Since Nepse has underperformed in the past three years and equity returns have been lower, debentures may be a safer option for long-term investors.

Equity and debentures are innovative financial instruments that are used to raise additional capital through the sale of certain stakes or issued debt for the purpose of growth and operation. Public corporations and government entities often issue these financial instruments to arrange additional liquidity for cushion or to scale up their business. For example, in the hydropower sector, projects often raise equity through initial public offerings (IPOs) or rights shares to pay off bank loans. Similarly, reputable organisations globally raise funds from capital markets through equity or debenture (bond) issuance.

Institutional asset management companies and individuals can make strategic asset allocation decisions between equity and debentures (i.e., unsecured/secured bonds) based on correlation to achieve maximum returns while reducing systematic risk. As a result, debenture issues with high coupon rates are traded at a premium price. Interest rates are influential variables that affect every income class, and fluctuations in interest rates may increase the prices of debentures issued with a 10% coupon rate. Here, I studied data of four years to understand the correlation between interest rates and debenture price movements in the country’s capital market. Equities (stocks) naturally have an inverse relationship with interest rates—when rates rise, they pose a headwind for equities, and when rates fall, they become a tailwind for equities.

Based on the chart, any change in interest rates affects the market price of debentures. In July 2020, the average fixed interest rate was 9.02%. However, debentures were trading above their face value of Rs 1,000. Over the following months, interest rates steadily declined with an inflow of liquidity into the financial system. Consequently, debenture prices appreciated, benefiting investors who capitalised on gains from the premium. Therefore, changes in prevailing fixed interest rates may impact the price of debentures with higher coupon rates.

It also shows that interest rate behaviour acts as a dynamic influencing variable in relationships between debentures prices and interest rates, and vice versa. Thus, in such a scenario, investors have a choice regarding the risk-return tradeoff between these two instruments, ideally balanced with equity valuation. Both instruments have historically played a vital role in constructing a company's optimal capital structure. A perfect balance between these instruments also maximises the company's book value by reducing its cost of capital.

The Capital Market of Nepal

Nepal's capital market, despite its three-decade history, is still in a nascent stage. Numerous tangible improvements are needed to transform it from a weak-form efficiency market to a vibrant, strong-form efficiency market. Investor awareness is crucial in this transformation, as financial literacy encourages individuals to develop better financial plans and maintain emotional control, which can reduce stress and improve mental health. Nepse, established in 1994, serves as the country's sole exchange, providing secondary market trading opportunities. As of January 2024, after three decades of operation, 249 companies from various sectors including banking, hydropower, hotels, and tourism are listed on the exchange.

The Nepse index is heavily weighted towards the banking sector, which accounts for 58.4% of total market capitalization, followed by the hydropower sector at 14.4%. Other listed companies make up the remaining share, while debenture instruments represent only a minimal portion of the market capitalization. This shows that the debentures market is relatively insignificant and of illiquid nature. While institutional investors may consider debentures for portfolio allocation, they have yet to become a popular choice among individual investors.

Rationale behind preferring equity over debentures 

Equity, or common shares, is simply the amount of money that a company owner has put in or owns. In the financial statements (i.e. balance sheet), the difference between assets and liabilities shows the total equity or net worth of the company. Equity is a leading indicator that analysts use to evaluate the financial health of a company. Similarly, a company can borrow money in two ways: borrowing a loan from a bank at a certain rate or by issuing debentures with an enabling fixed coupon rate or interest rate. It is also a cost-effective strategy for the company compared to borrowing a loan from a bank. 

A debenture is a legal contract between the issuer and the debt holder where a fixed coupon rate must be paid regularly, and the principal must be redeemed at maturity. In the case of shareholders, they are eligible to receive dividends after interest payments to debt holders. Hence, in the case of liquidation, debt holders are given priority to redeem their principal, whereas shareholders who own shares in a company may or may not receive back capital. In such a situation, the company may declare a capital loss which can save them from paying taxes. One important characteristic of debentures is the option to convert into equity shares, which is beneficial to investors.

Furthermore, in advanced capital markets, such as the US financial market valued at over $51 trillion, the debt markets are attractive. The US long-term treasury bonds of 30 years with an offer rate of 4.39% is considered more stable than equity where yields fluctuate based on market demand and overall interest rate changes in the economy. According to various research journals, the bond market is a more significant predictor of inflation and directly affects the price of everything.

The Monetary Policy of 2019/20 ‘A’ allowed class commercial banks to issue debentures of at least 25% of their paid-up capital. This paved the way for these banks to disburse liquid funds collected through debentures as loans. At that time, new provisions were arranged to tackle the shortage of loanable funds, resulting in changes in the CCD ratio to CD. Simultaneously, ‘B’ and ‘C’ class institutions were also allowed to issue bonds to address the shortage of funds. More than Rs 30 billion worth of debentures with an average coupon rate of 9.05% for a period of 5 to 10 years have been issued so far.

Recently, there has been an ongoing discourse about why debentures are not as popular as equity among investors. There may be various reasons for the lack of popularity of these debt instruments. Some of them are listed below:

1. These debt instruments are not very liquid and are not easy to trade.

2. A lack of awareness among investors about its benefits. Let's take an example: Ram, as an investor purchased 100 units of debentures of 10.25% SBID83for Rs 918 each on September 21,2023, with a yield of 11.17%. As of July 14, 2024, the debenture was traded at Rs 1,118. If Ram sold the debenture at the current rate, the return from the investment would be 21.78%. Alternatively, if he holds until the redemption period, i.e. FY 2082/83, he will realise a capital gain as well as an attractive yield.

3. The tendency of speculative investors on the equity market and the price of debenture volatility is less.

4. The unfair interest rates regulated by markets, such as cooperatives as well as unorganised markets, offer higher rates of interest than debenture yields.

5. Face value of units also drives investors away..

6. Companies seem reluctant to issue debt instruments, even though regulators forcefully require them. Therefore, regulators should create encouraging and friendly policy frameworks to make debentures more attractive.

 7. Debentures and fixed deposit rates are similar. This makes investors reluctant to show interest in debentures. For example, in the US, the 30-year long-term treasury bond rate is 4.39%, whereas the short-term fixed deposit rates average 5%, reflecting a close spread between long-term debt and short-term fixed deposit. Hence, from a return perspective, there is a significant premium for locking money in long-term debt.

According to various research journals, the bond market is a more significant predictor of inflation and directly affects the price of everything.

Conclusion

For astute investors, investing in the right assets at the right time can provide a steady and immediate income source while reducing portfolio risk. Diversifying across different asset classes is ideal for a well-balanced strategy, resulting in more stable and consistent returns over time. Since Nepse has underperformed in the past three years and equity returns have been lower, debentures may be a safer option for long-term investors seeking better returns in their portfolios.

Uncertainty and liquidity problems are persistent in Nepal. Interest rate volatility increases risk and potential loss, particularly for risk-averse investors. Therefore, wise and rational investors should develop strategies to capitalise on good returns while reducing systematic risk. Understanding investment dynamics helps investors make informed decisions based on their risk appetite, investment horizon, and return expectations.

(Luitel has worked in capital market in various capacities including as a portfolio manager and research analyst)