued two
types of TFCs, R for Regular Income and M for Money Multiplier
***Perpetual TFCs with offer of
redemption after every four years
Source: Prospectuses and News Reports
|
