Fixed Income Securities Market in Pakistan

A well functioning bond market is imperative for the development of a nation’s economy and ensuring the financial sector stability. This paper gives an overview of the current structure of Fixed Income Securities Market Pakistan and its functioning. The paper also focuses on the key obstacles which are in
Pakistan’s way to make its bond market strong, deep and liquid. Suggestions are also given to remove the

impediment from the development of an efficient Fixed Income Securities Market in Pakistan.

Introduction

An efficient fixed income security market, both government and corporate, is highly gratifying for the swift development of any economy as it leads to the efficient mobilization of resources for long-term investment. Governments can help achieve the allocative efficiency from the Market based Government Debt Securities . The frequent issues of securities of various maturities by the government helps building a yield curve that serves as the benchmark for the issuance of corporate debt securities.

Raising funds through bonds saves the company from the cumbersome procedure of issuing equity. Companies know their interest expenditures before hand and this known cost of capital helps them in planning & budgeting process. A strong bond market offers an alternative source of financing to companies other than banks. This alternative source of financing was quoted as “the spare tire” of economy by the former Federal Reserve Chairman Allan Greenspan . Lack of an efficient bond market is often seen as the primary reason behind the Asian Crisis. The banking sector could not stand in front of the Asian Crisis of 1997, FDI started flying back and the financial system had nothing to offer in terms of capital as the inability of the emerging markets of Asia to borrow long term in local currencies had resulted in very weak fixed income securities markets and this “Spare tire” was not available to the crisis struck countries. This shifted the focus of policy makers towards the creation of an efficient bond market. However, many crisis ridden emerging economies still lag behind in terms of the bond markets (Table-1)

Table-1

Country Bond Market as % of GDP Country Bond Market as % of GDP
India 0.4 Malaysia 38.2
China 0.7 USA 22
Brazil 0.6 Korea 21.1
Russia 1.5 Japan 16.3
Global Financial Stability Report-2005, IMF

So, a strong & efficient bond market and a strong banking sector offer healthy competition to each other and by complimenting each other ensure financial stability even if one source in under stress.

1. Country Background
Pakistan inherited an undersized and undeveloped financial structure after the independence. The financial structure that we have today in Pakistan is the result of many experiments, policy shifts and developments. We can segregate the eras of policy shifts & developments into following periods;

Till 1971, the primary focus was of the governments was on the development of commercial banks in the private sector and creating Development Institutions backed by government. The 1947-1960 era was marked with private sector development while the focus during the 1960-1971 was on the development of public sector institutions e.g. KPT, SSGCL, SNGP etc.

The private sector development almost clogged during the 1971-1990, owing to the nationalization policy of the Z.A Bhutto regime and non-friendly policy towards private businesses by their predecessors. The banking sector came into government’s control during this period. The government, however, followed more liberal and market based reform in the post 1990 era.

The fixed income securities market followed the similar shift as shown in the above given developments. The initial phase of the fixed income securities market is from 1947 to 1990. The government, federal as well as provincial, used to borrow on tap instruments and captive funding. Owing to the concessionary loans available from the state bank, the federal government could finance its fiscal deficits from these loans.

So, till 1990s, there was no scope for the development of an efficient government securities market that could provide a benchmark yield curve for the development of a private sector bond market

The government issued prize bonds in 1960s and some NSS schemes but since they were all on TAP so there could not develop a secondary market for them. In 1960s and 1970s the debentures issued by Pakistani corporations were listed on the stock exchanges with a very limited secondary market. Prior to 1990, the biggest issue of bonds by some corporation was by WAPDA (Table-2). This issue was a failure and the reasons are mentioned below. However, there is strong opinion that the debentures issued by WAPDA failed because the market was very immature for such kind of move.

.
Issuing Corporation WAPDA

Issuance Year 1988

Funds Generated RS 22.5 billion
Experience Failure
Reason WAPDA was unable to payback on maturity due to insufficient funds
No Secondary Market
Table-2

Post 1990 Era
The post 1990 era was marked with liberal reforms & market based reforms by the government in the economy. This is the era in which Pakistan came into the fixed income Securities Market. We can segregate the post 1990 bond market into 1) Government Debt Securities, 2) Corporate Debt Securities.

2. Government Debt Securities
The government of Pakistan has run over large fiscal deficits over the two decades. The fiscal deficit stands at $373 billion in fiscal year 2006-07 . This has resulted into the accumulation of large domestic debt of Rs. 2511 billion in fiscal year 2006-07

3.1 PIBs- Pakistan Investment Bonds
Government of Pakistan issued long term paper (FIBs) in 1992, with this came into being the long term yield curve so the corporate enteritis to benchmark and issue their own long term securities. The auction of FIBs was stopped in 1998 due to less response by the public on the declining earnings on these instruments. At that time, there was no long term marketable government security that could meet the investment needs of institutional investors. The, government, in order to develop the longer end of its debt market for creating a benchmark yield curve and to enhance the corporate debt market, decided to launch Pakistan Investment Bonds in December 2000. These bonds have the following characteristics

• Issued in five tenors of 3, 5, 10, 15 and 20-years maturity.
• Primary Dealer maintains a Subsidiary General Ledger Account (SGLA) with SBP for the settlement purpose
• Purchased by individuals, institutions and corporate bodies including banks irrespective of their residential status.
• SBP & Ministry of Finance announce the coupon rates and the target amounts after consulting each other
• Profit is Paid Semiannually

The PIBs represent 63% of total permanent debt while 13.23% of the total domestic debt by March 2007.

3.2 MTBs
Market Treasury Bills are the short term securities for government borrowing. They have the following Characteristics;
• Issued in three tenors of 3-month, 6-month and 12-months maturity
• Zero Coupon bonds sold at a discount to their face values
• Purchased by individuals, institutions and corporate bodies including banks irrespective of their residential status.
• Primary Dealer maintains a Subsidiary General Ledger Account (SGLA) with SBP for the settlement purpose
The outstanding amount of MTBs as of March 2007 is Rs. 1086.25 billion (43.25% of total Domestic Debt)

3.3 Auction Process for Government Securities
State bank of Pakistan acts as an agent for the government to raise the short term & long term funds from the market. State Bank sells the MTBs and PIBs to the 10 primary Dealers through price sealed bids auction.

The 10 primary dealers are:
• ABN Amro Bank NV
• Citibank
• Habib Bank Limited
• JS Bank Limited
• MCB Bank Limited
• National Bank of Pakistan
• Pak Oman Investment Co.
• Prime Commercial Bank
• Standard Chartered Bank (Pakistan) Limited
• United Bank Limited

The auction of MTBs is done on a fixed schedule on fortnightly basis while the auction of PIBs is done under Jumbo issuance mechanism under which the previous issues are reopened in order to enhance their liquidity in the secondary market.

Domestic Debt Profile of Pakistan-March 2007

Domestic Debt

$2511.969Billion
Permanent Debt 528.802
Market Loans 3.026
Federal Government Bonds 9.313
Income Tax Bonds 0.022
Government Bonds 0.052
Special Governemnt Bonds for SLIC ( capitalization) 0.585
Bearer National Fund Bonds(BNFB) 0.007
Special National Fund Bonds 0.001
Government Bonds (issued to HBL for settlement of CBR Refund) 9,805 9805
Federal Investment Bonds(Auction) 3.331
Federal Investment Bonds (TAP) 0.001
Pakistan Investment Bonds (PIBs) 332.534
Prize Bonds 170.126
F loating Debt $ 1086.524 billion
Treasury Bills(3 Months) 0.013
Market Treasury Bills 556.67
MTBs for Replenishment 529.994
Unfunded Debt $ 896.643 billion
Defence Savings Certificates 291041
National Deposit Certificates 0.023
Khas Deposit Certificates 0.28
Special Savings Certificates 143.528
Special Savings Certificates 0.286
Regular Income Certificates 572.23
Bahbood Savings Certificates 181.716
Khas Deposit Accounts 0.321
Savings Accounts 9.224
Special Savings Accounts 55.272
Mahana Amdani Accounts 2.479
Pensioners’ Benefit Accounts 66.903
Postal Life Insurance 67.122
GP Fund 20.723

Source-Economic Analysis Department, SBP

3. Corporate Debt Market/Statutory Debt Market
The bond market in Pakistan saw its first corporate issuance in 1995 by Packages Limited. The trend of issuing TFCs could not pick up the pace till 2000 when government stopped the institutional investors to invest in NSS which proved to be highly beneficial for TFCs. Almost all the public offers were over-subscribed, this was also mainly due to the declining interest rates offered by banks and the National Savings Schemes (NSS). There is a great potential in the Pakistani debt market that is yet to be explored. Currently the corporate debt market is 1.12% of the total GDP.
4.1 TFCs
The first TFC was issued in 1995 by the Packages Limited (Table-3).
Table-3
Issuing Corporation Packages Limited
Funds Raised RS 232 million
Issuance Year 1995
Rating (PACRA) A+
Coupon Rate 18.50%

The largest TFC was issued by PIA in 2003 (Table-4)

Table-4
Issuing Corporation PIA
Funds Raised RS 15.4 billion
Issuance Year 2003
Reason Purchase of Boeing 777s

Table-5 TFCs in Pakistan
Type of Security Redeemable Debt Security
Legislative Background Companies Ordinance, 1984
Distinctive Feature Sharia Compliance/ Interest Rate was termed as “Expected Profit Rate”
Year of First Issue 1995
Largest Issue RS 15.4 billion
Smallest Issue RS 100 million
Average Issue RS 660 million
Benchmark Rates KIBOR, DSCs
Type of Interest Rate Floating

The interest rates, however, are falling for TFCs (Table-5). A major reason can be the falling interest rates for KIBOR, NSS, PIB and discount rate (Graph-1). Moreover, the trend has shifted from non-financial institutions issuing TFCs to Banks issuing TFCs to raise their Tier II capital

4.2 Role of Credit Rating Agency
There are two credit rating agencies in Pakistan. The Pakistan Credit Rating Agency (PACRA) was established in 1994 prior to the first public issue of Term Finance Certificate in 1995. PACRA is a joint venture between LSE & Fitch-IBCA of UK. The second credit rating agency is DCR-VIS which is a joint venture between Duff & Phelps Rating Agency & Vital Information Services (a local company).

The objectives of PACRA are to provide technical assistance for establishing operating procedures, establishing mechanisms for rating, the training of professional personnel Joint handling of rating process in initial stages, a review of public information on the client and its industry, preparation of agenda for discussion with the issuer. For this the agency meets the issuer, and has a rating committee meeting. During this meeting the agency holds a discussion and assignment of rating. The issuer is advised of the rating and the rating and report is made public

Graph-1

Source: SBP & “Fostering Bond Market in Pakistan”, Farhan Hameed

4. Impediments to Bond Market Development in Pakistan
The economy of Pakistan is booming and there is a lot of potential for growth in the coming years. The governmental policies and the overall economic environment of the region promises a lot in terms of financial development, Pakistan is the fastest growing economy in south Asia and this has attracted many foreign investors. This is evident from the fact that in the fiscal year 2006-2007 the net foreign direct investment in the country was greater then $6billion. There is a vast potential that is yet to be explored in the fixed income securities market of Pakistan. There is widespread agreement among the government and private sector participants that Pakistan needs a viable bond market in order to mobilize private savings efficiently for long term investments.
We can mention here some obstacles which are in the way to create a strong & efficient bond market in the country.

5.1 Crowding Out by the Government Securities
A very big hurdle in the development of an efficient corporate bond market in Pakistan is the fact that the Government Securities and the Corporate Securities both compete for the same pool of resources. The government has the advantage of being the risk free. Government attracts savings from the retail investors through NSS while from the institutional buyers through PIBs and MTBs. Since the government securities are risk free so their rates should be less than the TFCs which have more risk than the government securities but the TFCs are priced very close to the Defense Saving Certificates which are another type of government securities with 10 year maturity and government guarantee. So this very small difference of returns between a riskless investment (DSCs) & risky investment (TFCs) make the later less attractive for the investor. So there lacks a level playing field between the government securities and that of corporate sector.

5.2 Lack of Benchmark Yield Curve
There does not exist a credible long term yield curve which hinders the development of an efficient corporate bond market in Pakistan. PIBs are the long term papers issued by the government and there are two reasons behind for which they do not form a credible long term yield curve. First the interest rates on the PIBs are not market driven, government teds to keep them low while market expects them to be high. This is why since 2004 there has been only one successful auction of PIBs and other bids were rejected. Secondly, there is hardly any secondary market for the PIBs which undermine its status as the benchmark. Due to recent scraping of PIB’s auctions, its supply has decreased in the market which has resulted into increased prices of the bond so we see that prices have increased just because of a factor of demand and supply that has nothing to do with the actual attractiveness of the security and the state of the nation’s economy.
Since government has the influence over the institutional investors so they buy government’s long term paper even at lower rates but even they don’t keep and trade the PIBs till maturity in order to avoid booking the capital losses.
Since the PIBs by now means serve as the benchmark for the issuance of the corporate bonds so TFCs are issued by the corporate entities making the floating interest rates, like KIBOR, the benchmark rate.

5.3 Administrative Hurdles
The issuance cost of TFC is a big hurdle in the way of development a strong bond market in Pakistan. In addition to the coupon rate of the bond, the costs include the stamp duty as 0.15 % of the face value, listing charges, trustee fee, advertising fee and rating charges. These issuing costs can really affect the development of a bond market. The cost of issuing in Japan was approximately 2.5 % of the face value that hampered the growth of the bond market in the country, as opposed to only 0.7% in USA.
On the other hand SECP & SBP are following discriminating policies towards the corporate bonds. State Bank of Pakistan does not consider the investment in TFCs eligible for SLR. However, SBP allowed the Sukuk Islamic Bonds issued by WAPDA to be the part of SLR “Statutory Liquidity requirement “of the banks. This shows a clear example of ad-hoc policies by the regulators. Such regulations shatter the investor confidence in the bond market.

5.4 Liquidity/ Secondary Market
Although TFCs are listed on the stock exchanges but still there is hardly any trading. In the absence of well functioning secondary market investors demand higher premium for liquidity on TFCs which increases the cost of capital for the issuing firm. World over, the bonds are traded over the counter (OTC) and large corporate issues are encouraged. The scale of issues is very small in Pakistan and that means that even small trading can affect the price which is a negative aspect.
Above all, the pricing and trading of bonds is highly complex mechanism which requires very sophisticated professionals & financial analysts which are hardly available in a developing country like Pakistan.

5.5 Non-diverse Investor Base
The major part of the government securities is in the form of MTBs and they are mostly bought by the financial institutions which use them for the REPOs. That’s why the bonds are only purchased by the banks only and are exchanged in between themselves. The diverse investor base is imperative for making the bond market less volatile and reducing the risk. A more diverse set of market players is considered beneficial to help eliminate the uniform direction and provide greater stability to the market.

5.6 Disclosure Requirements/Transparency
Pakistani investors are more risk averse and they have always been prone to invest in NSS and gold which offer almost negligible risk. The transparency requirements have to be met by the companies in order to issue debt. Lack of transparency in local private firms makes them less likely to attract the investors by issuing debt, specially the foreign investors who are used to work in very regulated and transparent environment where hardly anything is left to chance. Most of the companies lack the reputation to qualify for a rating that could elicit a satisfactory public response
5. Recommendations
The current economic circumstances in Pakistan satisfy many of the prerequisites for the development of an efficient fixed income securities market. A strong corporate debt market can flourish at the point where Pakistan is standing today with stable macroeconomic indicators and excellent banking system. However, still some steps are yet to be taken in order to take Pakistani bond market to its actual potential. Some of those steps are put as recommendations here;

6.1 Building a yield curve for the bond market
The government should create a long term yield curve for the bonds this could be achieved through ensuring regular issues of the government bonds of various maturities. However, emphasize should be on building the long term yield curve which is almost non-existent in Pakistan. A benchmark yield curve helps in the pricing of other fixed income instruments. This would not only attract the new investors but will also help in enhancing the confidence of customers on the economic policies and the local itself.

In order to ensure the regular supply of PIBs in the market, government should come up with a proper issuance calendar with clearly indicated targets. Government should borrow more from market at market rates rather than from the State Bank. Even if there does not exist a secondary market and government increases the issuance of PIBs at market determined rates, it can help create a benchmark yield curve. The lack of supply of PIBs in the market results into an artificial increase in their prices which should be avoided and the government should ensure the regular issues of PIBs even if it does not require the funds. This is because the fact that the regular issues would stop the increase in the prices of PIBs just because their unavailability and their prices would reflect their actual market worth and the state of the Pakistan’s economy and PIBs would serve as the justified and credible benchmark long term yield curve. The economic managers of the country state that the less issuance of the PIBs in last two years is due to high inflows in NSS. The government should understand that it will have to issue PIBs regularly even if it is running in surpluses. It is the same as the government raised $500 million from Euro bonds when it did not require the funds but issued the bonds just to show the presence in the international market . The similar approach should be adopted in the domestic market.

6.2 Increased Size of the Bond Market
A big hurdle in the creation of a secondary market in Pakistan has been the limited size of the issuance. The policymakers should focus on the fact that larger the size of the outstanding bond market, the larger is the turnover and the liquidity. Since the outstanding size of MTBs and PIBs is just $ 23 billion in Pakistan which is quite small. In order to create the size of the market, the government can opt for issuing the bonds for some specific maturity, mainly the long term maturity. The major chunk of the outstanding domestic debt is in the form of MTBs which are short term 6 or 12 months securities. The preference should be given to PIBs with 10 years maturity. This increased focus by government on PIBs would enhance its market size and there would be more turnover and trading in this long term government security that would give it a market based price and interest rate which would further become a justified and credible benchmark for the corporate bonds.

6.3 Stopping Institutional Investors from NSS
The government of Pakistan barred the institutional investors to invest in NSS in 2001 but it has allowed the institutions to invest in NSS. This would damage the market for TFCs since the institutions would invest largely in NSS. The government should also lower the interest rates on NSS as they serve as the benchmark for the long term corporate funds and since the current rates are high on them so they make the rates on corporate bonds higher. Since the NSS certificates are usually not held to maturity so actual cost of debt is even lower so this further distorts the rates on corporate bonds.

6.4 TFCs as the part of SRL
The SBP should accept the TFCs of blue chip companies as the part of SLR, statutory liquidity requirement. This would not be a big deviation from the current policies as SBP accepts the NIT units as the part of the SLR which is similar in nature to a TFC and NIT certificates are not rated by any rating agency but a company that issues TFCs is a rated company so SBP should reconsider its policy towards TFCs. This would increase the marketability of TFCs and Banks and other Non Banking Financial Institution would be more interested in buying TFCs for Repos purpose.

6.5 Diversifying Investor Base
Currently the majority of bondholders are financial institutions i.e. banks. Retail investors and foreign investors have much smaller participation in the bond market. This small investor base gives rise to a one-way market. A sort of cartel has developed and only a few buyers are able to dictate the terms. The government could increase the customer bade by targeting the retail customers. For this purpose, the government can use the channel it uses to sell prize bonds to local investors. Since the government has infrastructure available for selling the prize bonds so there would be less costs related to this new approach. This more diverse set of market players will be beneficial in eliminating the uniform direction and will provide greater stability to the market.

6.6 Investor Awareness
The government should announce the calendar for the auctions of the bonds and this should be communicated to the potential investors. The aim of announcing should be that people should know ahead of time and it should be seen as continuity, predictability, and transparency in issuing bonds. The prices and rates should be given immediately in the local newspaper as well as on the website of SECP & SBP.

6.7 Availability of Professionals
as mentioned above, the mechanism of bond market is highly complex and integrated so pricing and other related activities is very challenging and requires exceptional professional skills which are scarce in Pakistan, even in many institutions. Most of the investors, both retail and institutional, fail to gauge the sentiment of the market and opt for the buy & hold strategy. State Bank and SECP should conduct regular investor awareness seminars of international standards. SECP & SBP should offer the training programs to professionals to make them equipped with the skills needed to work in bond market. The SBP, SECP, Leading Banks, Brokerage Houses and other financial Institutions should work closely with the top business schools of the country (NIMS, IBA, and LUMS) to equip the students of finance & accounting with the skills which are needed by a professional to work in a bond market.

6.8 Risk Management/ Hedging Instruments
Hedging instruments are essential to mitigate the risk associated with the bonds and enhance the investor confidence and thus create an efficient and liquid bond market. Government should encourage the institutions to come up with interest rate futures and bond futures and these futures should be allowed to be traded on the stock exchanges in order to provide them liquidity.

6.9 Administrative Reforms
The government should ease the issuance procedure of TFCs at SECP and remove the administrative hurdles. So, the companies would be more motivated to issue TFCs. The government should revise the stamp duty on TFCs. SECP should be proactive in its approach. With the passage of development, there would be new kinds of debt securities in the Pakistani market; the SECP should be ready to formulate policies for such securities.

6.10 Stopping the Municipal Bonds
The government should only issue bonds at the federal level and no provincial and municipal government’s should be allowed to issue bonds as they don’t have an income of their own and are dependent on the federal and the provincial government for the allocation of the resources. Generally the municipal administrations are in deficit coupled with corruption and mismanagement of resources has lead to the malfunctioning of the municipal government. The issuance of the municipal bonds would only lead to the default and putting the federal bonds credibility at stake.
Conclusion
Developing a well-functioning, deep and liquid bond market is not an easy task. The scenario in Pakistan is much more conducive today for the development of an efficient strong bond market than a decade ago but still much is left to be done. Relevant institutions, both from government & public sector, will have to be very well focused and work collectively for the bond market development in Pakistan. It may take a long time in turning today’s Pakistani bond market into an efficient one that comes at par with those of developed countries but if Pakistan makes the structural adjustments today, the affects would start to become visible in the recent future in the form of benefits sought. If we recall the words of Mr. Allan Greenspan, the former chairman of the Federal Reserve, Pakistan still does not have that “spare tire” of that economy that can hedge against any possible financial & economic crisis in the future. Today we have to make a well directed and calculated effort to provide the country with this “spare tire” and a strong shield against any possible catastrophe.

[1] 2nd SBP Conference, Call for Papers, Fixed Income Market Development in Emerging Market Economics.
[2] Barbie & Martin, 2001, “Government Debt as Insurance against Macroeconomic Risk”, Paper Abstract
[3] Allon Greenspan, Former Federal Reserve Chairman, Speaking to a delegation of Financial Professionals & Economists in Sundaresan University, Columbia, 2005
[4] Arif, M., 2006, “Developing Bond Market in Pakistan”, Research Paper Presented at SBP conference held at Karachi
[5] Associated Press of Pakistan, Budget Statistics
[6] Daily Times, Sunday, 20th May 2007
[7] FSCD Circular No. 1 of 2007, SBP
[8] Luengnaruemitcha and Ong, 2005, “An Anatomy of Corporate Bond Markets: Growing Pains and Knowledge Gains”, Research Paper
[9] Dr Ashfaq Hasan, Economic & Business Review of Daily ‘DAWN’ on March 15, 2004
[10] McCauley & Remolona, Their Statement about the minimum size of the Bond Market.
[11] Pongpen Ruengvirayudh, “Fixed Income Market Development in Emerging Market Economies: Thailand”
[12] Farhan Hameed, “Fostering Corporate Bond Market in Pakistan”, 2006, Research Paper presented at SBP conference
[13] Ms. Uzma Khalil, “The Development of Debt Securities Market- Country Experience of Pakistan”, 2004, Research paper written for World Bank Seminar on Strengthening Bond Market in Pakistan.
[14] Shabbir H. Kazmi, “A Growing Market for TFCs”, 2000.

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