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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