ECONOMYNEXT 0 Listed debentures have mushroomed over the last two years after the State made them tax free in an attempt to boost the debt market.
While it has brought results, the move may also undermine the development of an orderly market based on credit fundamentals.
It has also created a tax shelter for the rich, while the state taxes basic foods like potatoes, cereals, milk and canned fish in a bid to force less affluent workers to bow down to the desires of autarkists.
Most state interventions, which favour sections of the citizenry or one type of economic activity against another have unintended consequences. Such interventions often do not even achieve the objective they set out to do.
Tax breaks to start venture capital companies for example gave tax free luxury cars to their founders but little else.
There was a time when interest on corporate debt and government debt was treated differently. Removing that anomaly was a step to end discrimination and mistreating of citizens by rulers, promoting just rule of law in the process.
With tax free listed bonds, rule of law is undermined not by imposing a new restriction on the freedom of private citizens, but by creating an imbalance between listed issues, bank deposits and state debt.
Positives
In this case the intention of the regulators – to boost the listed debt market – has been achieved.
Large volumes of money has been raised through tax free debentures. In 2014, 54 billion rupees of bonds were sold.
Some companies sold listed bonds and repaid bank loans. This is also good as buyers get a better return and borrowers pay a lower rate with intermediation margins being small or non-existent in debt markets compared to banks.
The first few companies that came to the market were also the larger, stronger companies with better credit ratings, or a lower chance of default. Some were already in debt markets.
There were very few small investors in these bonds. They were snapped up by banks themselves.
But there are two emerging dangers, especially with bank interest rates now very low.
Risk Awareness
In an unhampered market operating efficiently individuals, will buy debt keeping in mind default risk. If there is sufficient information, investors will eventually assess the default risk and demand a higher return from riskier companies through the market.
That is why finance companies have to pay higher rates than banks.
Credit ratings also help the market better understand the likelihood of default.
In Sri Lanka, a great deal of effort was put by authorities such as the Central Bank over decades to set up rating agencies starting with what is now known as Fitch.
With the ending of its monopoly, there was more competition. Issuers should be free to go to the agency that perhaps gives them a better price for example.
However concerns emerged, after some companies left Fitch soon after being downgraded and went to the other two rating agencies.
While it is quite understandable for companies to switch rating agencies if fees are higher, when companies leave agencies just after a downgrade to another, it raised questions.
The license of Lanka Ratings earlier know as RAM Ratings, was withdrawn by the regulators earlier this year, amid questions about it methodology among others.
Ratings Shopping
Of course when an issuer moves to another rating agencies, soon after a downgrade, vigilant investors may conclude that the second agency was chosen because it offered a better looking rating, a practice known as ‘ratings shopping’.
Ratings shopping is defined as a situation where an issuer chooses a rating agency that will assign the highest rating, or choose one that has the most lax criteria.
There have been attempts to bring rules to prevent or discourage ratings shopping in other markets and the debate has intensified in aftermath of the burst credit bubble leading to the Great Recession.
A regulation that requires a minimum of two ratings for example is intended to discourage ratings shopping.
The US Securities and Exchange Commission SEC has anti-ratings shopping regulations such as its SEC Rule 17g-5 which requires agencies to disclose underlying information on how it arrived at a particular decision. This has opened the door to unsolicited ratings by other agencies using the information provided. But ratings agencies of course did not originally emerge as part of regulatory moves like in Sri Lanka. They were products of the people acting in markets and were built solely on their reputation and usefulness to market participants.
That means over time the market will eventually perceive that an ‘A’ rating given by an agency that consistently accommodates ratings shoppers is in fact a ‘BBB’ or below, with or without regulations.
But for investors to take ratings of some agencies with a pinch of a salt, takes time. It will happen after defaults come.
Eventually such perceptions or ‘rules of nature’ established by markets will be more effective than any regulation brought by force. In the meantime however, some investors who do not have all the information will be misled.
Because rating agencies were established here with a regulatory push, people just believed them without any track record of defaults.
The Securities and Exchange Commission however has taken early action.
Tier II Risks
Investors in Sri Lanka also do not seem to have enough information about Tier II bonds sold by banks. Tier II bonds are like shares and will be used to repay band deposits.
But unlike shares they cannot participate in dividends and capital gains that are available in good times. In ‘good times’ their yield can be low.
Tier II bonds were devised in the West and were targeted at institutions who were supposed to be better qualified to ‘keep an eye’ on banks than individual depositors.
Several countries in Asia, including India and Thailand have banned small savers from buying Tier II bonds, since the idea behind the bonds was to get investors with deeper pockets to take the hit and repay small depositors.
One can correctly argue that it is up to the retail investor to lose their money and buy Tier II bonds if they want to and no regulatory compulsion to save them from their own is needed.
In that sense Sri Lanka’s markets are freer than in India and Thailand.
But investors do not seem to make much of a distinction between Tier II bonds and other bonds and there has been not much debate on the issue here. As a result an information gap may be exist.
It may be good idea for the Colombo Stock Exchange and Securities and Exchange Commission to flag the Tier II bonds in prospectuses with a caveat that while such instruments carry almost the risks of equity while giving fixed income style returns.
Information is better than regulation, and our framework of disclosure regulation is also based on that simple basis.
Credit Confusion
In a market where rating agencies are still developing, and ratings shopping has only just started here, the tax breaks can further confuse perceptions of credit fundamentals.
Many investors seem to be buying the bond simply because of the tax break, throwing credit fundamentals to the wind.
Unlike loans taken from banks with regular repayments, where borrowers start paying back bit by bit, these bonds have bullet repayments. Sinking funds that collect cash to meet the bullet payment are scarce here.
Increasingly the market will find that higher risk companies are going for tax free listed bonds.
When interest rates are low, the incentive to go for tax free bonds will be even stronger, opening the door to firing a debenture bubble with complements of the State and interventionists.
All this is fine as long as the wider market is aware of the risks, and regulators who push for state ‘incentives’ also understand the consequences that they are asking for.
This column is based on ‘The Price Signal by Bellwether‘ published in the October 2015 issue of the Echelon Magazine. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link. The i-tunes app can be downloaded from here.