INTRODUCTION

Fixed Income, as the name suggests, is an investment avenue wherein the investor gets predictable returns at set intervals of time. This investment class is relatively safe with low volatility and forms an ideal investment option for people looking at fixed returns with low default risk, e.g., retired individuals.

Fixed income securities denote debt of the issuer, i.e., they are an acknowledgment or promissory note of money received by the issuer from the investor. Following are the characteristics of fixed income securities:

- Fixed maturity period ranging from as low as 91 days to 30 years.

- Specified coupon or interest rate

- Generally issued at a discount to face value and the investor profits from the difference in the issue and redeemed price

There are various types of fixed income securities around the world. The securities that will be covered in this report are:

1. Term Finance Certificates (TFCs)

2. Pakistan Investment Bonds (PIBs)

3. Market Treasury Bills (MTBs)

4. Islamic Sukuks

PURPOSE

The purpose of this report is to describe the types of fixed income securities that are available in Pakistan and how they are accounted for. Further it analyses the risk and return of these securities from the point of view of investors and the performance of these securities in the last 5 years. It also describes how treasury operations work in Pakistan. In the end the report reaches its conclusion with recommendations as to which fixed income security should be invested in keeping in mind the risk and return for a period of 5 years.

TYPES OF FIXED INCOME SECURITIES

Term Finance Certificates (TFCs) & Sukuk Bonds

Term Finance Certificates and Sukuks are corporate bonds issued by corporate entities to raise funds for their entities specific needs. Similar to all other bonds, under these debt instruments, the issuer promises to pay a specified rate of interest (floating or fixed- in case of floating it is generally linked with the KIBOR rate) on a specified principal amount at specified intervals and repay the principal amount at regular intervals or stepped on payments or balloon maturity. The coupon payments on TFCs and Sukuks are generally floating. The coupon rates mostly depend on the KIBOR rates, adding a spread on the KIBOR depending upon the credit risk of the borrower. Recently the corporate debt market of Pakistan established and saw a boom in 2007-2008. There is immense potential for further establishment in the corporate debt market.

Administration, repayment, and security / collateral of the Sukuks / TFCs are governed by Registered Agreements under which the bonds are floated. TFCs are listed as well as unlisted. Sukuks / TFCs issued for a period of 365 days or less are classified as Short Term Debt, and those issued of a period of over 365 days are classified as Long Term Debt.

Sukuks / TFCs can be traded daily and are quoted on the website of Mutual Funds Association of Pakistan (www.mufap.com.pk) and are marked to market on daily basis. Every Company must get its instrument rated for an authorized credit rating agency on a continuous basis till the life of the instrument. The rating should also be disclosed in the accounts of the Company.

Difference between TFCs and Sukuks Bonds

The basic difference between conventional bonds and Sukuk lies in the way they are structured and floated. In the conventional system of bond issue and trading, the element of 'interest' is at the center of all transactions. Sukuk, on the other hand, are structured in such a way that the issue is asset backed and is based on "an exchange of approved asset for some financial consideration" that allows the investors to earn lawful profits from transactions. The underlying asset, contract, and payment mechanism of the Sukuk while being commercially viable has to be aligned with the requirements of the Shariah.

Who can issue Term Finance Certificates and Sukuks?

A Public Limited Company is eligible to offer TFCs to the general public through issue, publication and circulation of prospectus under section 57 read with section 120 of the Ordinance. The entity as well as the instrument should have a minimum credit rating grade of Triple B Minus (BBB-) assigned by a credit rating agency registered with the Commission under the Credit Rating Companies Rules, 1995.

Being corporate debt instruments, TFCs and Sukuks are risky assets, in the sense that they carry varying degrees of default risk. On the other hand, government debt obligations – T-Bills, PIBs – are defined as risk free assets, although, strictly speaking, even government bonds carry some level of sovereign default risk. To compensate investors for the higher default risk compared to government debt, corporate bonds offer a higher yield (risk spread) over comparable government bonds.

Following is the page that appears on Mutual Funds Association of Pakistan website.

Risks Associates with Term Finance Certificates

The major risk that term finance certificates and Sukuks carry is the default risk. Default risk is the risk that the borrower will not be able to make payments on the bond as agreed in the Finance Agreement. The State Bank of Pakistan has specifically mentioned the treatment of TFCs / Sukuks in case a borrower subsequently defaults on a financing facility. Following is the abstract from the Prudential Regulations issued by SBP.

Classification	Determinant	Treatment of Income	Provisions to be made
Substandard	Where markup/	Unrealized mark-up	Provision of 25%
	interest or	/interest to be kept in	of the
	principal is	Memorandum Account	outstanding
	overdue by 90	and not to be credited	principal amount
	days or more	to Income Account
	from the due	except when realized in
	Date.	Cash. Unrealized mark
		up/interest already
		taken to income account
		to be reversed and kept
		in Memorandum
		Account.
Doubtful	Where markup/	As above	Provision of 50%
	interest or		of the
	principal is		outstanding
	overdue by 180		principal amount
	days or more
	from the due
	Date.
Loss	Where markup/	As above	Provision of 100%
	interest or		of the
	principal is		outstanding
	overdue by 360		principal amount
	days or more
	from the due
	Date.

Market Treasury Bills

These securities are non-interest bearing debt instruments issued at a discount to face value, which pay full face value at maturity. These may be issued by public or private entities, and generally have original maturities ranging from under one month to 1 year. No interest payments are made on these instruments. The return to the investor is the difference between the amount paid at issuance and the amount received at maturity.

In our economy, Government Treasury Bills of 3, 6 and 12 months are zero coupon securities. SBP auctions T-bills through primary dealers on fortnightly basis with pre-specified target for each auction announced at the beginning of the quarter for next three months. These are issued in accordance with the Public Debt Act, 1944. They are issued in denominations of PKR 5,000. The ultimate custodian of these securities is the SBP, however banks maintains these securities in the Investor Portfolio Account on behalf of their customers.

How to buy Market Treasury Bills?

After opening an account investor can instruct its bank to buy either from the primary market or from the secondary market through “non-competitive bidding process” in regular auctions conducted by the SBP or from the secondary market.

Market treasury bills are only redeemable at maturity. However, any investor can sell MTBs in secondary market through its bank. If an investor holds the MTB till maturity, the PKR value equivalent to face value will be credited to the account of the investor through its bank on the maturity of the MTB.

Following is the list of primary dealers of Market Treasury Bills and Pakistan Investment Bonds in Pakistan:

1. JS Bank Limited

2. Habib Bank Limited

3. Faysal Bank Limited

4. NIB Bank Limited

5. National Bank of Pakistan

6. Bank Al-Falah Limited

7. Pak Oman Investment Company Limited

8. United Bank Limited

9. Standard Chartered Bank Limited

10. Citi Bank

11. MCB Bank Limited

Pakistan Investment Bonds

Pakistan Investment Bonds are Medium to Long Term Bonds issued by the Government of Pakistan, for 3years, 5years, 7 years, 10years, 15years, 20years and 30 years maturities. PIBs have fixed coupon payment. SBP auctions PIB through primary dealers based on borrowing needs of GOP, but as per announced target of the paper for six monthly periods. PIBs may be issued at premium or discount to par.

They are issued in accordance with the Public Debt Act, 1944 and are issued in multiples of PKR 100,000. The ultimate custodian of these securities is the SBP, however banks maintains these securities in the Investor Portfolio Account on behalf of their customers.

How to buy Pakistan Investment Bonds?

Pakistan Investment Bonds are only redeemable at maturity. However, any investor can sell PIBs in secondary market through its bank. If an investor holds the PIB till maturity, the PKR value equivalent to face value will be credited to the account of the investor through its bank on the maturity of the PIB.

Pakistan Investment Bonds and Market Treasury Bills are revalued daily. The rates used for revaluation of PIBs and MTBs are updated daily on Financial Market Association website (www.fma.com.pk). Following is the rate sheet of PIBs and MTBs published on FMA website on the November 20, 2012:

Risks Associated with Federal Government Securities

As mentioned earlier federal government Securities carry zero default risk. The major risk associated with PIBs and MTBs is the interest rate risk. Due to the reason that MTBs are short term instruments the interest rate risk does not impact the value of MTBs as much as it does to the value of PIBs.

The value of federal government securities depend on the daily PKRV rates quoted by FMA. The PKRV rates determine the yield to maturity on the securities. Hence, increase in the yield to maturity rates decrease the value of federal government securities as their coupon payments are fixed. Conversely, decrease in the yield to maturity increases the value of these securities.

HOW TREASURY OPERATIONS WORK

Treasury Operations is charged with monitoring and managing liquidity for operations, identifying opportunities and implementing investment strategies, implementing debt structure, and managing banking services. To enquire how treasury function operates we arranged a meeting with the following people:

Name	Company	Department	Designation
Eraj Hashmi	National Bank of Pakistan	Capital Market Wing	AVP
Ismael Ahmad	National Bank of Pakistan	Treasury Settlement Wing	SVP

Mr. Eraj Hashmi helped us in documenting the following procedures for Term Finance Certificates and Sukuk Bonds:

Investment in Term Finance Certificates and Sukuk Bonds are either made through the primary market or through the secondary market

Investment in TFC's and Sukuk Bonds through Primary Market

Information about counterparties is obtained from market researchers and approved brokers before investing. Corporate and Investment Banking Group (CIBG) also makes an analysis of the counterparties on an ongoing basis by analyzing financial statements and other primary measures as well as secondary data from different research tools and sources. NBP does not invest in companies classified as Defaulter by KSE. On the basis of such research the CIBG makes the sale and purchase of the TFC's or Sukuk Bonds. If any company becomes defaulter after investment, CIBG decides whether to disinvest in it or not.

The Corporate Investment Banking Department (CIBG) analyses the counter party and sends its recommendations through Credit Request Form (CRF) & Information Memorandum to the Credit Committee, which then further analyses it and approves the transaction with counter party.

If the investment transaction is successful, CIBG forwards the details of the investment to the back office which is also the Finance Control which enters the details of the investment in the system. Concurrently, payment is approved by the Heads of Financial Control Division.

Investment in TFC's and Sukuk Bonds through Secondary Market

For purchase and sale of TFCs in the secondary market approval of Credit Committee is not required. Deals for secondary market purchase and sale are done on the phone by front office dealers authorized by the Equity Investment Committee.

After the deal is finalized, the deal ticket along with the repayment schedule is forwarded by the front office to back office for payment and recording in the system. Back office gives a request to the Finance department for preparation of cheque which is paid through the UBL clearing account and voucher is created for entry in main General Ledger.

Investment in Federal Government Securities

Mr. Ismael Ahmad helped us in documenting the following procedures for Market Treasury Bills and Pakistan Investment Bonds:

Investment in MTBs and PIBs depends on whether they expect the KIBOR rates to go steepen or flatten. After predicting the yield curve the department decides how much is to be invested in MTBs and PIBs of different maturities. The Dealers in the treasury department are assigned limits on a per day transaction volume basis or on a single transaction size basis. Dealers shall observe both the individual transaction size limit and/or aggregate volume per day limit as per their respective allocations. If the predictions on the KIBOR rates subsequently change, the department determines how much is to be disinvested accordingly.

Transaction details of all executed Money Market and Securities deals should capture the deal type, transaction date, value date, counter party name, Security, transaction amount, rate, broker's name (if applicable), trader's name and signature.

Treasury settlement wing must prepare a confirmation for each transaction and forward the confirmation to the counter party. Confirmations should contain all pertinent details of the transaction. It is the bank's policy to automate the confirmation process in all trading environments to the extent possible.

A transaction is considered confirmed upon receipt of the counter party’s confirmation. The confirmation can be in the form of counterparty’s own deal confirmation or the bank's outgoing confirmation signed and returned by the counter party.

Treasury Settlement wing ensures all Money Market contracts executed by the trader(s) are promptly processed, by reviewing the deal for accuracy, completeness, and proper approval. The deal tickets are verified with broker’s confirmation, with Reuters’ as the case may be.

THE MOST FEASIBLE FIXED INCOME SECURITY

For deciding which fixed income security to be invested in we must consider the required risk, the expected return and the time horizon of the investment. Further from our research we have found that Term Finance Certificates and Sukuk Bonds are inversely related with the Federal Government Securities (MTBs & PIBs i.e.). This is due to the reason that returns on TFCs and Sukuk Bonds increases as KIBOR increases, as most of the issued certificates and bonds float along with the KIBOR. Whereas, in the case of Federal Government Securities, as the KIBOR increases, the value of MTBs and PIBs decrease due to interest rate risk. Hence, these securities move in opposite directions. Federal Government Securities on the other hand, however, carry negligible default risk as they are backed the Government of Pakistan. Therefore, the decision on which fixed income security to be invested in depends on, in which direction you predict the KIBOR is going to move. The State Bank of Pakistan has recently cut the discount rate to 9.5% in its latest monetary policy. This decision has been welcomed by corporations and is urging SBP to bring the discount rate level to 6-7% in order to support the industrial investment in the current economic scenario with poor law and order situation and severe shortage of energy and high POL prices. Hence after reviewing the current scenario, federal government securities seem to be a more feasible option.

The decision on whether to invest in Market Treasury Bills or Pakistan Investment Bonds depends on the predictions of the yield to maturity curve. If the market predicts the long term rates to rise more than the short term rates in the future investment in MTBs and shorter maturity PIBs is a better option. However, if the market predicts short term interest rates to rise more than the long term interest rates, longer maturity PIBs must be invested in.

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Sunday 30 December 2012

Fixed Income Securities