Corporate bond market development

The Securities and Exchange Commission (SEC) set up a Corporate Bond Development Task Force (CBDTF), consisting of a cross section of market participants, to identify impediments, formulate strategies and an action plan to develop a vibrant corporate bond market as an initiative of the Capital Market Development Master Plan. This article presents a summary of key findings by the CBDTF.

A well developed corporate bond market has a significantly positive impact on the country’s economic growth and the financial system stability. It helps firms raise long-term capital at relatively lower costs and provides investors with long-term investment instruments.

It plays a vital role in risk diversification of the financial system, through providing a cushion to reduce vulnerability of the macro-economy to both external and internal shocks.

The corporate bond market in Sri Lanka is relatively underdeveloped with a total outstanding of Rs. 19 billion listed corporate bonds as at end 2007, which is about 1.4 per cent and 2.2 per cent of the total Government bills/bonds (GSs) outstanding and the equity market capitalisation respectively or 0.5 per cent of the GDP as at the end of 2007. Compared with other Asian countries, the size of the corporate bond market in Sri Lanka is significantly smaller as shown below.

The issuer and investor bases are very narrow. The secondary market hardly has any liquidity. There are no active bond traders and market makers.

There is also a sizable unlisted corporate bond market where the primary market is loosely regulated, whilst the secondary market is not regulated at all. The lack of a reliable benchmark yield curve, anomaly in the interest rate structure, coupled with the lack of transparency in the GSs market are some of the causes for inappropriate pricing of corporate bonds, resulting in bond financing being relatively more expensive than bank borrowings.

The lack of general awareness on the corporate bond market, the limited number of qualified issuers and the current high interest rate environment also contribute to the lack of supply of corporate bonds.

The limited number of intermediaries engaging in the corporate bond business, their narrow distribution channels and the underdeveloped unit trust industry has made it difficult for investors to access the corporate bond market. Institutional investors such as pension funds and insurance companies which play a vital role in the development of the market in other countries do not actively participate in the corporate bond market. The current high volatility in interest rates, together with the absence of risk management tools has discouraged investors to actively trade corporate bonds.

The distorted tax treatment on corporate bonds and the lack of market transparency have further limited the activities in the secondary market.

The unregulated, unlisted corporate bond market and the limited role and responsibility of bond trustees could lead to loss of investor confidence in the market. The current settlement system has a potential systemic risk exposure due to the utilising of a single settlement bank.

The widening and broadening of the issuer and investor based are the first steps for the development of the corporate bond market, which includes encouraging potential issuers such as SOEs and Public Private Partnership (PPP) projects to issue bonds, creating a secondary mortgage market, establishing a reliable benchmark yield, correcting anomaly in interest rate structure, improving awareness on risk-reward structure, greater participation of institutional investors and relaxing the restriction on foreign investor participation.

The market access needs to be improved through enhancing and creating distribution channels to reach investors, developing the unit trust industry and improving skills and expertise of intermediaries on corporate bonds.

Improving market liquidity and the price discovery mechanism is a key to developing secondary market activity. This will include enhancing the market transparency and information availability of GSs and corporate bonds, developing tools to facilitate the liquidity creation such as repo and borrowing/lending of corporate bonds, interest rate derivative instruments and removing the distorted tax treatment of corporate bonds.

Laws and regulations need to be expanded and strengthened to enhance bond holder protection and create an effective regulatory framework for the corporate bond market, including expansion of the SEC’s regulatory framework to the unlisted securities market and unregulated key intermediaries in the bond market and a streamlining of the present regulatory arrangements in the corporate bond market.

Creating a robust depository and settlement system will reduce the systemic risk, including the mandatory lodging of securities in the CDS, strengthening the fund settlement mechanism, thereby creating an efficient depository and settlement system for unlisted bonds as well.

These initiatives have to be supported by a series of awareness building and education programmes related to fixed income products targeting issuers, investors, intermediaries, regulators and financial journalists to improve their financial literacy on debt market products and develop their technical capacity.