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BR Research

Bond auctions: Build long term market first

The cat and mouse game between the treasury offices of Q blocks and big banks continues. In a PIB auction earlier...
16 Oct 2020

The cat and mouse game between the treasury offices of Q blocks and big banks continues. In a PIB auction earlier this week, participation was too low. Some may say that market wants rates based on forward looking inflation, while the ministry is keen on issuing at rates linked to prevailing policy rate. But there is a fundamental flaw in this argument.

What people are referring to as ‘market’ is commercial banks where dominance of a big few is a norm. Commercial banks globally are not the buyers of bonds and the case is even more pronounced for Pakistan. In fact, there is no big buyer(s) of fixed rate bonds in Pakistan.

Banks have no need for long term bonds on their balance sheets. Hence, they would only indulge when it is time to mint money. Cases in hand are over Rs2 trillion issuance of PIBs in 2014 and over Rs1 trillion in 2019 – both at peaking rates. And in the following years, banks’ profitability grew due to capital gains. The SBP likes this policy as central bank’s performance is linked to stability of banks. If banks are making huge profits by investing in risk free government bonds, then regulator’s performance is better too.

The IMF rightly wants government to increase its debt maturity profile; but the modus operandi is wrong. The buyers of long term bonds are usually pension funds and insurance companies. The issuers are usually government, private sector, infrastructure and mortgage refinance companies.

Banks’ business is mostly in floating rates loans and that is good enough to cater to their low maturity liabilities. In Pakistan, banks’ liability maturity profile is even lower. Around two -third of bank deposits are in current accounts and saving accounts (CASA). These are demand liabilities and can be called any time. Within time liabilities, around 80-90 percent of fixed deposits maturity is below one year. Thus, overall deposit maturity of banks is around 6 months or low. How can such banks take long positions in fixed rate bonds? They would only do when they can make a killing. They did this in the past and are doing right now.

One cannot blame banks to have this approach. One cannot blame SBP to support banks for this approach. One cannot blame ministry of finance to not accept these. And one cannot blame IMF to push for enhancing maturity profile of government debt. The problem is that the overall risk and return matrix is misaligned. The better way to move forward is to build market for long term buyers and then push government to increase maturity profile.

The need is to develop pension, insurance and long term mortgage markets. Not so long ago, Punjab Pension Fund had to take permission for investing beyond 6 months’ maturity papers. Not so long ago, institutional investors were allowed to invest in NSS – mostly private pension and provident funds were investing in it. The government needs to end all such kind of distortions in the market.

There should be a carrot and stick approach for developing pension and insurance markets. The culture is required to be inculcated. Recently, SBP has made it mandatory for banks to carry 5 percent of loan portfolio in housing and construction (including mortgage consumer finance) by Dec 2021. This will create space for the development of mortgage refinance companies – PMRC is in the process of issuing Sukuk of Rs2-3.5 billion. More such issuances in conventional and Islamic bonds market are required.

There should be incentives for private sector pension funds and insurance issuances. It’s a known fact that pension bomb is in the making in the public sector – be it federal or provincial. Most of these pensions are unfunded. That has to change, and this will create a market for long term bonds.

This practice of reliance on banks for buying long term bonds is hitting taxpayers hard. Since banks do not need long term fixed bonds, they are opportunists. They only come when there is easy money in the making. Else, they rely on short term papers and floating bonds. This is evident from the fact that irrespective of rates, investing in T-Bills by banks never stopped. Now the ministry is offering floating bonds and there is appetite. This should continue. But for issuance of long term bonds for improving maturity of government debt, the first step is to build a market for this. Or else, repeat of 2014 and 2019 will continue and the debt profile will keep on improving and worsening with interest rates cycles.