How second bond market will complicate State pricing of domestic debt

Introducing another bond trading platform could present the National Treasury with a dilemma on how to price bonds when borrowing locally.

The Capital Markets Authority (CMA) recently approved an application for a licence for Over-the-Counter (OTC) trading by the East African Bond Exchange (EABX).

It is the second exchange after a similar one run by the Nairobi Securities Exchange (NSE).

An OTC market is a platform that allows traders to trade without having to go through a formal securities exchange.

It allows traders to have bilateral negotiations without involving the intermediaries with electronic capture of their activities eliminating the need for an intermediary.

Trading of bonds—mostly long-dated Treasury bonds—has for long been only through the NSE’s broker-intermediated exchange.

Analysts say the two platforms mean more options for investors buying and selling Treasury bills and bonds in the secondary market.

While they note that Treasury is likely to continue to use the NSE Yield Curve to price bonds, some Treasury insiders say that running the two exchanges would prove problematic.

The Central Bank of Kenya (CBK) uses the NSE Yield Curve to determine how much interest to offer investors when raising money locally through bonds.

The yield curve is also used by other players in the financial services sector to price certain loans, including mortgages.

There are also reports that Treasury and CBK have not been reading from the same script on the new development, with the former noting that more exchanges would make trading in bonds more transparent and accountable.

But CBK is of the view that additional exchanges could interfere with deriving a yield curve.

“When the second bonds exchange becomes fully operational and effectively darts competing with the NSE, it could present a challenge for CBK as to which yield curve will be in use… basically which yield curve will be the reference point. The thing is that all stakeholders are involved in the creation of the NSE yield curve,” said a CBK source who sought anonymity so as to speak freely, adding that this has made the NSE yield curve more transparent. 

The source also noted that there are concerns that a senior Treasury official has been listed as a director of EABX, which he noted raised eyebrows as Treasury’s role in the establishment of the new exchange.

EABX has listed Daniel Ndolo, the director of debt policy, strategy and risk management at National Treasury, as a non-executive director.

Treasury has previously said the government had no stake in EABX.

The yield curve shows the different interest rates that the government pays on loans it has taken in the domestic market. The loans have varying maturity dates.

“The NSE yield curve will likely remain the benchmark yield. Their plans to provide a real-time yield curve that factors in activities of the quotations board will underpin its importance as a barometer to the fixed income pricing,” said Director, Fixed Income & Sovereign Bonds at Renaissance Capital Eric Ruenji.

“It goes without saying that the historical data that the NSE yield curve provides is crucial in mapping out cyclical and secular trends over time, a critical aspect in pricing primary market and secondary market papers.”

A second bonds exchange was among the conditions by the International Monetary Fund (IMF) for its Extended Fund Facility and Extended Credit Facility to the country. Treasury committed to operationalise an automated bonds exchange that would complement NSE.

Following IMF’s January review of the credit programme to Kenya, which is the sixth review since the lending programme started in 2021, Kenya committed to the IMF that it would take steps towards operationalizing an OTC automated exchange to complement the operations of the NSE.

“We will further enhance the market infrastructure through policy support to market participants to operationalize an over-the-counter automated exchange to complement the broker-intermediate Nairobi Securities Exchange,” said Treasury officials to the IMF.

“The aim of the exchange will be to promote trading transparency and settlement efficiency and attract more capital in the economy eventually leading to reduction of yields and cost of new public debt.”

Other than the dilemma over which way the yield curve will go, NSE is also expected to take heat from the new exchange, especially if the market for bonds does not grow as fast and the two exchanges start a fierce fight for existing customers. 

“EABX may sap some liquidity from the NSE given that the same clients who trade on the NSE may be the same trading on the new exchange,” said Renaissance Capital’s Mr Ruenji.

“With a general expectation of rising domestic debt - even pinned as a per cent of GDP, the quantum is expected to grow. This implies that the cake is big enough for two players. In addition, having a broader bond market should also assist corporates and more so SMEs in raising capital effectively.”

The NSE recently responded to the fresh competition from EABX, announcing that it has been allowed to operationalise a hybrid fixed-income market.

The bourse said the hybrid fixed income exchange will combine both on-screen and over-the-counter (OTC) trading of government and corporate bonds and comes shortly after EABX recently unveiled its OTC exchange.

It noted that the hybrid model will improve pre-trade transparency through the introduction of a Quotations Board which will provide investors with increased visibility into market quotes, thereby supporting more informed trading.