When Equity Group released its half-year financial results last week, many eyes were drawn to a line on its income statement that showed the lender’s total comprehensive income stood at a negative Sh13.88 billion, yet profit after tax had gone up by 36 percent to Sh24.4 billion.
This was all down to a downward revision in the value of bonds on the bank’s books, essentially an erosion in the paper value of these holdings that comprise both local Treasury bonds and international issuances denominated in hard currencies.
It is largely similar to the periodic erosion of paper wealth at the equities market at the Nairobi Securities Exchange (NSE), depending on daily share price movements.
And just like the paper wealth movement at the stock market, such losses or gains in valuations would only be realised upon sale of a security, hence those holding the papers to maturity need not include such deficits on profit and loss line.
Equity, at the end of June, held investment securities worth Sh365 billion, out of which Sh236.8 billion were in form of Kenya government Treasury bonds and bills.
“Essentially what we are saying is that the yield at the Nairobi Securities Exchange (NSE) and the Eurobonds has gone up significantly. This is because of the appreciation of the US dollar against all other currencies, where for instance it has now hit parity with the Euro,” said Equity Group chief executive officer James Mwangi.
“But we hold that portfolio to maturity so it will never actualise (as a loss), and yet it's a very high earning portfolio.”
A look at the books of all the nine tier one lenders for the six months to June shows similar adjustments in the fair value of their investment securities, with these lenders collectively taking a paper hit worth Sh58.9 billion on their bonds holdings.
In June 2021, this downward revaluation stood at just Sh312 million, reflecting the stable yields in the bonds market at the time. The paper erosion in value is a direct result of the rising yields on bonds both locally and in the international market. Whenever yields on bonds rise in the market, the price of these papers falls.
In the past one year, the yield curve for government securities has risen significantly, indicative of rising risk perception on lending to the State.
The rates on short-term Treasury bills are now averaging between 8.5 percent and 10 percent, while bonds rates have risen to the range of 11.5 percent to 13.9 percent from 9.5 percent to 13 percent a year earlier.
Yields (or indicative rates) in the secondary market are a pointer of the interest rate that investors would demand to lend to the government at that particular time.
They are an indicator of the risk rating that investors apply on new lending to the government, hence guiding the pricing of new bond offers being floated.
At the same time, the price one would command when selling their bonds drops when yields go up, due to factors of demand and supply.
The prospects of offloading bonds in hand and reinvesting the proceeds in higher earning papers (due to elevated yields) means that many would be looking to sell, and there would be few buyers since they can get better returns by participating on primary sales of new bonds.
Sellers are therefore forced to offer a discount on the selling price their bonds in the secondary market in order to secure buyers, hence the drop in valuation of these existing papers.
For banks, these price drops translate into billions of shillings worth of devaluation of bond holdings, given their position as the biggest lenders to the government in the domestic market.
At the end of June, the nine tier-one lenders—who control 75 percent of the banking industry by market share—held Sh1.36 trillion worth of government securities, up from Sh1.25 trillion a year earlier.
Crucially though, the dip in bond valuations does not reflect in their profitability under the current accounting standards being applied by the banking sector (IFRS 9), unless they sell their holdings and book a loss. At the same time, their capital is also shielded from harm from a regulatory point of view.
“The good thing is that, the Central Bank of Kenya (CBK) recognise it so it doesn't affect our capital ratios…it's not written off against our regulatory capital.
The international accounting standards also recognise it so it doesn’t go through the profit and loss, it goes to fair value and is offset against capital for accounting purposes but not for regulatory purposes, so it doesn't affect the bank,” said Mr Mwangi.
There is a downside, however, for the government as it looks to borrow even more money from the domestic market to fill its budget hole in the current fiscal year.
As a result of the rising yields hurting the market valuation of their bonds, banks have been exercising caution when taking on new bonds, contributing to the recent underperformance in bond issuances floated by the Treasury.
For instance, the August Treasury bond sale that targeted Sh50 billion fell Sh11.5 billion below target as demands for higher rates forced the CBK to leave bids on the table.
Two other papers floated in July also returned below par volumes for the government. The first, a tap sale of an infrastructure bond first sold in June, raised Sh6.4 billion out of a target of Sh20 billion.
The second consisted two reopened 15-year papers that the State floated in mid-July seeking Sh40 billion, which raised Sh9.3 billion.
In the current fiscal year, the government is seeking to borrow Sh845 billion to finance the budget deficit, out of which a net of Sh565 billion is expected to come from the domestic market and the rest from external lenders.
Internationally, the government has been unable to issue a new Eurobond this year because of elevated rate demands by investors, with yields in the secondary market in London and Irish stock markets where Kenya has listed its existing portfolio of Eurobonds going to as high as 22 percent in June.
“It is a consideration because there is a lot of uncertainty, and not so much because of the Kenyan market per se but the global macros. We are seeing that Europe is in recession for instance, and these are factors that could influence trade among other things,” said Absa Bank Kenya chief executive Jeremy Awori.
“Banks have made their own assessments as to whether they want to hold on to government instruments, and especially those that they are trading. Things will however settle after the elections.”
Global shocks have largely been to blame for the uncertainty in the market which has pushed rate demands higher. The Russia-Ukraine war which began in February has been the biggest factor after disrupting global supply of key commodities such as food grain and oil, which Ukraine and Russia are significant source markets.
As a result, global inflation has gone up significantly this year, compounded by drought in Europe, Africa and Asia that has caused the prices of food items to shoot up as countries conserve limited supplies for their domestic use.
The US, UK and EU have also been raising their interest rates in response to their inflation hitting multi-decade highs, with the effect of drawing capital from emerging and frontier economies such as Kenya.
This has also strengthened the dollar, and made local markets less attractive to investors as other currencies such as the Kenya shilling suffer steep depreciation.
Locally, inflation has also gone up sharply this year, rising to a 62-month high of 8.3 percent in July due to higher cost of imported goods, fuel and raw materials.
In its May monetary policy committee meeting, the CBK raised its base rate by 0.5 percentage points to 7.5 percent, signalling the higher yield demands in the domestic debt space as banks adjusted to the tightening of the market.