Bond Market in Pakistan

Financial Institutions
Abul Hasan Masood (9219)

Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219)

Introduction of Bond Market

The bond market also known as the debt, credit, or fixed income market is a financial market where participants buy and sell debt securities usually in the form of bonds.

Background
Bond markets play an important role in mobilization of capital. The investments are very necessary for economic development of a country. A good market will help promote economic growth and reduce the risk of financial crises. To improve the efficiency of the bond market what can be done is that financial market regulation and supervision should be strengthened, market infrastructure should be enhanced, new investments areas (products) for better mobilization of savings and improvement of investor bases. 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 governments control during this period. The government, however, followed more liberal and market based reform in the post 1990 era.

Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219) 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. 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

Today, the bond market is composed of Pakistan investment bonds, corporate bonds, Sukuks and commercial paper. Overall this market is 5% of GDP at the moment which is very small as compared to other economies.

Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219)

Significance of Bond Market for Pakistan

Bond market is of great significance to a country that faces large budget deficits, like Pakistan. Generally a well developed bond market is important for these reasons:

Increasing the competitiveness and efficiency of the financial system, which here is dominated by large banks. At micro economic level development of securities market helps change the financial system from bank-oriented system to multi layered system where capital markets can complement bank financing.

Enhancing the stability of the financial system by creating alternatives to banks, that will reduce the power of banks simply

It provides a resort for domestic funding and budget deficits other than by central bank

Bond market helps in the implementation of monetary policy, including achievement of monetary targets or may be inflation objectives

The development of bond market can force the financial intermediaries to develop other products like Repo, Structured finance and Derivatives.

Cost of debt servicing can be reduced through funding of Government Budget deficits on market-oriented funds.

Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219) Further I can say development of local bond market provides: Diversification of financial sector into equity, debt and bank financing Effective allocation of capital competition in financial sector Supports infrastructure development, privatization, securitization, and the rise of new institutional investors requiring long term assets to match long term liabilities Reduces the currency, interest rate and funding exposures risks Allows more efficient allocation of savings by reducing banks role that also reduces the element of political interference Allows borrowers to use capital that is tailored to their assets and operations Provides retail and institutional investors with several high quality and liquid domestic saving vehicles.

Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219)

Objectives of Bond Market

To establish a free market that encourages the widest participation of ownership in enterprises A free market that regulates itself Enhance the democratization of wealth Promote the development of the capital market Protect investors Ensure full and fair disclosure about securities Minimize insider training and keep the market efficient up to the possible limit

Development of bond market

Following are the essential areas which are necessary to be developed for realization of fixed income market in Pakistan.

Money market and Monetary operations Issuance strategy, market access and debt management framework Developing benchmark issues Investor base Primary market Secondary market Settlement infrastructure Legal and regulatory framework Taxation policy Linkages of sub national/Private sector bonds with government bond market Sequencing of development

Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219)

Plan for the development of bond market

There cannot be any doubt that financial system of Pakistan has a lot of potential, however, it is to be searched and put in place. Another angle, which needs to be brought into the system, is to integrate it with global financial system. The vision, which anybody can have in the market for the future financial system of Pakistan, can be briefed as :

It has to be market based The market should have its own policing system in addition to Regulatory framework. Development of new hedging products like derivatives. Updating of accounting/auditing and reporting system in line with the international standards. Fully automated financial system. New Government Securities Act to replace out dated Public Debt Act 1944. Listing of Government Securities on Stock Exchange to widen investor base. Implementation of Real Time Gross System to mitigate systematic risk in fund settlement. Bond stripping to create liquidity in the bond market and to induct zero coupon yield curve. To foster growth of corporate Bond market in Pakistan by making it cost effective. To develop trading/Risk Management/Price dissemination mechanism for Corporate Bond Market. Financial Institutions to have controls i.e. Clear Strategies of duties at all levels, Dual Controls, Rotations of assignment of duties, Internal auditing of all operations, Audit programs for external auditing, Operational reviews

Development of newly inducted Islamic finance

Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219) Development of investor base specifically Mutual Funds Development of Sub National Bond Market in Pakistan Development of Infrastructure/Mortgage Finance

Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219)

Bond market in Pakistan

Current status and Overview
Liberalization of the financial system and the switch from credit planning to a market based monetary policy has created a secondary market for government bonds in Pakistan. Trading in treasury bills and in short-term federal bonds provides the basis for open market operations of the state bank.

In 1991, the government with the consultation of World Bank, started issuance of two types of securitiesone of short-term maturity and the other of long-term maturity on the basis of auction through the intermediation of primary dealers, i.e. treasury Bills (short-term) and federal investment bonds (long-term). The salient features of the treasury bills are as under:

T-Bills
The bills are issued at a discount. The investors are required to quote the price at which they are willing to buy t-bills of Rs.100 face value. Individuals, institutions and corporate bodies including banks/DFIs are eligible to purchase the bills. The principal and profit accrued thereon is guaranteed by the government. Principal and profit is payable on maturity. T-bills can be traded freely and are transferable by endorsement and delivery. Tax is deducted at source under the Income Tax Ordinance 1979.

Federal Investment Bonds

Bonds are of three different maturity periods viz. three years, five years and ten years. Shortterm FIBs have also been issued.

Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219) Individuals, institutions and corporate bodies including banks, irrespective of their residential status can purchase bonds. There is no quantitative limit on purchases. Bonds are redeemable at par on completion of their respective maturity period. In case cash is require before the maturity date of the bond, the investor may approach his banker et his bonds converted into cash at the market price. In the manner, the government bonds can be traded freely in the secondary market before their maturity date. Each bank is required to display daily sale and purchase prices of bonds at their main branches in major cities.

WAPDA, NDFC, BEL, PICIC, and some other firms have also issued non-government corporate bonds and certificates. Trading is very limited. Investment banks which were expected to play a major market-making role have not succeeded in doing so. Term Finance Certificate (TFCs) has been issued by financial and manufacturing companies from time to time. 62 TFCs instruments have been issued on the KSE during 1996-2003 (21 of these were issued in 2002-2003). The secondary market is shallow and largely confined to the public debt sector. The range of financial assets available is limited. The growth of the secondary market has been restricted by the expansion of the national saving schemes (NSS), which are very popular with the public. Rates of return in the secondary market are generally lower than those offered by the national saving schemes although rates on these schemes have been drastically reduced during 2000-2002. The growth of the secondary market is limited by the interventions of the government in the auctioning process to hold down interest rates. Such intervention has been reduced since 1997, when the autonomy of the state bank was recognized through the amendment of the State Bank of Pakistan Act 1962.

About Rs.5 billion worth of TFCs were issued during 1995-2000. There was major upsurge in 2002 but the secondary market in TFCs is much undeveloped. Pakistan Investment Bond issues are significantly larger (exceeding Rs.100 billion in 2001-2002 for example). A

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Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219) secondary market has not developed in PIBs and PIBs are not regarded as a capital market instrument. The public is not informed of what the government does with the money raised through Pakistan Investment Bond issues.

Hindrances in development of Bond Market

Fiscal and Trade Deficits Law and Order Problem Bad Governance, lack of accountability on the part of bureaucracy, Public and Private Sector institutions. Ineffective Implementation of law and delay in adjudication Lack of market expertise Lack of awareness of new financial products Lack of infrastructure and automation Lack of stringent regulatory policies and their effective enforcement. Lack of self-policing system in the market. Lack of awareness of market ethical values. Political interference in the regulatory functions. Clear laws curtailing clear interpretations Inconsistent supply and small size issues of Government Bonds. Corporate Bond market being not cost effective due to stamp duties levied by the issuance and time taking procedure for their approval. Non issuance of sovereign Sukuk. Transaction cost as stamps duties on Commercial Paper making them non cost effective.

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Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219)

Action plan for development of Bond Market of Pakistan

Create depth in money and securities market to improve the transmission channel of monetary policy. This would facilitate investors/issuers to have better view of interest rate movements. This includes introduction of SBP own instruments, review of monetary policy execution framework to switch over to explicit interest rate targeting, establishment of Market Stabilization Fund (an arrangement in which government share the cost of monetary policy operations with central bank), capacity building of DPCO, Projections of Government Cash flows. Building up institutional and market microstructure for developing Government securities market in Pakistan i.e. developing distribution channel through market makers and dealers having expertise in securities business. Keeping consistent supply of large size long-term government instruments for creating liquidity and proper yield curve. To achieve this goal, reopening, stripping and fundability need to be allowed Timely market information to the issuers as well to investor through data dissemination. Diversifying the investor base. The steps include development of Asset Management Firms/Mutual Funds/Discount Houses to diversify investor base through legislative support. Containing crowding-out effect through reducing deficit financing for developing Corporate Bond Market. Creating appetite for bond market by supporting Islamic Fund Industry, Mortgage and Infrastructure Finance initiatives. Building Bench mark curves i.e. Revaluation, Clean, IRS, zero coupon curves. Aligning Sub National/local Governments/Public Sector requirements with

Government Bond Market by providing them same infrastructure.

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Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219) Reducing fees/Stamp duties on Corporate Bonds/Commercial papers to make them cost effective. Allowing Supranational Bonds in Pakistan to create liquidity in Corporate Bonds Market and to have best international practices through their presence. Attracting non-resident investors by providing them better opportunities to have positive yields by extending some concessions like tax exemptions. New legislation aligned with current environment for Government as well Corporate Securities Market. Creating tax base on equity providing level playing field to all investors. Allowing international depositories linked with domestic depositors for facilitating international investors to invest in Pakistan. Establishing cross border settlement mechanism. This would reduce cost of doing business in own and with others markets. Developing Derivatives market for facilitating investors/issuers to hedge the risks on their portfolios. Developing Bond Market in sequenced manner i.e. from simple to complex instruments/infrastructure.

For developing above Government as well regulators (central bank and securities commission) to work together in devising policies and then coordination in their implementation process.

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Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219)

Appendix

Pakistan's bond market on a rising trend

By: Erum Zaidi | Published: November 20, 2010

KARACHI - The Government raised a net amount of Rs64.31 billion, as against the target of Rs60 billion, through the auctions of Pakistan Investment Bonds (PIBs during 2009-10 (FY10) mainly due to reopening of the previous issues throughout the year, according to SBP Annual Report on the working of the Bank (Performance Review) for the year 2009-10 released recently. The report stated that investors seemed most interested in 10-year PIBs, as about 60 per cent of the money was raised through this tenor. As a result of these borrowings, the outstanding balance of the PIBs increased to Rs 505.29 billion at the end of FY10 compared to Rs 440.99 billion at the end of FY09.

MARKET TREASURY BILLS A net amount of Rs467 billion (face value) was generated by the Government by means of Market Treasury Bills (MTBs) in 2009-10 compared to net Rs304 billion in the previous year. A total of 25 auctions were held by SBP during the year in which the primary dealers offered an accumulative amount of Rs3.2 trillion against the target amount of Rs1.36 trillion. In an effort to broaden the investor base, SBP allowed non-competitive bids in June 2009 - a process that allows individuals, small investors and non-banks to invest directly in MTBs. A total amount of Rs20 billion (face value) was raised through non-competitive bids during FY10. Mutual funds remained the most active non-bank investors in the MTBs capturing 63 per cent share in total amount raised via noncompetitive bids. SBP is also working in collaboration with National Institutional Facilitation Technologies (Pvt) Ltd, to develop a

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Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219) web portal where retail investors will be able to place noncompetitive bids directly in each auction, Report said.

GOVERNMENT IJARA SUKUK The issuance of Government of Pakistan Ijara Sukuk which had been a longstanding need of Islamic banking industry has also served as a new source of funds for the Government. The Report revealed that during FY10 government conducted only one Sukuk auction of 3year tenor amounting to Rs15.32. A total of four tranches of GoP Ijara Sukuk had been issued since its introduction in 2008 amounting to Rs42.24 billion.

E-BOND: ELECTRONIC BOND TRADING PLATFORM As a major step in the development of fixed income markets in Pakistan, an electronic fixed income trading platform provided by Bloomberg called EBND was launched on January 11, 2010. The platform is currently being used for trading of government securities only; however, it has the capacity to support trading of corporate debt instruments as well. EBND which is already in use in 18 countries has the following key features:

A central display provides the best live quotes by price makers of all outstanding issues. Dissemination of real time information to investors on transactions in fixed income market. Price takers can approach multiple price makers for firm quotes. Choice for price makers to enter and trade on firm, anonymous orders. Facilitate for users to customize their counterparty credit database. Option to manually input any bilateral deal which is not concluded on Bloomberg through a Voice Trade Capture feature.

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Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219)

Although this is a front-end system, straight through processing interface is possible with local settlement systems and banks internal systems as it is based on FIX protocol.

The report predicted that the introduction of this platform is expected to provide not only a boost to fixed income market; it also has a lot for all market participants. The availability of real-time information about yields and turnover will help the issuer in determining demand for its paper and make better funding decisions. Moreover, the platform is likely to attract more investors to the market as the price discovery process becomes much easier resulting into enhanced liquidity and lower liquidity premium.

This will also result in further development of liquid yield curves for various market segments. With the availability of a widened investor base, banks would be able to shift Govt debt from their books freeing up funds for private sector credit, it said. The fact that Bloomberg is offering its services in all major financial markets in the world is another advantage of the system as it will provide international investors with an additional window on Pakistans economy, it added.

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Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219)

References
Money and banking in Pakistan, fifth edition, SA Meenai, oxford university press,2004 Bond market development in Pakistan, Muhammad Muavia Nov 2005 Bond market development in Pakistan by Muhammad Arif 2007 The Nation November 20th 2010

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Bond Market in Pakistan

Financial Institutions Abul Hasan Masood (9219)

Contents
Introduction of Bond Market ........................................................................................................ 1 Background .................................................................................................................................... 2 Significance of Bond Market for Pakistan .................................................................................... 4 Objectives of Bond Market ........................................................................................................... 6 Development of bond market....................................................................................................... 6 Plan for the development of bond market .................................................................................. 7 Bond market in Pakistan................................................................................................................ 9 Current status and Overview .................................................................................................... 9 T-Bills ........................................................................................................................................... 9 Federal Investment Bonds ........................................................................................................ 9 Hindrances in development of Bond Market ............................................................................. 11 Action plan for development of Bond Market of Pakistan ....................................................... 12 Appendix ....................................................................................................................................... 14 Pakistan's bond market on a rising trend ................................................................................. 14 References ................................................................................................................................... 17