Assignment : 02

Does bond market will add value in financial market

with respect to Bangladesh:

Problems & Prospects

Submitted To;

SHISH HAIDER CHOWDHURYSHISH HAIDER CHOWDHURYSHISH HAIDER CHOWDHURYSHISH HAIDER CHOWDHURY

Institute of Business Administration, Jahangirnagar University, Dhaka.

Submitted By;

Md. Imran Al Arefen 2012 03 079 Section: 01

Submission Deadline: Dec 21, 2013 (Saturday)

FIN-502 Investment Analysis & Portfolio Management

A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. projects and activities. Bonds are commonly referred to as fixedone of the three main asset classes, along with stocks and cash equivalents.

Proper valuation is very important to make a effective financial market.

calculating a bond's price, which uses the basic present value (PV) formula for a given

discount rate:

Here:

F = face values iF = contractual interest rateC = F * iF = coupon payment (periodic interest payment)N = number of paymentsi = market interest rate, or required yield, or observed / appropriateM = value at maturity, usually equals face valueP = market price of bond.

The bond market is a financial market where participants buy and sell debt securities, usually in the form of bonds. Bond Market is composed of Treasury bond, Municipal Bond and Corporate Bond. This is of two kindsof bond products depending etc. Bond Market in Bangladeshcorporate bond; but does not have any municipal bpercent of the domestic savingsare investments in the debt marketThere hardly exists a corporateonly a small number f well-known issuersfloated.

Definition of 'Bond'

A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of

Bonds are commonly referred to as fixed-income securities and are one of the three main asset classes, along with stocks and cash equivalents.

Valuation

Proper valuation is very important to make a effective financial market. This

calculating a bond's price, which uses the basic present value (PV) formula for a given

= contractual interest rate = coupon payment (periodic interest payment)

N = number of payments i = market interest rate, or required yield, or observed / appropriate yield to maturityM = value at maturity, usually equals face value P = market price of bond.

What is Bond

The bond market is a financial market where participants buy and sell debt securities, usually in the form of bonds. Bond Market is composed of Treasury bond, Municipal Bond and Corporate Bond. This is of two kinds- Organized and OTC markets. There are various types

on provisions, maturities, coupon rate, options, convertibility, in Bangladesh is dominated by treasury debt securities. It has now only one

not have any municipal bond/debenture. In recent years, around 70 domestic savings are held in the form of bank deposits, while only 30 percent

debt market which is entirely dominated by government instruments. corporate bond market in the country, it has a debenture market with

known issuers. As of today, only one corporate bond has been

Definition of 'Bond'

A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by

and foreign governments to finance a variety of income securities and are

one of the three main asset classes, along with stocks and cash equivalents.

Valuation of 'Bond'

This formula for

calculating a bond's price, which uses the basic present value (PV) formula for a given

yield to maturity

What is Bond Market?

The bond market is a financial market where participants buy and sell debt securities, usually in the form of bonds. Bond Market is composed of Treasury bond, Municipal Bond and

ere are various types on provisions, maturities, coupon rate, options, convertibility,

is dominated by treasury debt securities. It has now only one ond/debenture. In recent years, around 70

are held in the form of bank deposits, while only 30 percent which is entirely dominated by government instruments.

market in the country, it has a debenture market with . As of today, only one corporate bond has been

Ownership Structure of Bond

From the viewpoint of ownership, bonds can be divided in two categories; namely-

i. Registered bonds: these bonds require the issuer to maintain records of who owns the

bonds and automatically send coupon payments to the owners.

ii. Bearer bonds: these bonds require the owner to clip coupons attached to the bond and

send them to the issuer to receive coupon payments.

Classification by Issuer i. Govt. bonds: govt. bonds are bonds issued by the govt. in a country to acquire funds from people, including individual and organizations. As govt. can always raise taxes to pay bond payments, these bonds have almost zero default risk and as a result, they show excellent liquidity.

ii. Treasury bonds : govt. debt securities maturing in ten to thirty years

iii. Treasury notes: govt. debt securities maturing in one to ten years

iv. Consoles: a special class of debt securities that never matures. As a result, these bonds pay only interest. Of course, investors can always sell them in secondary market. These types of bonds exist only in England and are quite rare. They are not used in our country Bangladesh.

v. Municipal bonds: these are bonds issued by local municipality. These are quite similar to govt. bonds in nature, and as municipal authority can also make payments by collecting taxes, these bonds also have almost zero default risk. They provide a slight lower return than govt. bonds, but due to tax advantages from such bonds, the after tax return is often higher than govt. bonds. As a result, many investors prefer these bonds to govt. bonds. We can classify them as following-

vi. Corporate bonds: these are bonds issued by corporations. Although these bonds provide comparatively higher return than govt. or municipal bonds, they also have a higher default risk. And their face value is usually in 1000, which attracts small investors too.

Types of Bonds

coupon bonds- these are bonds that promises a fixed face value at the maturity and periodic interest payments zero coupon bonds- these are bonds that do not provide any sort of interest payments, rather only provide the face value at maturity. As a result, these bonds are issued at a deep discount from par value. Convertible bonds- these bonds allow investors to exchange bonds for shares of the issuer company. As shares show a potentiality of high return, investors are often willing to accept a lower rate on them, which helps corporations to obtain funds at a lower cost Junk bonds- these are bonds that promise a high return but also has a high degree of default risk.

Major Impediments to Bond Market Development The obstacles to bond market development can be divided into two broad categories: those around and across the market, and those inside the fixed-income markets.

Around and Across the Market:

The obstacles in this group stem from the political situation, the macroeconomic situation, and the broader financial system.

The Political Situation: Nationwide program of strikes, processions, and mass meetings by political parties have weakened the government’s intentions to foster changes such as the development of the financial market. In addition, certain commercial and financial regulations are outdated. Governance and accountability are lacking in certain areas, and inefficiency is present in the financial system, mainly concerning the state-owned banking sector.

Macroeconomic Situation: The consolidated public sector deficit, taking into account losses incurred by state-owned enterprises, is much higher and underscores the need for improved fiscal management; however, a sense of urgency is missing in policymaking, despite the growing imbalances in the economy and crowding out as Bangladesh continues to channel vast monetary resources into servicing bad loans. Given that macroeconomic changes can happen in short periods of time and that nonperforming loan, which account for a third of the loan portfolio, can create financial sector vulnerability, the bad-loan situation could trigger a severe liquidity crisis nationwide

Broader Laws and Regulations: Certain omissions or drawbacks of the broader laws and regulations directly affect development of the fixed-income market. First, with regard to the ownership of land, the law provides for the registration of deeds rather than of ownership, which makes it impossible to

take land as collateral for bond issuance. Second, the law makes arbitration a cumbersome and slow process; moreover, foreign arbitration awards are not enforceable in Bangladesh. Third, in terms of obtaining issuers, there is no privatization law to lend transparency and authority to the privatization process, although one is at present being drafted. Fourth, Bangladesh’s laws represent a mixture of codified British common law and legal principles from various religious heritages. So, Bangladesh courts are limited in their ability to function effectively.

Broader Financial System: The broader financial system includes the banking sector, nonbanking sector, government securities market, and short-term money markets. Banking sector. Bangladesh’s banking system, which is dominated by state-owned NCBs, creates two serious problems for a local corporate bond market. First, the system provides low-cost loans to state owned enterprises, which account for a large part of the corporate sector. This undermines development of the corporate bond market because other financial institutions are unable to compete with these “under priced loans.” Indeed, the state-owned enterprises constitute a large part of the NCBs’ business. Nonbanking sector. The nonbanking portion of the financial sector consists of two small stock exchanges (Dhaka and Chittagong), both of which have still not recovered from the bull market problems of 1996, which left the public suspicious of corporate institutions because it is hard to get them to disclose their figures.

Government securities market: GSC issuances offer significantly higher rates than local bank deposits, which create a relatively high rate for risk-free and tax-free government securities. This establishes a disincentive to invest in corporate securities. GSCs create a high benchmark interest rate foundation for corporate securities. That matters because it is very hard to compete with risk-free government debt.

Short-term money markets: Money markets provide another foundation for bond markets. The money markets in Bangladesh are quite small. There is an interbank market, in which commercial banks borrow and lend to adjust their short. Normal maturities range from overnight to 30 days. Bangladesh also has a forward market for U.S. dollars against the taka, but only for short maturities. There is no commercial paper market. This weak form of short-term money market also hinders the development of a strong bond debenture market.

Problems of Bond Market of Bangladesh

i. Absence of Market-determined Interest Rate

ii. Regulatory Reform

iii. Lack of Benchmark Bonds

iv. Unbundled Pension and Insurance Funds

v. High Yielding Government Instruments Hindering Private Sector Bond Issue

vi. Poor Marketability

vii. High Time to Market for Time Consuming and Complicated Administrative Process

viii. Undefined Economic Benefits

ix. Investor’s Reluctance to Maintain Bond Portfolio

x. Conservative Policy of Investors

xi. Lack of Awareness Program for Investors and Risk Associated Sequential Process

xii. Adverse Perception by Market Participant of Settlement Risk

xiii. Lack of Intermediaries with Expertise in Debt Products

xiv. High Floatation Cost

xv. Political Instability

xvi. Poor Disclosure of Accounting Information

xvii. Lack of Awareness and Confidence in Debt Products

xviii. Dominance of Banking System

xix. Poor Savings and Investment Rate

xx. Financial Sector Vulnerability for Huge Non-Performing Loans

xxi. Moderate Economic Growth

xxii. Low Interest Rate Environment

Future Prospects

Bangladesh is one of the poorest countries in the world, with approximately 140 million inhabitants, of which about 50% live below the poverty line. Although its GNP growth rates—in the range of 4%–5% year—are attractive, they suggest that it will take Bangladesh 25 years to double its per capita income. In order to reduce the incidence of poverty to about 11%, as it hopes to do, Bangladesh will have to achieve economic growth rates of 7.5% or more a year. According to several studies (see, for example, World Bank, “Bangladesh, Key Challenges for the Next Millennium,” April 1999), economy has the capacity to move out of poverty with increasing speed, but that will require decisive policy actions in several areas, not least of which is the financial market.

In the past few years, there have been a number of significant changes in Bangladesh economy. The RMG sector has survived and taken quite a strong position after removal of quotas. Jute industries have a new life and jute goods export have increased. Tea, leather and other industries are also in good shape now. Foreign remittance has increased significantly.

Also within the country, a wide class of new entrepreneurs has evolved and there are many new business firms operating. Growth have been very high in telecom and power (especially gas) sector. Current money market and govt. banks do not have enough funds to support all these firms. There would be a better scenario if these firms get in the market by issuing stocks, bonds and debentures.

If the country’s positive macroeconomic trends continue into the future, the fiscal deficit and bad-loan situation will ease up and these factors would pose less threat to the financial market

Again, the government has committed itself to launching financial reforms that could help accelerate the country’s rate of growth. The main goal of these reforms is to reduce the direct controls on the financial system, and to deregulate and introduce a new set of market-oriented approaches to financial sector activity.

Despite the earlier setbacks the bond markets in Bangladesh is ready to take off. The need for abound market in Bangladesh deserves attention because of the following:

A. Foreign aid flow is diminishing and the trend is expected to continue. B. Specialized banks are not in a position to supply desired level of long term fund. C. Commercial banks have strategically cut down their long term lending. D. The concept of prudent asset mix is most likely to generate demand for investment

grade bonds. E. The Provident Funds and Insurance Companies Funds are not generally allowed to

invest their funds in stock market instruments. There is a bright possibility that these funds may be permitted to invest a part of their funds in marketable instruments subject to prudential guidelines, which may necessitate supply of lucrative debt instruments.

F. Reduction in the interest on Govt. savings instruments and withdrawal of certain savings instruments is expected to boost demand for debt instruments.

G. The registration fee for trust deed has been reduced from 2.5% (on the amount of debentures) to Tk. 2500.00 providing a very significant incentive.

H. There are now credit rating agencies to provide rating prospective issuer. I. Any interest paid by investor on money borrowed for investment in debentures is

deducted from total income. J. Interest income not exceeding Tk. 20000 received by an individual investor on

debentures approved by SEC is excluded from total income. K. The interest on Zero coupon bond approved by SEC at the hand of the recipient is tax-

exempt up to Tk. 25000.00. Such interest exceeding Tk. 25000.00 is subjected to tax @10% deducted at source. Banks and other financial institutions and insurance companies which are the mainstay of demand for bonds will now pay 10% tax on interest on such bonds instead of 45% tax payable on other income.

Recommendations

Bangladesh will eventually need an efficient capital & debt market that can mobilize domestic and foreign resources for investment. For the time being, however, Bangladesh should focus on creating a well organized, regulated, and attractive primary market in both public and private placements.

For this, Bangladesh needs a healthy non-bank financial institution (NBFI) sector to increase mobilization and make competitive financing available in a fixed-income market. To achieve that end, it must break the NCBs’ monopoly. Although the government is aware of this problem and has put forward some relevant reforms, there are no real incentives to speed up the process, maybe because of political considerations.

We also believe that the following steps are also necessary for development of a strong bond and debenture market in Bangladesh-

• Political problems should be minimized • Laws and regulations must be updated • Governance and accountability should be improved • Weaknesses in the financial system should be removed • Bad loan problem must be solved • Large corporations should be encouraged to use financial market for funding • GSC and NCB’s monopoly should be stopped • Firms in the high growth industries, like telecom industries, should be brought into the

financial market • The money market should be improved to assist in developing a strong bond and

debenture market.