RISK COMPENSATION
RISK COMPENSATION: WHY DO THEY INVEST LESS IN BONDS THAN IN DEPOSITS, AND IS THE GAME WORTH THE CANDLE AT ALL
Over the past few months, I have been periodically approached for advice on raising funds through the issuance of corporate bonds on the local or international market. They are mostly representatives of successful private companies implementing serious projects.
What are the reasons for such interest right now? Let's try to figure it out.
It seems that the main reasons for the increased interest in bonds were the understandable long-term processes of economic and business development in the country. In 2016-2018, most enterprises started their first projects with their funds or investments from partners, and repatriated resources previously withdrawn abroad for this purpose. But from 2018 to 2020, along with the development of the banking segment, most of the business resources were already attracted through a bank loan.
The pandemic, the growth of retail bank lending and the corresponding reduction in resources for the corporate segment, the increase in the quality of risk and compliance control in banks, and the increase in loan rates have somewhat slowed down this process. Companies have begun to consider alternative financing options. And by the end of 2022, the banal problem of borrowers' lack of collateral came to the fore.
That is, entrepreneurs, believing in the course of reforms, launched their projects, with the development of business, even more opportunities began to appear, and their implementation was carried out at the expense of loans. At some point, all the available assets were mortgaged. At the same time, opportunities, ideas, and new projects remained, and new ones appeared, but it is no longer possible to finance them.
In such a situation, it is logical to apply for external unsecured financing to maximize the leverage (usually about 2.5–3.5 of the company's EBITDA, including all existing debts) available to the business. We are just at this stage.
Advantages of bonds
So what are the advantages of bonds, other than the absence of a requirement for collateral (or at least a simpler assessment of it)? There are enough of them:
What are the reasons for such interest right now? Let's try to figure it out.
It seems that the main reasons for the increased interest in bonds were the understandable long-term processes of economic and business development in the country. In 2016-2018, most enterprises started their first projects with their funds or investments from partners, and repatriated resources previously withdrawn abroad for this purpose. But from 2018 to 2020, along with the development of the banking segment, most of the business resources were already attracted through a bank loan.
The pandemic, the growth of retail bank lending and the corresponding reduction in resources for the corporate segment, the increase in the quality of risk and compliance control in banks, and the increase in loan rates have somewhat slowed down this process. Companies have begun to consider alternative financing options. And by the end of 2022, the banal problem of borrowers' lack of collateral came to the fore.
That is, entrepreneurs, believing in the course of reforms, launched their projects, with the development of business, even more opportunities began to appear, and their implementation was carried out at the expense of loans. At some point, all the available assets were mortgaged. At the same time, opportunities, ideas, and new projects remained, and new ones appeared, but it is no longer possible to finance them.
In such a situation, it is logical to apply for external unsecured financing to maximize the leverage (usually about 2.5–3.5 of the company's EBITDA, including all existing debts) available to the business. We are just at this stage.
Advantages of bonds
So what are the advantages of bonds, other than the absence of a requirement for collateral (or at least a simpler assessment of it)? There are enough of them:
- no requirements for the intended use;
- the possibility of postponing the payment of the principal debt to the end of the circulation period;
- flexibility in structuring the terms of repayment of funds (for example, it is possible to allow early repayment of part of the issue);
- flexibility in determining and timing the payment of the coupon payment (you can link it to the results of activities or issue discount bonds sold below par, but for which payments are not made during the circulation period and income is generated when the nominal value is repaid);
- tax benefits (in Uzbekistan, neither coupon income nor capital gains on resale are taxed);
- liquidity for the investor (it is possible to sell, mortgage, change bonds during the term of circulation without agreement with the issuer, which is much easier to resell a loan between banks).
But all these advantages have a downside — the price.
Based on my experience, the history itself, and the current state of the market, it is clear that there are no significant volumes of placements today since there is a large gap in the assessment of the value of such an instrument by issuers and investors. Investors are more likely to be right here, understand the additional risks in all the "opportunities" and want to see a reasonable "compensation" for these risks in a higher level of income on bonds.
The average deposit rates for individuals are about 21-22%, and some banks pay 25-26% for two-year deposits. At the same time, the deposit is guaranteed by the state. Moreover, as we have seen in recent examples with the problems of depositors of banks that have lost their licenses, the state also accepts over-obligations to maintain confidence in the banking market. At the same time, most deposits have three-click liquidity in the mobile application. And trust in banks, although not at the highest level, is much greater than any instruments on the securities market.
Based on my experience, the history itself, and the current state of the market, it is clear that there are no significant volumes of placements today since there is a large gap in the assessment of the value of such an instrument by issuers and investors. Investors are more likely to be right here, understand the additional risks in all the "opportunities" and want to see a reasonable "compensation" for these risks in a higher level of income on bonds.
The average deposit rates for individuals are about 21-22%, and some banks pay 25-26% for two-year deposits. At the same time, the deposit is guaranteed by the state. Moreover, as we have seen in recent examples with the problems of depositors of banks that have lost their licenses, the state also accepts over-obligations to maintain confidence in the banking market. At the same time, most deposits have three-click liquidity in the mobile application. And trust in banks, although not at the highest level, is much greater than any instruments on the securities market.
There are also very interesting alternatives to the deposit. Rising real estate prices, high-interest income, the rising cost of cars in the primary and secondary markets, and even the purchase of gold in jewelry and bullion bring a solid income. All this is much more tangible and understandable to most people — even experienced professionals and businessmen unfamiliar with the securities market.
Can a bond issue boast the same? Is it guaranteed by the state? No. Maybe the deposit is reliable? Also, no, because you need to know how it was evaluated and how I, with my 0.1% investment in a bond issue, got a piece of the mortgaged building. Maybe then the cash flow structure is better for me as an investor? Again, no. Deposits and apartment rentals generate income every month, while bonds are usually quarterly or less frequently. Liquidity? It is practically non-existent on the secondary market, and most bonds are held to maturity.
If a bond is riskier than a deposit, has no liquidity in the secondary market, and pays income less often, it is logical that all this should be reflected in the yield level. But, unfortunately, most business owners are morally not ready to accept such conditions and pay above what they pay on loans, and sometimes they try to offer lower rates. In this case, it will be difficult to successfully issue bonds.
It all depends on the profitability. What it should be is an open question, and there will be an answer for each individual situation.
Unfortunately, the quality of the borrower in Uzbekistan does not play a significant role yet and it is very difficult to convince investors that some issue with a lower yield, but from a more reliable issuer, will be a better investment than a large promised income from a high-risk transaction.
Example. I think everyone understands that if some AAA-rated bank wants to place bonds in Uzbekistan, then the yield of such bonds should be lower than the key rate of the Central Bank of the Republic of Uzbekistan — because the rating of the organization is higher. It seems logical, but I really want to look at those who in their right mind will go to buy bonds with such a yield in the presence of many other opportunities on the market, including government securities.
I do not yet know how to explain the importance of borrower quality and the cost of risk to most unqualified investors — certainly not through an analysis of the Sharpe ratio. Perhaps only a few small defaults will help you understand that there is a risk and it needs to be properly assessed. Nothing teaches you more than losing your own money.
Moreover, recently we had the first default on bonds in the domestic market in many years, which, apparently, unexpectedly caused the withdrawal of the international rating from the issuer. I hope this will become an important example for many: bond issuance is not only an opportunity but also a responsibility.
But — to practice! About ten publicly placed issues and more than twenty private ones are currently circulating on the market. The main part of them has a maturity of 18-36 months, and the rates are about 22-24% (although there are issues with rates of 27-28%). The volume of public offerings is just over 150 billion soums. Moreover, half of the issues are not fully posted, which already speaks volumes.
For most clients, we recommend making debut issues with the shortest possible duration, preferably in 18-24 months, in order to be relatively comparable with the average deposit terms. At the same time, it is desirable-
It is advisable to immediately plan their repayment through additional issues in the future: if a year and a half passed successfully for the company and for the market, the issuer was able to convince investors of its development and reliability, build a communication structure with them, then we can hope that the next issue will be with a longer period or with a lower coupon rate.
When there are enough such issues, it will be possible to say that the company has built a "yield curve" — an approximate graph of how it can borrow for different periods: 6 months, a year, 3 years, 5 years, 10 years, etc. With such information, third-party investors can already estimate approximately at what rates they will be able to offer their financing to the issuer. This also opens up new opportunities in negotiations with banks and creditors.
Probably, experienced specialists will criticize me, pointing out that for a new, dynamically developing company on the market, this curve will be strongly influenced by its development and that borrowings will not be "homogeneous" in quality and condition of the borrower at every single moment. Therefore, curves are usually built for sovereign debt. But let's leave that out for now to focus on the importance of a long-term approach to bond issuance.
How did these issues fit, given all the disadvantages that I listed above: risks, liquidity, and regularity of payments? First of all, it is worth noting the presence of a tax arbitration factor: at the moment, income from bonds is not taxed, so it is more profitable for a large investor to buy bonds than to issue a direct loan under the same conditions. At a rate of 20%, a whole 1% is saved, which is quite significant. That is why some banks are actively involved in the process, and in private placements, a large share is taken up by transactions with affiliates and shareholders who convert loans into bonds.
Another factor is the development of legislation. Recently, microfinance organizations were allowed to raise funds through bonds, which they began to use with pleasure. In addition, by another decision of the president, state-owned companies are recommended to finance part of their investment program through the issuance of bonds.
In the future, I hope there will be a change in the assessment of the opportunities that open up on the part of entrepreneurs who will be willing to pay above the loan rates and attract financing here and now for a more dynamic development of their projects.
Thus, despite all the difficulties (first of all, the lack of liquidity in the market and uncertainty about the possible volume of attraction), I am convinced that the bond market in Uzbekistan will develop and will be very rapidly. A couple of successful releases from Daredevils will attract a lot of other players, and the appearance of new products will open the market to other investors.
When this happens, it would be good to be "fully prepared" — to have ready-made reports, financial calculations, communication with underwriters and brokers, an investor relations and PR team. After all, the earlier you start the preparation process, the cheaper it will be.
Then, when the company has already been able to attract all available debt capital, it becomes possible to sell part of the company's capital as part of a private equity transaction or a public offering (IPO) on the stock exchange. But this is a topic for a separate conversation…
Can a bond issue boast the same? Is it guaranteed by the state? No. Maybe the deposit is reliable? Also, no, because you need to know how it was evaluated and how I, with my 0.1% investment in a bond issue, got a piece of the mortgaged building. Maybe then the cash flow structure is better for me as an investor? Again, no. Deposits and apartment rentals generate income every month, while bonds are usually quarterly or less frequently. Liquidity? It is practically non-existent on the secondary market, and most bonds are held to maturity.
If a bond is riskier than a deposit, has no liquidity in the secondary market, and pays income less often, it is logical that all this should be reflected in the yield level. But, unfortunately, most business owners are morally not ready to accept such conditions and pay above what they pay on loans, and sometimes they try to offer lower rates. In this case, it will be difficult to successfully issue bonds.
It all depends on the profitability. What it should be is an open question, and there will be an answer for each individual situation.
Unfortunately, the quality of the borrower in Uzbekistan does not play a significant role yet and it is very difficult to convince investors that some issue with a lower yield, but from a more reliable issuer, will be a better investment than a large promised income from a high-risk transaction.
Example. I think everyone understands that if some AAA-rated bank wants to place bonds in Uzbekistan, then the yield of such bonds should be lower than the key rate of the Central Bank of the Republic of Uzbekistan — because the rating of the organization is higher. It seems logical, but I really want to look at those who in their right mind will go to buy bonds with such a yield in the presence of many other opportunities on the market, including government securities.
I do not yet know how to explain the importance of borrower quality and the cost of risk to most unqualified investors — certainly not through an analysis of the Sharpe ratio. Perhaps only a few small defaults will help you understand that there is a risk and it needs to be properly assessed. Nothing teaches you more than losing your own money.
Moreover, recently we had the first default on bonds in the domestic market in many years, which, apparently, unexpectedly caused the withdrawal of the international rating from the issuer. I hope this will become an important example for many: bond issuance is not only an opportunity but also a responsibility.
But — to practice! About ten publicly placed issues and more than twenty private ones are currently circulating on the market. The main part of them has a maturity of 18-36 months, and the rates are about 22-24% (although there are issues with rates of 27-28%). The volume of public offerings is just over 150 billion soums. Moreover, half of the issues are not fully posted, which already speaks volumes.
For most clients, we recommend making debut issues with the shortest possible duration, preferably in 18-24 months, in order to be relatively comparable with the average deposit terms. At the same time, it is desirable-
It is advisable to immediately plan their repayment through additional issues in the future: if a year and a half passed successfully for the company and for the market, the issuer was able to convince investors of its development and reliability, build a communication structure with them, then we can hope that the next issue will be with a longer period or with a lower coupon rate.
When there are enough such issues, it will be possible to say that the company has built a "yield curve" — an approximate graph of how it can borrow for different periods: 6 months, a year, 3 years, 5 years, 10 years, etc. With such information, third-party investors can already estimate approximately at what rates they will be able to offer their financing to the issuer. This also opens up new opportunities in negotiations with banks and creditors.
Probably, experienced specialists will criticize me, pointing out that for a new, dynamically developing company on the market, this curve will be strongly influenced by its development and that borrowings will not be "homogeneous" in quality and condition of the borrower at every single moment. Therefore, curves are usually built for sovereign debt. But let's leave that out for now to focus on the importance of a long-term approach to bond issuance.
How did these issues fit, given all the disadvantages that I listed above: risks, liquidity, and regularity of payments? First of all, it is worth noting the presence of a tax arbitration factor: at the moment, income from bonds is not taxed, so it is more profitable for a large investor to buy bonds than to issue a direct loan under the same conditions. At a rate of 20%, a whole 1% is saved, which is quite significant. That is why some banks are actively involved in the process, and in private placements, a large share is taken up by transactions with affiliates and shareholders who convert loans into bonds.
Another factor is the development of legislation. Recently, microfinance organizations were allowed to raise funds through bonds, which they began to use with pleasure. In addition, by another decision of the president, state-owned companies are recommended to finance part of their investment program through the issuance of bonds.
In the future, I hope there will be a change in the assessment of the opportunities that open up on the part of entrepreneurs who will be willing to pay above the loan rates and attract financing here and now for a more dynamic development of their projects.
Thus, despite all the difficulties (first of all, the lack of liquidity in the market and uncertainty about the possible volume of attraction), I am convinced that the bond market in Uzbekistan will develop and will be very rapidly. A couple of successful releases from Daredevils will attract a lot of other players, and the appearance of new products will open the market to other investors.
When this happens, it would be good to be "fully prepared" — to have ready-made reports, financial calculations, communication with underwriters and brokers, an investor relations and PR team. After all, the earlier you start the preparation process, the cheaper it will be.
Then, when the company has already been able to attract all available debt capital, it becomes possible to sell part of the company's capital as part of a private equity transaction or a public offering (IPO) on the stock exchange. But this is a topic for a separate conversation…
