Investing in Corporate Debt

By Naveen Samarasekera, Manager – Corporate Finance First Capital Limited

Steering through diverse investment tools can be perplexing for the average investor. Investor education is crucial as knowledgeable and empowered investors contribute towards a vibrant market. Corporate Debt instruments are one of many investment options available to investors and the following explores the mechanisms of listed debenture investment options in the Sri Lankan market.

What is a debenture?

In general, debt instruments may be issued by the Government or a Corporate. Government debt is termed Treasury Bills and Bonds. Corporate debt comprises of instruments such as debentures (secured/unsecured, rated/unrated, listed/unlisted), securitized paper, promissory notes and commercial paper. The specifications are important when considering an investment and will also determine the risk, return and liquidity of the investment.

A debenture is a medium to long-term corporate debt instrument, issued by a company (issuer) to borrow money with the aim of fulfilling capital requirements, sourced at a fixed rate of interest or floating, usually pegged to a Government Treasury Bill rate. Debenture investments are considered a fixed income asset as it produces a fixed income to the holder(s) (lender) by paying a specified percentage of coupon payment on designated dates and repaying the principal value of the borrowing at maturity.

Is it different from buying shares of companies?  (How does debt differ from equity?)

Yes it is different.

The process of buying shares of a company refers to buying securities or a stake of a particular company that has listed its equity capital for investors to purchase through the Colombo Stock Exchange (CSE). Earnings for shareholders come from the growth in share prices and dividend payments (share of profits) if and when the company declares a dividend.

However, shareholders are the last to get settled on liquidation if the company goes into default. The share prices of companies that are under performing may also result in the price of shares declining and the investors losing the value of their investment.

In contrast, debt holders of a company cannot claim ownership or have any claims to future profits of the business. The investor will only be lending capital to the company and the borrower’s only obligation is to repay the loan with interest.

Unlike dividends which will generally depend on the earnings made by the company, the issuer is contractually obliged to pay the lender interest payments until their obligations are met.

Listed debt can also be traded in the secondary market similar to shares. In Sri Lanka this process is facilitated by the DEX System of the CSE. The secondary market trading of debentures are a means of transferring of asset from one lender to another. The swift transferring of debentures increases liquidity and gives lenders a way of trading debt instruments in the market.

Is it a popular investment option?

The average Sri Lankan is generally aware of the equity (stock) market than of the debt market. However, in 2015 Sri Lanka saw LKR 83,414,408,000 being raised through debt IPOs and in 2014 the value was LKR 54,234,870,000, compared to LKR 329,564,800and LKR 2,693,834,800 in equity IPOs in 2015 and 2014 respectively.

As mentioned above, listed corporate debt is traded through the CSE and anyone interested in debentures can find upcoming issues on the CSE website.  Further, investment banks will have information regarding listed debentures available for trading and unlisted corporate debt instruments such as securitized paper, promissory notes and commercial paper currently available in the market.

Who does these investment option suit the most?

Currently, there are high-net-worth individuals, corporates, unit trust funds, provident funds trust /endowment funds and a small base of retail investors.

The key is to understand your investment objectives. Although there are risks such as credit and interest rates risks to be aware of, a competent intermediary such as an investment bank will guide you through the process of identifying the best investment for you based on your risk appetite and overall investment portfolio.

What are the risks and benefits for investors investing in corporate debt?

The most significant benefits of investing in corporate debt are the tax holidays (for listed debt) and flexibility of transferring through the secondary market.

Additionally, debt instruments are considered less risky than investments in the stock market as the market is less volatile, and if the company is liquidated it’s debtors come before the shareholders.

It is important to remember that investors in debt instruments are subject to credit risk arising from a borrower failing to make required payments, liquidity risk limiting the transferability of your debt portfolio and interest rate risk, by which the value of instruments rise or decline based on interest rate changes.

The Role of Regulators

The capital market of Sri Lanka is regulated by the Securities and Exchange Commission (SEC) which is the authority that consents to a corporate listing their debt, while the CSE through its corporate affairs arm monitors and ensure that the company complies with all listing requirements.

Debentures must carry a minimum BBB credit rating to list on CSE and comply with the applicable sections of the companies act.

-END-

Note

This article is a part of First Capital Holdings PLC’s Investor Education Series. The Investor Education Series is aimed at improving investment education and financial literacy in Sri Lanka and enabling investors to make informed decisions about investments and the financial market and is not an endorsement of specific products.

About the Writer

Naveen Samarasekera, Manager – Corporate Finance First Capital Limited

Naveen counts more than 12 years of experience in various business areas both overseas and in Sri Lanka. Prior to joining First Capital he was working as a Business Development Consultant engaging in Financial Planning and Advisory Services for Corporates and High Net-worth Individuals.

He holds a Diploma in Business from the Auckland University of Technology, Diploma in Management from NZIM, a Bachelor of Commerce Degree from the University of Auckland, New Zealand and is an Associate Member of the Chartered Institute of Management Accountants UK
(CIMA).