Bond Market Pricing and Trading Strategies - Analysis of Pakistan Bond Market - Case Study Example

1. Interest Rate Outlook of Pakistan: bank of Pakistan has reduced the discount rate overall by 200bps during the last three monetary policy announcements since November 2014. The discount rate came down from 10% to 8% (SBP, 2015). The reduction in the discount rate is accompanied with the decline in the inflation number in terms of YOY CPI to 2.49% for the month of March 2015 as compared to 3.24% for the month of January (PBS, 2015). In this scenario, it can be expected that the CPI figure will continue its downward trajectory and remain in the range of 5%-6% for the fiscal year 2015. On the foreign exchange front, the reserves have hit their highest level of 16.136 billion in last five years and remittances are increasing as well (SBP, 2015). Oil prices are expected to remain around the current level in the near future which will continue to have a positive impact on Balance of Payments. In these circumstances with expected low inflationary environment to prevail and positive real interest rate of around 525bps, we expect SBP to slash discount rate by 50bps in its upcoming monetary policy to boost economic growth. The privatization commission of Pakistan has made a target to generate funds up to PKR 198 Billion through the privatization process, which includes the divestment of HBL, UBL, PPL, OGDCL etc. However, the increase in the liquidity through the privatization process may reduce the long term liquidity of the government in terms of dividend income. Government has announced the dividend income target for the fiscal year 2015 if 82 Bio but due to the privatization process or divestment of the shareholdings in the highest dividend paying shares may lead to the decrease in the liquidity from the dividend income by about 15%, which may lead to the non fulfillment of the target of Rs 82Billion in terms of dividend income (Hussain, 2015). The short term outlook of the economy is also dependent on how the funds from the privatization proceeds will be utilized. It is highly expected that the funds will either reduce the fiscal deficit or fulfill the losses of the Government Organizations such as 200Bio of PIA loss and 300Bio of other organizational losses. Therefore, if the funds will be utilized to fulfill the losses only then the demand for the money will be increased further and theoretically the interest rate will be increased to deal with the monetary demands. In terms of the Foreign Exchange Reserves, which is also a contributing factor towards the monetary policy development, has reached at the level of $16 Billion during the week ended in feb 27 2015 (SBP, 2015). The reserves have shown the increase by $196 million during the month. The reason is that the funds from International development association had been released. Moreover, the tranches of Extended Fund facility will also be released within 2015, which will increase the reserves further. In terms of the trade deficits it can be noted that the trade deficit remained the same if it is compared to the last year (SBP, 2015). However, due to the reduction in oil prices the second quarter of FY15 has shown the record imports of oil in Pakistan. The increase in oil demand along with the increase in the international oil prices lead to the increase in inflationary pressure. Despite of the fact that the CPI expectations are low but practically the expected increase in the oil prices may lead to the increase in the prices of the related goods. It can be implied that Pakistan is currently fulfilling the targets of IMF in terms of economic numbers but practical aspects may have opposite affects on the growth of the economy. Source: http://www.sbp.org.pk/ecodata/exp_import_BOP.pdf During the month of January 2015, IMF has made a projection of 3 to 5 percent growth during 2015. Currently Govt of Pakistan has borrowed 950Bio since June 2014 till April 2015. The Govt is expecting to borrow Rs.1.5 trillion till June 2015 (SBP, 2015). The Borrowings are expected to be increased further during 2015. Considering the economic theory the increase in the borrowing may cause the increase in the interest rates to control the increased borrowing of the govt. however, the expected utilization of the borrowing is also an important factor to determine the discount rates. Currently State Bank of Pakistan is cooperating with the Ministry of finance to evaluate the Govt losses and budget deficit issues. Moreover, Pakistan is under IMF program and expecting more tranches as well (IMF, 2015). Therefore, combining the factors of utilization of borrowed funds and fulfillment of the IMF defined targets for the economic development of Pakistan expect the further decrease in interest rates. A recent decline of more than 1000 points in the stock market during the month of March did not show any fundamentals. The reason behind the decline was the excessive selling from the foreign investors along with the manipulations by the speculators. After the decline the stock market recovered abruptly within two days time period. After the crises Karachi Stock Exchange has increased the monitoring on margin trading (Soomro, 2015). The implication of the news is that the Pakistan’s financial market is highly speculative and based on decisions of some key influence market players. Therefore, the effects of such market players may lead to the outlook of the Pakistan’s economy highly speculative. In addition to this, the increase in growth expectation from IMF, increase in Foreign Reserves, reduction in interest rates and reduction in CPI are all the positive factors contributing towards economy but despite of the existence of the positive fundamentals, Pakistan has recently faced stock market crash 2. Evaluation what is currently Discounted in the market The interest rate outlook creates greater opportunity in the bond trading market. The yield curve which is shown below represents the steepness of the yield curve. The yield curve shows that the steepness in the yield curve has been increased, which can be proved from the yield differential between 1 year T-bill and 10 year PIB was 0.33bps i.e 12.65% in 10 year PIB and 12 .32% in 1 year t-bill. The spread increases by March 2015 to 152bps i.e 9.47% in 10 year PIB and 7.95% in 1year t- bill. Using the data of PKRV the risk premiums are shown below. Table 1: Risk Premium Risk Premiums Date 31-Mar-10 31-Mar-15 Difference In Spread 8 to 15 Day 0.29 0.02 -0.27 16 to 30 Day 0.41 0.04 -0.37 31 to 60 Day 0.51 0.04 -0.47 61 to 90 Day 0.54 -0.02 -0.56 91 to 120 Day 0.59 -0.06 -0.65 121 to 180 Day 0.64 -0.08 -0.72 181 to 270 Day 0.71 -0.09 -0.8 271 to 365 Day 0.75 -0.09 -0.84 1-2 Year 0.83 0.02 -0.81 2-3 Year 0.85 0.16 -0.69 3-4 Year 0.9 0.49 -0.41 4-5 Year 0.92 0.66 -0.26 5-6 year 1.04 0.92 -0.12 6-7 year 1.07 1.09 0.02 7-8 Year 1.08 1.17 0.09 8-9 Year 1.07 1.37 0.3 9-10 Year 1.08 1.43 0.35 10-15 Year 1.45 2.14 0.69 15-20 Year 1.58 2.47 0.89 Source: http://topics.bloomberg.com/state-bank-of-pakistan/ Source: http://topics.bloomberg.com/state-bank-of-pakistan/ As can be seen from the table and the yield curve graph above it can be seen that since 31st March 2010 the Risk Premiums have increased considerably. Another interesting thing that supports the interest rate outlook is that the spread between the Overnight Repo Rate and the securities maturities till 6 years have shown decreasing trends. However, the spread or risk premium has shown increasing trend from 6 years onwards. The increase in the spread and decrease in the discount rates clearly gives the indications of positive long term outlook that attracts long term investors. The increase in steepness of the yield curve short term movements may not attract investors. Therefore, the yield curve difference supports the interest rate outlook presented above. The risk factors which are involved in the interest rate outlook are as follows 2.1 Speculation Risk: As already discussed above the stock market of Pakistan is filled with some volume players, who may have the power to trade against the market fundamentals. Therefore, the stock market despite of the positive fundamentals may move negatively. The unanticipated market is one of the key risk factor that may reduce the confidence of the foreign investors in the corporate sector in long term perspective. This reduction in confidence may negatively affect the projections of economic indicators including discount rates 2.2 Liquidity Risk: The second and the most important risk factor in term of the discount rate projection is that if Pakistan is not able to fulfil the IMF requirements in terms of utilization of funds will not be fulfilled then the future tranches under IMF extended fund facility will not be received and the Pakistan will be facing the severe liquidity issues. Currently state bank intervene in the Pakistan money market through open market operation injection function by setting the target rate of 7.50%. Currently state bank intervene in the Pakistan money market through open market operation injection function by setting the target rate of 7.50%. The size of the Open Market Injection is Rs. 950Bio. This shows that the Money Market of Pakistan is currently short of liquidity with about Rs 1 trillion. The amount is expected to be increased because of the increase participation in the auction of Pakistan investment bonds, which may lead to further shortage of liquidity and increase the interest rates 2.3 Maturity Risk The reduction in discount rate and increase in the steepness of the yield curve may lead the banks to borrow in short term and lend in long term. This may subject to both maturity and liquidity risk. In such cases the demand for borrowing may be increased, which will increase the interest rates. o 3. Identification of the Bond Trading Strategy: Pakistan is considered one of the most attractive markets in terms of bond yields. The average yield for Pakistan Investment bonds ranges from 7.50% to 9.50%. Currently, 3 year, 5 Year and 10 year bonds are actively traded in the Pakistan treasury market (Bloomberg, 2015). The strategy, which is adopted by the bond market of Pakistan, is shifting from the outright long at the long end of the yield curve to the outright short at the long end of the yield curve. Using the data from Q1 2010 To Q2 2015, it can be seen that Pakistan treasury investments has moved from Market Treasury Bills to Pakistan Investment Bonds, which shows the clear indication of the movement towards outright long position in long end yield curve and short position in the short end yield curve. The ratio of PIBs to MTB in Q1-FY1030/70 which is increased to 65/35 by Q2 FY15 Table 2: Govt Securities Holdings of Pakistan As at end Period Total (PIBs) Total (MTBs) Total PIB% MTB% Q1-FY10 456.7 1,073.10 1,529.80 30% 70% Q2-FY10 473.7 1,158.10 1,631.80 29% 71% Q3-FY10 493.4 1,227.0 1,720.40 29% 71% Q4-FY10 505.2 1,349.10 1,854.30 27% 73% Q1-FY11 500.2 1,429.50 1,929.70 26% 74% Q2-FY11 522.1 1,538.10 2,060.20 25% 75% Q3-FY11 561.3 1,755.50 2,316.80 24% 76% Q4-FY11 618.5 1,971.10 2,589.60 24% 76% Q1-FY12 670.7 2,315.50 2,986.20 22% 78% Q2-FY12 882.0 2,514.90 3,396.90 26% 74% Q3-FY12 925.8 2,639.0 3,564.80 26% 74% Q4-FY12 974.7 2,592.10 3,566.80 27% 73% Q1-FY13 1,075.0 3,002.60 4,077.60 26% 74% Q2-FY13 1,119.80 3,003.10 4,122.90 27% 73% Q3-FY13 1,118.60 3,143.70 4,262.30 26% 74% Q4-FY13 1,321.90 3,151.0 4,472.90 30% 70% Q1-FY14 1,301.80 2,939.60 4,241.40 31% 69% Q2-FY14 1,379.90 3,181.20 4,561.10 30% 70% Q3-FY14 2,365.0 2,802.80 5,167.80 46% 54% Q4-FY14 3,223.50 1,878.90 5,102.40 63% 37% Q1-FY15 3,457.60 1,976.90 5,434.50 64% 36% Q2-FY15 3,811.80 2,050.10 5,861.90 65% 35% Currently in the bond market the issues which are being actively traded includes 3-year, 5-year and 10 year bonds. On 26th March 2015, State bank of Pakistan Issued new bonds (SBP, 2015), their prices along with the yields as on 14th April 2015 are as follows Table 3: Calculations The Yield curve for 3 year, 5 year and 10 year bonds are as follows as follows Table 4: PKRV Rates http://www.fma.com.pk/ Figure 1: Bond Yields As can be seen from the portfolio holdings of Pakistan Investment Bonds and Treasury Bills along with the 3-year, 5 year and 10 year bond yields it can be observed that yields are showing downward pressure because of the increase in demand of the bonds which increases the price and reduces the yields. In addition to this, using the yields as on 14th April 2015, it can be seen from the calculation above that the bonds are traded at premium i.e. their yields are lower than the coupon payments. All the factors including yield curve comparison of 31st March 2010 and 31st March 2015 along with YOY CPI figure of 2.49% for Feb 2015 and a decreasing discount rate, which is standing at the level of 7.5% clearly represents the long term positive outlook of the economy of Pakistan, which leads to the formulation of the bond trading strategy of increasing the bond holding and reducing the holdings of treasury Bills i.e. outright long on long end of the yield curve and outright short on short end of the yield curve. The reason is that the further expectation in the reduction in discount rate will reduce the yields and increase the prices of the bonds at a rate higher than that of treasury bills. Following is the calculation of the capital gain on per pip change in the yield of the bonds for 3 year, 5 year and 10 year Bonds. The capital gain is just a difference in clean price, which is shown as the offer price in the calculation sheet. Table 5: Capital Gain Calculation 3 Year PIB Table 6: Capital Gain Calculation 5 Year PIB Table 7: Capital Gain Calculation 10 Year PIB As can be seen from the calculations above increase in the tenor of the bond increases the per pip price difference. Moreover, interest rate outlook clearly indicates further decrease in the yields on the long term bonds in this year. Therefore, the strategy to buy long term bonds and short treasury bills increase the capital gain. 4. Monitor the Performance of the Strategy As the expected trading strategy is further increasing the portfolio holdings among the banking and non banking sectors of the economy in terms of bonds, but the following issues should also be considered 4.1 Initial Target of the Trade State bank of Pakistan has defined the targets of the upcoming bond auctions till june 2015 as follows Source: Bloomberg The data from the Bloomberg clearly show that till june the state bank of Pakistan is targeting to increase the bond holding because the maturing amount is PKR 5.8Bio whereas the target to issue new bonds is PKR 150Bio. Moreover, in order to fulfil the IMF requirements the expected discount rate in the upcoming monetary policy is 7%. Therefore, the initial target of the trade is holding till June 2015. 4.2 Stop Loss Order Need Moreover, due to the continuous decline in the discount rate and expected adjustment of the target rate in the repo market by September 2015, it is expected that the after the june-15 MPS the discount rate will not decrease further. Holding the bonds after that may reduce the profitability and stop loss orders may have to be placed. 4.3 Economic Information to Monitor Two most important economic information to monitor are 1. the discount rate movement i.e. MPS and 2. Liquidity targets of SBP 4.4 Important News for the reassessment of the trade It includes IMF forecasts regarding the Interest rate movement because all the economic numbers move according to the targets defined by IMF to fulfil the requirement for EFF i.e. Extended Fund Facility. 4.5 Change in the expectations of the Size of the Trade The Size of the trade will only be increased if the liquidity in the financial market will increase from other sources to reduce the current Open Market Operation requirement, which is currently Rs 950 Bio. Source: Bloomberg 4.6 News To reassess the trade negatively News regarding terrorist attacks and war in Pakistan may negatively affect the long term ratings of PIBs and their demands will be reduced. 4.7 Tradeoffs under certain Conditions The Treasury bill holdings will be liquidated to buy the Pakistan Investment bonds during the condition when the liquidity is short Bibliography 1. Bloomberg, 2015. Bloomberg. [Online] Available at: www.bloomberg.com 2. Hussain, D., 2015. Selling Gees that Lay the Golden Egg. Dawn News, 13 April. 3. IMF, 2015. Pakistan and the IMF. [Online] Available at: https://www.imf.org/external/country/PAK/ 4. PBS, 2015. PBS Price Statistics. [Online] Available at: http://www.pbs.gov.pk/content/price-statistics 5. SBP, 2015. Pakistan Debt & Liability Profile. [Online] Available at: http://www.sbp.org.pk/ecodata/Profile.pdf 6. SBP, 2015. SBP Eco Data Auction Investment. [Online] Available at: http://www.sbp.org.pk/Ecodata/Auction-Investment.pdf 7. SBP, 2015. SBP Ecodata Exp Imp. [Online] Available at: http://www.sbp.org.pk/ecodata/exp_import_BOP.pdf 8. SBP, 2015. SBP Ecodata Forex Reserves. [Online] Available at: http://www.sbp.org.pk/ecodata/forex.pdf 9. SBP, 2015. SBP Economic Data. [Online] Available at: http://www.sbp.org.pk/ecodata/index2.asp 10. Soomro, A. A., 2015. KSE is not a Casino. [Online] Available at: http://blogs.tribune.com.pk/story/26951/the-karachi-stock-market-is-not-a-casino-pakistan-stop-gambling/ Read More