Sagit column – Bond market: sunny desert, cloudy outlook

By Addmore Chakurira

OVER the past four to five years the bond market has been virtually non-existent, having last been slightly active around 2000/1, when interest rates and year-on-year inflation were stil

l around 50%.

Fixed income investors have been forced to invest passively on the bond market due to the lack of liquidity and attractiveness of returns on the secondary market. The unattractive features and lack of issuance of bonds has been to the detriment of pension funds, insurance companies, asset management companies as the prescribed asset ratio has not been met thus the funds for developmental purposes have been hard to come by.

Essentially, bonds involve lending money for a specific period of time at a fixed rate of interest. Generally, bondholders have a senior claim to a company’s assets in the event of a corporate “restructuring”, hence they are more secure (as compared to equity investments).

The bond market offers a reliable alternative to banks and other lenders who might demand less attractive financing terms than the capital markets are able to provide such as a higher rate of interest. Ultimately the cost savings derived from bonds benefit both taxpayers and shareholders by lowering the borrower’s overall expenses.

Bonds can be issued by both public (government, local municipalities, parastatals), and private sector (both privately held and publicly traded corporations) for major fund raising drives. These could be agro bonds for agriculture development, mortgage-backed securities ie bonds created from mortgage loans, corporate bonds, bonds issued by Zinra for road development and maintenance, Zesa for rural electrification, NRZ for railway line maintenance.

Bonds can also be used to bolster tier one capital adequacy ratio; fund share buy-backs, dividends, or empowerment deals and lengthening the funding profile of a consumer credit book. For investors bonds can help in preserving capital, supplementing income, and enhancing total return. The beauty about fixed income securities is that they afford investors an enormous amount of flexibility to receive interest payments on a monthly, quarterly or semi-annual basis.

In the fixed income market, “the yield curve” (which is pivotal to the issuance and trading of bonds) refers to the central bank’s treasury yield curve, constructed from the yield-to-maturity of the bank’s treasury securities ranging from short to intermediate to long maturities.

The treasury curve is usually upward sloping, meaning the yields (or spot rates) on short-term maturities, are lower than the yields on intermediate and long-term maturities, ie investors demand a premium to entice them to invest for longer terms.

However, short-term yields can be higher than yields on longer maturities, producing an inverted treasury curve (which has and is the prevailing shape of the curve on the local market), largely as a result of the depressed interest rate regime. This allows for short-term interest rate arbitrage opportunities and discourages savings.

That said, under the current environment investors are expecting to earn more for a longer holding period; thus, the yield curve should reflect expectations about where interest rates and inflation are headed. So, the two-year treasury yield is anticipated to be higher than the one-year yield, thus the market is expecting inflation and a high reinvestment risk between years one and two. If this notion is anything to go by then the yield curve should be upward sloping and this might result in an increased level of activity on the bond market, thus encouraging savings and freeing funds for national and economic development.

Falling interest rates make outstanding bonds more attractive, while conversely, rising interest rates cause fixed rate securities to lose principal value. Regardless of a bond’s fluctuating price during its lifetime, the principal of the bond is returned at face value when it matures.

With the Reserve Bank of Zimbabwe (RBZ) having made it clear that it intends to make compounded returns in the 10 to 20 percentage points region above the prevailing inflation rate for overnight accommodation, a near-term interest rate increase is unlikely. Given that core CPI has been heading decisively lower and that momentum is anticipated to be maintained, y-o-y inflation is expected to eventually stabilise over the next two years.

The RBZ is expected to continue cutting rates as needed, subsequently bond prices will raise. Tradability on the secondary market can pick up providing for greater market liquidity enhanced by strong demand from investors seeking ways to enhance the overall yield in their fixed income portfolios.

The budget deficit, which is projected could reach upwards of $1 trillion this fiscal year, promotes a significant need for government securities issuance exacerbated by the need to restructure government and quasi-government debt. The restructuring of government debt might result in the reintroduction of bonds and a more robust auction schedule, particularly for long dated paper.

Even in this not-so-favourable environment bonds can still be issued and traded although these need to be structured to suit the operating environment. Inflation-linked bonds, which have their coupon rate linked to the prevailing inflation rate, might prove attractive. Instead of issuing the special treasury bills to mop excess liquidity, the RBZ could have issued a modified callable or an inflation linked bond.

In callable bonds, bonds issuers sell redeemable debt in order to give them the flexibility to purchase or call the bonds prior to maturity after a specified date. Thus making good economic sense to issuer in a falling interest rate environment since it allows them to raise the same amount of debt at a lower interest rate.

“Make your money in stocks, but keep your money in bonds” is an old Wall Street adage.

Information contained herein has been derived from sources believed to be reliable but is not guaranteed as to its accuracy and does not purport to be a complete analysis of the security, company or industry involved. Neither Sagit Financial Holdings nor its subsidiaries/affiliates accept any responsibility for liabilities arising from use of this article or its contents.