Thursday, 5 January 2012

Analysing the K30 billion Reserve Bank bonds

Sunduzwayo Madise 

Malawi, through the Rserve Bank of Malawi (RBM), recently floated four bonds totalling K30 billion ($179.6 million). Two were K10 billion ($59.9 million) each and the other two were of K5 billion ($29.9 million) each. These bonds are staggered over a two and five-year repayment period.
The two and three-year notes will offer coupons (returns) of eight percent and 8.5 percent, respectively, while coupon rates on the four and five-year notes are 9.5 percent and 10 percent. Law lecturer, legal practitioner and financial analystSunduzwayo Madise takes an in-depth look at the bonds.
From a financial analysis viewpoint, this bond offer can be attributed to two scenarios; at least in the case of Malawi.
1. There is too much excess liquidity so the bonds are to mop up this excess liquidity. Last time this happened was when the RBM bond of K5 billion had matured and the RBM argued that flooding the market with K5 billion in one injection would be inflationary.
So the RBM issued another K5 billion bond so that the money supply could be held in equilibrium (i.e. the two bonds could cancel each other so to say). This is one of the monetary policy objectives of the RBM and has nothing to do with Treasury (or ideally should have nothing to do with Treasury).
2. Government needs to borrow money to finance its budget or other development needs. In this case, the RBM is an agent of Treasury as this is outside monetary policy.
Why the K30 billion bonds?
Now let us analyse the K30 billion bonds.
They have been offered to the domestic and international market so the rationale for these ‘instruments’ being monetary policy tools falls away.
Therefore, (and the RBM has confirmed) this is government borrowing, but this borrowing is not limited to domestic borrowing only as the bonds are open to international investors too.
The question then is: What is the borrowing for? Is it to meet a shortfall in revenue? Granted the 2011/12 financial year will see a decline in revenue and the Minister of Finance has already twice downgraded our GDP growth forecast; and we are only at mid-point of the budget. In fact the RBM has said the bonds will be used to ‘restructure domestic debt and develop a benchmark yield curve’. Was this not factored into the budget or do we need extra funds to meet this obligation? And what does ‘developing a benchmark yield curve’ really mean in lay man’s language?
The bonds offer a return of eight percent per annum. The savings return in Malawi is between one and three percent. This means government is aware that if it were to float the bonds at a rate close to the savings return, they may not be adequately subscribed.
Secondly, the almost five to seven percent difference demonstrates that the saving rate in Malawi is not a true market rate as such no one should be surprised that Malawians are not saving. Money by its nature depreciates every year. In a country with an inflation rate of around nine percent; putting one’s money in a savings account returning three percent means more or less you are losing money (or value on your investment). No wonder National Bank of Malawi had their bond at 10 percent and if I were an investment manager, that would have been the place to put some money in because it had a one year maturity period.
Will they help?
Now while returns of between eight and 10 percent may look attractive to the international investor ( the return in Europe is between one and six percent, depending on where; although Greece, Italy and Ireland have now pushed this to seven percent), but most international investors will not invest in Africa unless the return is twice what the RBM is currently offering.
The reason Africa is said to be the new investor’s playground is because of its high return on investment. The possible devaluation of the Malawi Kwacha does also not help matters. While it is a fact that the kwacha cannot remain at the same value (as against other currents) for the next five years, an imminent devaluation (or the fear of one) may adversely impact the action.
For purposes of simple economics, let us assume that person “A” buys a five year bond and the kwacha is devalued over the same period at 10 percent. “A” will end up having zero negative return in his investment, and this is the same whether “A” is a Malawian investor or a foreigner although it may be considered more risky for the foreign investor.
Or indeed since the bonds are offered at a discounted rate, let us assume one buys a discounted K100 bond and pays K90 for it but will receive K100 in two years, for example. If the kwacha loses value in the period of ‘investment,’ by the time one receives the K100 note, its real value will not be the K100 of 2011.
In other words, it will be the same K100 but will not have the same purchasing power (cannot buy the same products that it would have bought in 2011). One might need maybe K110 or K120 to buy the same things (if not more). It is an inherent characteristic of money worldwide to lose its value. Does this then mean the international and local investors may shy away and not subscribe to the bonds offer?
Any lesson?
Maybe a lesson from the last RBM K5 billion bond auction is apt (June 2011). The indicative return then was 8.5 percent. When the bond results were announced, the return was at 15 percent (for an offer of 8.5 percent). This was viewed by some as a sign of desperation on the part of RBM to mop/borrow at whatever the cost (almost twice the cost at that time). It is submitted that the same is likely to happen now and if government is desperate for funds, then yes, it will be prepared to borrow costly! The announcement of the subscription of these bonds will, therefore, be eagerly awaited and provide a basis for further analysis.
In any event, investment managers must now be looking at rearranging their portfolios to ensure they cash in into this bond market. Government bonds by their nature offer the most attractive security because of the perpetuity nature of governments.
Government bonds are, therefore, perceived as a safe investment. And one of the key factors to consider in the investment market is stability and it does not hurt to have a portion that promises a stable return for the next five years. The fear may be that financial houses which would otherwise lend to more risky clients (albeit at a higher interest) may opt for this stability and security at the expense of other clients.
The semi-annual payments may also be an attractive offer as compared to the annual payments of most investments in the financial sector. The bond offer may, therefore, lead to a squeezing out of the poor but riskier borrower.
But has time not come for the financial sector to get itself properly organised and serious so that we can be rated by top rating agencies such as Standard &Poor, Fitch &Moody’s for both our sovereign bonds as well as corporate bonds. S&P has just given a 'positive' to Nigeria sovereign bonds and I am sure the next floatation in the country will be warmly welcomed. The lack of rating on our part also means we do not attract quality investors, and we may end up attracting some riff-raffs, including currency speculators and this may force us to capitulate on the return that is eventually given out. Malawi has in 2010-2011 passed a plethora of financial service laws and the stage may be set to move on to the next level.
But why is the bond market a viable alternative than for example bank loans or an offer of equity (shares)? For starters, compared to bank loans, bonds are all winner financial instruments. Take the Malawian situation, for example, the difference between the savings rate and the lending rate (so called “water”) is quite huge; and is reflective of an unstable financial market where lending is risky. Therefore for bonds, the person issuing the bonds borrows money at a much lower rate than the bank lending rate and the person lending the borrower does so at a higher return than the savings rate. It is a win-win situation.
For corporates, this may also be a better option than offering equity. In the first place, not all investors want to own shares in a company and sometimes it may not be wise for the corporate to do this as it can lead to dilution of shares and diminishing of the investment which existing shareholders have in the company. Corporate bonds, therefore, offer the best means of companies accessing cheaper financing without losing control of the companies (of course this may occur should the company fail to repay). The difference in corporate and government bonds is that the latter is long term and has the advantage of sovereign guarantee.
Sunbird Tourism recently announced that it was exploring offering a K2 billion bond. The realisation of this potential auction is also being eagerly awaited for and one can only encourage Sunbird that is the way to go. Hopefully, other companies can also follow suit and raise financing from the investment market at a cheaper price.
The emergence of a proper bond market will, however, prove a challenge for the banking (lending) sector as banks will have to ‘invent’ new financial instruments to maintain their high profitability as they can no longer rely on lending. The reason is that the bonds will become more attractive to the savings base and the bank may lose (a section of) this base. Furthermore, even now, without a strong and competitive bond market, the return on savings is very low and no serious investor or any investment manager worth his salt will put their money in a savings account.
Take the example of the entrepreneur farmer. If he had sold his maize two months ago at K1 500 and put his money in the bank, he would have got around the same amount after one year (the interest is really negligible). But if he decided to keep his maize and were to sell it now, he would sell it for K3 000 and may then use the K3 000 to buy other products which are likely to appreciate, thereby ‘multiplying’ his money. The products become his investment. In a consuming country such as Malawi, most products by their nature appreciate in value and where savings rates are very low, there is wisdom in investing in products (buying things). There is also an emergence of flourishing barter trade which should not be ignored, especially with a squeeze on forex.
However, and in conclusion, the question to our Members of Parliament is; has Minister of Finance explained why we are borrowing almost over 10 percent of our budget at once. There is need for more explanation on its need to restructure domestic debt and develop a benchmark yield curve as stated by RBM.