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  2. 2. INTRODUCTION  The bond market in Sri Lanka commenced its active operations in 1990‟s with the issuance of medium and long-term bonds, both by the government and the corporate sector.  This process has been accelerated in line with the financial sector reforms and restructuring programme implemented in the last decade. The debt management policy of the government has substantially reformed by shifting from issuing non- marketable instruments (such as Rupee loans) and short-term marketable instruments (such as Treasury bills) to medium and long-term marketable instruments. As a result, the government compelled to introduce a long-term marketable and fixed income type new debt instrument; Treasury bond in 1997 to raise funds from the domestic market to finance the government budgetary operations. Subsequently, government borrowings through non- marketable instruments and short-term marketable instruments have been gradually reduced over the period.
  3. 3.  Furthermore, the government has exercised the early retirement facility or “call option” of the existing stock of non-marketable securities to replace them by Treasury bonds to accelerate the development of the bond market.  The gradual increase of the maturity structure of the Treasury bonds enabled the market to establish a medium-term yield curve which has provided a benchmark for the domestic corporate bond market.
  4. 4.  The improvement of primary and secondary markets, computerisation of market infrastructure, scrip less form issuing system and improvement of payments and settlements systems.  The required reforms have also been brought into the legal framework, appropriate to the development of the bond market for the smooth transformation towards the market based debt management.  The authority strengthened the monitoring and regulatory work at the central level, in order to ensure the safety and security of investment made by the public and stability of the overall financial system.  The authority’s continuous commitments on this process and fairly developed domestic money market operations helped develop the bond market, specially government bond market within a relatively shorter time period.
  5. 5.  The government has recognized the importance of developing the corporate bond market to diversify the funding sources in order to reduce the high reliance on the banking system and the equity market.  Further, it would lower the vulnerability of the corporate sector to unforeseen forces as experienced by some of Asian countries during the Asian Financial Crisis. In this regard, a number of policy measures have been implemented with a view of developing the corporate bond market. They include mandatory requirement of credit rating and publication of such rating for all varieties of debt instruments, registration requirement of all corporate bonds, entrust regulatory functions of corporate bonds to the Colombo Stock Exchange (CSE) and providing facilities to trade corporate bonds in the stock market.
  6. 6.  This development process has to be continued with a well-designed awareness programme to educate both corporate players and investors about the important role that could be played by the bond market providing alternative options for investors to invest their savings and for corporate players to reduce the vulnerability to the system risks by diversifying their alternative funding sources.
  7. 7.  In Sri Lanka, bonds issued in the domestic market could be broadly divided into three types in terms of the issuers‟ ownership; government bonds, debentures issued by public enterprises and debentures issued by the corporate sector.  The domestic bond market commenced its active operations only after the issuance of medium and long term tradable government bonds: Treasury bonds in 1997. It is a product of the new public debt management strategy envisaged by the government towards the issuance of medium and long term marketable securities to raise funds for government budgetary operations.  The issuance of a marketable, liquid and long term debt instrument such as Treasury bonds was a long felt need in the domestic market enabling local investors to match their supply of long-term funds with the demand for long- term funds from the government.
  8. 8.  In line with this process, necessary steps have been taken to improve the market infrastructure and streamline the regulatory framework to enhance the liquidity and efficiency in the bond market operation.  In addition, government has extended series of concessions specially tax concessions to the participants in the bond market to popularize government bonds among local investors.  Although, the corporate bond market is relatively small, the development of government bond market and establishment of the long term yield curve with liquid secondary market play as benchmark role and guide the activities of the corporate bond market.
  9. 9.  A rupee denominated government bond market is represented by Treasury bonds and accounted for over 60 per cent (Rs 890 bn or US$ 8.3 bn) of government domestic debt stock at end 2006.  Treasury bonds are tradable, medium and long term fixed income securities issued under the Registered Stock and Securities Ordinance (RSSO) carrying semi-annual coupon (interest) payments. These bonds are issued under multiple bidding auction basis in scrip less form.  The coupon rate is announced by the Central Bank prior to each auction and the market at the auction in the primary market determines yield of the bond. Treasury bonds are considered as a liquid asset and opened for Central Bank window for outright sales and purchases and Repo and Reverse Repo transactions since 1998.  The opening of the government Treasury bond market for foreign investors in 2006 could be considered as a major milestone to improve the competitiveness and expand the investor-base in the bond market.
  10. 10.  In addition, the Central Bank introduced a new foreign currency denominated debt instrument, called Sri Lanka Development Bonds (SLDBs) in 2001 to finance growing fiscal deficit thereby lower the pressure on the domestic rupee market.  The issues of SLDBs, are made under the Foreign Loan Act and issues are in scrip form. It is a floating rate bond and the interest rate is linked to LIBOR plus a competitive margin. However, there is no regular issuing pattern as in the Treasury bond market.  Due to these features, SLDBs are not considered as an active, tradable and liquid debt instrument. The outstanding SLDB stock as at end 2006 amounted to US$ 580 mn.
  11. 11.  In the past, few public enterprises (such as Housing Development Finance Corporation (HDFC)) have issued debentures to raise funds for their long- term resource requirement and lower their dependency to the government budget. However, this process was gradually abandoned in the recent past and outstanding stock of debentures issued by public enterprises is now at a negligible level.  In addition, Sri Lanka government issued its debut sovereign bonds to international capital market in 2007. The issuance size determined at US$ 500 million to make it bench mark size, in order to get the highest appetite from the investor comments.  The bond has a maturity period of 5 years and a coupon rate of 8.25%. The bond issue was over subscribed amounted to US$ 1.62 billion and investors‟ profile shows its attractiveness across the entire global capital markets.
  12. 12.  The corporate bond market mainly consists of debentures issued by financial institutions and few large corporate players in the domestic market.  Although, the corporate bond market is relatively small, recent debenture issues have vast differences in their features such as fixed and variable interest bonds, unsecured and secured bonds, capital guaranteed bonds, subordinated bonds, convertible bonds and callable bonds.  However, high degree of financial intermediation, a complex issuance process of corporate bonds, lack of proper risk reward structure and high issuance cost specially for small corporate hinder the issuance of corporate bonds in the domestic market.
  13. 13.  Recognising the benefits of developing the bond market, a series of measures and policy initiation have been introduced to facilitate the activities in the Treasury bond market as well as corporate bond market.  In order to improve the attraction of Treasury bonds, several measures were implemented to improve the liquidity in the bond market. These include the reduction of high fragmentation in the bond market, introduction of re-opening system for selected on-the-run liquid bonds, extending the yield curve and introduction of index- link bonds.  Since the primary dealers have exclusive rights to participate to the primary auction of the bond market, several measures were taken to strengthen the primary dealer system. These measures include the gradual increase of minimum capital requirement, (currently Rs. 300 million) introduction of dedicated primary dealer system and imposition of risk- weighted capital adequacy (8%) framework.
  14. 14.  In addition, a close monitoring system was also introduced for Primary dealers by conducting regular on-site supervision and off-site surveillance in order to ensure the stability of the primary dealer system in the financial system of the economy. Recent institutions include the PD diversification process which is expected to be implemented in two stages in 2008.  Introduction of Scrip less Securities Settlement System (SSSS), Real Time Gross Settlement System (RTGS), Central Depository System (CDS) and Delivery Versus Payment (DVP) System were major initiatives to improve the clearing and settlement system in the bond market.  The provision of Intra day Liquidity Facility (ILF) through the Central Bank and allowing PD to access to the Central Bank repo window was considered as new developments to improve the liquidity and eliminate the settlement risk in the market.
  15. 15.  Specially in 2007, Central Bank has conducted an aggressive awareness campaign. This programme mainly covered by issuing newspaper advertisements, printed documents, conducting seminars and media discussions targeting prospective investors.  Until 2006, rupee denominated government securities market was restricted for foreign investors. Recognising the advantages of attracting foreign investment into this market, Treasury bond market was opened for foreign investors in 2006 with limited access facility.  In the corporate bond market, the government has initiated series of measures to improve the infrastructure and provided several concessions for investors in order to develop the bond market. Among them, major initiatives include improvements of the infrastructure in trading bonds in the market. In addition, a decision taken by the SEC to open a training college to improve the capacity of market players would help to create an efficient corporate bond market.
  16. 16.  The bond market in Sri Lanka shows an imbalanced development, more developments in the government bond market and slow progress of the corporate bond market.  The continuation of the deficit budget policy, which requires funds largely from the domestic market, compelled the authorities to develop the government bond market. The Central Bank plays a vital role in developing the government bond market.  Further, extension of bond trading to the stock market helps further development of liquidity in the bond market. This development helped to raise funds at a lower cost while providing investors a market based investment environment.  In the corporate bond market, relatively small corporate sector, high cost of issuing bond under complex mechanism and limited investors coupled with the availability of funds from alternative sources at a rate closer to interest of government securities could be cited as main factors that prevented the development of the corporate bond market.