The fairly undeveloped and opaque Kenyan bond market is playing out in
favour of investment and commercial banks.
But, investigations by The EastAfrican show that the bid by commercial
banks to protect their profitability in 2011 saw them play smart games in the
bond market to avoid huge losses.
This was the case in 2010 when the interest rates went as low as 1.6
per cent — and the banks booked handsome profits from bond trading.
However, during bad times, when interest rates rise — like they did in
the second half of 2011 — banks work hard to dodge the losses by playing smart
on accounting rules.
An analysis of the market data for 2011 and interviews with financial
market players show that then, scores of Kenyan commercial banks played behind
a tool known as “sell-buyback” to hide their bond losses.
Last year, banks faced huge losses as interest went up, hurting bond
prices.
International banks operating in Kenya, however played by the rules,
thanks to strict standards applied globally.
In a series of articles, The EastAfrican tries to pry open the bond
market to the investing public by explaining dealings which have exposed
loopholes in the bond market which traded Ksh891 billion ($10.6 million) last
year, and bred millionaire traders. (see related stories)
The inner dealings in the bonds market are expected to come to light in
the Central Bank of Kenya (CBK) annual banking sector report, whose audit for
2011 the regulator finalised early September, according to bankers who spoke to
The EastAfrican.
However, some bankers said CBK may be more concerned about how banks’
main business — collecting deposits and lending to customers — is performing
than trying to nit-pick on why the bond bubble did not burst in 2011.
“Banking is based on confidence. That is why the regulators will be
keen on looking at the deposit and the lending side of the business. The
regulators would be very concerned if the deposits are threatened. Many banks
cooked their books in 2011 because of the losses in bonds but the regulator is
unlikely to pick it up,” said a senior official at a commercial bank.
Ordinarily, a bond is a borrowing instrument used by companies and
governments to raise funds from the public and traded at the stock market.
The borrower promises to pay back in full with regular payments of
interest, usually semi-annually.
Buyers (investors) who include individuals, commercial banks and
investment companies, have the option of either holding their bonds until the
company or government pays them back in full, or trading them at the bourse.
n choosing to trade their bonds, investors are guided by interest rates
— the cost of money. If the interest rates are rising, other interested
investors prefer not to buy the bond in the market because they think they can
always get the bond when interest rates have peaked, so the seller of a bond
will lower the price, and the rest of the market takes the cue, lowering the
price of the bonds.
But when interest rates are falling, investors want to buy bonds with
an attractive interest rate, before the interest rates reach the bottom, so the
rush to buy leads to a rise in bond prices.
So, if you bought a bond when the market interest rate was 10 per cent
and then sell it when the market rates have gone down, say to five per cent,
prudence dictates you sell at a high price as the buyer will be enjoying high
rates of returns when other investors are currently buying at the lower return
of five per cent.
Banks can also use bonds as a form of security to borrow money from
another bank, the same way an individual can use their car log book to borrow
money.
There are two options here: The bank that is borrowing money, for say
two weeks, will put up its bond as security.
The lending bank will put a charge on the bond, which means the
borrowing bank still has ownership of the bond but because of the charge on the
bond, it cannot use it.
The second option is that the bank borrowing money will sell its bond,
at an agreed price to the lender. In this case, the bond as a security changes
ownership from one bank to another.
But there is an agreement that the borrower will buy back the bond and
repay the loan from the lending bank. If the borrower defaults, the lender can
sell the bond to recover the money.
Banks are allowed to hold bonds in three baskets. First, they can hold
the bonds until they mature, accounting for interest earned in any given period
as income and never recognising any capital gains or losses that might result
from movements in interest rates in the financial markets.
This basket is called Held to Maturity (HTM). Second, there are bonds
that banks buy to speculate in the financial markets in order to take advantage
of movements in currencies, inflation and interest rates.
Any unrealised gain or loss is accounted for in the balance sheet and
thus has the effect of reducing the shareholders’ funds in the case of a loss
or increase if a gain is made.
This basket is called Available for Sale (AFS). The third basket is
where banks hold the bonds for purposes of trading them for a gain. Any loss or
gain is accounted for through the profit and loss account. This basket is
called Held for Trading (HFT).
There are stringent rules on how the banks move a bond from one basket
to another. A bank cannot sell a bond held in the HTM basket before it matures.
If it does, then the basked is “tainted” and the bank would have to
sell all the bonds in that basket. And if the bank decides to move bonds from
either the AFS or the HFT market at a time when interest rates are rising and
bond valuations are falling, the bank is compelled to sell the bonds at market
prices and buy them back according to the market prices
In 2011, when interest rates rose sharply, the commercial banks, which
were holding billions of shillings in bonds in the HFT basket, should have
declared their reduced value in their profit and loss accounts.
But instead, they circumvented this by using the “sell-buyback” tool
(where a bank sells its bond and later buys it back).
They turned to other banks and highly-liquid institutions, such as
parastatals, to sell the bonds at the rates at which they had bought them in
2010, with the promise to later buy them at slightly lower rates as an
incentive for the other parties to take up the bonds.
So, for example, if bank “A” was holding a bond that it had bought at
an interest rate of nine per cent, and the market rates had gone up to 15 per
cent, it sold to bank “B” at the same nine per cent.
After a short while, bank “A” would buy back the bond at 8.5 per cent.
Since the rate had been artificially brought down, bank “B” booked a profit of
0.5 percentage point. Bank “A” then moved the bond, previously in the Hold For
Trade basket to the Available for Sale or Held to Maturity basket.
During this transaction the investment bank selected to handle the deal
would collect trading commissions twice.
A circular by the Institute of Certified Public Accountants (ICPAK),
the custodian of accounting standards seeks to explain how banks can move bonds
across the baskets, under the International Financial Reporting Standards.
Data on the trading of bonds, especially in periods close to June and
December, when banks report their half-year and full year results, reveal
trends of an abnormal market.
On December 22, for example, a Ksh150 million ($1.79 million) 12-year
bond issued in 2009 (IFB1/2009/012) traded at 6.54 per cent, only for another
similar bond to trade 30 minutes later at a more market-reflective rate of
15.90 per cent.
“Someone would have to be willing to take the big loss permanently for
the trade to be deemed a normal trade,” said a fund manager who did not wish to
be named.
If the trade was to happen at 15.9 per cent the seller of the bond
would have to report a Ksh14 million ($166,667) loss from the trade
attributable to the 9.36 percentage margin. If the trade was to be genuine, the
buyer is incurring an opportunity loss of a similar margin.
However the buyer is sure that the buyer will come back for his bond at
a lower rate allowing him to earn a return.
A week later, on December 29, a Ksh150 million ($1.78 million) trade of
a similar bond (IFB1/2009/012) was traded at 5.05 per cent.
Assuming it’s the same parties (the data which had the names of
participating parties deleted) then the initial buyer who is now selling is
making an estimated Ksh2.2 million ($26,190) in a week — attributable to the
1.49 percentage margin between his buying and selling price.
On December 16, Ksh660 million ($7.86 million) of a 15-year bond were
traded at 6.95 per cent, below the yield curve rate of 13.37 per cent. Such
trades resulted in the distortion of the yield curve which should have raised a
red flag to market regulators.
“Banks were doing this claiming that they were having a liquidity
crunch. Which crunch, when they were not lending due to the high interest
rates?” asked an investment banker.
A recent Citigroup report estimated that by failing to observe
international accounting standards, specifically standard 39, which guides on
how financial assets should be reported, a number of banks overstated their
profits between 2007 and 2011 by between 15 and 23 per cent.
Bond traders who spoke to The EastAfrican however, defended the
sell-buybacks at below market prices, saying that local rules allowed for such
trade.
“There are no foreign investors — the market is entirely local and
local rules apply. Whatever happened then was with the full knowledge of the
auditors and ICPAK and so there is nothing illegal,” said an official of the
Bond Traders Association.
In its financial sector stability report released last week, CBK
admitted to the extent of the problem which faced the banking sector as
interest rates shot up and the bonds were seen as a hot potato. Banks wanted to
dump the bonds.
“The second half of 2011
experienced excessive volatility, with bonds’ yields hitting the roof in
response to risks manifested in short-term interest rates, high inflationary
pressures and general lack of demand from investors.
Holders of existing bonds
panicked and resorted to dumping their stocks to cut losses,” said CBK in the
report released last Wednesday, referring to a period last year when interest
rates shot through the roof as the regulator scrambled to protect the shilling.
This was the first official report that acknowledged how the bond
market had turned against the banks.
With the market confidence at its lowest ebb, CBK and the market
players said they introduced sell-buy backs in October 2011 “to provide
liquidity for bondholders who needed cash urgently but faced difficulties in
selling their bonds.”
CBK, however, added: “Introduction of sell-buy backs in October 2011 to
restore confidence helped somehow, but it was characterised by pricing risks.”
The pricing risks resulted in the distortion of the market price list,
referred to as yield curve, as the sell-buy backs were done at below market
prices which led to a collapse of the corporate bonds market and a near-crush
of the entire bond market, pointed out the Central Bank.
“Corporate bonds market, whose pricing is benchmarked on government
bonds, totally collapsed during the period, as pricing was not only
unpredictable, but punitive,” the report adds.
Bankers who spoke with The EastAfrican said the banks lending money to
other banks faced a pricing dilemma: “At what price do you buy the bond?”
Since interest rates had gone up then the borrower, if he were to sell
the bond would have to sell it at a lower price and enter a loss in the profit
and loss account.
So, banks which needed to borrow money through the sell-buyback
transactions urged their lending counterparts to take the bond at the same
price which the borrower had bought the bond and not at the market price.
But some lending banks refused to buy the bonds at a price set by the
borrower, insisting they will only buy the bonds at the market price.
One banker explained: “If I have a house which I bought at Ksh1 billion
($11.9 million) and the value of the house drops to Ksh700 million ($8.3
million), who would want to buy the house at Ksh1 billion ($11.9 million)?”
Standard Investment Bank, in a report released in July, noted that had
the banks strictly adopted the International Accounting Standard 39, they
“would have treated sale of AFS securities as yielding realised losses/gains,
which are recognised in the income statement.”
In 2015, a new accounting standard, IFRS 9 requiring that banks hold
bonds in only the Hold for Trade and Hold For Maturity baskets, will come into
effect. Analysts note that once this is adopted, banks will have little room to
play accounting gimmicks.
“Post-adoption, banks will have less room to smooth earnings as was
witnessed in 2011, where available for sale securities were reclassified as
held to maturity by entering into sell-buy back agreements,” said the
investment bank house.
Source: The EastAfrican,http://www.theeastafrican.co.ke, reported by George Ngigi and Emmanuel Were in
Nairobi, Kenya
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