The Central bank of Kenya
Kenyan banks are holding up to Ksh1.59 trillion ($10.7 billion) worth of Treasury bonds that is at risk of losing significant value as a result of the high interest rate regime sustained by the government’s increased borrowing from the domestic market.
This could impact liquidity and the ability of the lenders to meet maturing debt obligations.
When interest rates go up, the value of bonds goes down, and bondholders’ wealth goes down.
By June, banks reported bond revaluation losses on two- and 20-year Treasury bonds of Ksh102.7 billion ($689.26 million), according to the Central Bank of Kenya (CBK).
The CBK estimates that if the average bond yields increase to 18.85 percent and 19.89 percent, under moderate and severe scenarios, banks will record unrealised bond valuation losses of Ksh154.8 billion ($1 billion) under moderate scenario and Ksh208.7 billion ($1.4 billion) under the severe scenario, against the baseline estimates of Ksh96 billion ($644.29 million).
“We should diversify our investments. We hope that, with more taxes, there will be less appetite for debt and this will bring down the interest rates and the value of the bonds can go up,” said Prof XN Iraki of the University of Nairobi’s Faculty of Business and Management Sciences.
Rising interest rates affect bond values through mark-to-market unrealised valuation losses for bonds held for trading and available for sale, which are charged on the banks’ capital.
“Therefore, the banking sector is exposed to the government securities in terms of assets and liquidity,” says the CBK.
Coupon yields
According to the regulator, the changes in the bond yields are explained by inflation, Central Bank Rate (CBR), interbank rate, Treasury bill rate and the lending rate.
The Treasury bill rate accounts for about nine percent of the change in the bond yields while the CBR accounts for 0.9 percent.
According to CBK, the coupon rate and yields in the domestic secondary market for bonds and Kenya Government Eurobonds increased in the first half of this year, reflecting reduced liquidity and tight financial conditions.
By June, banks’ total assets stood at Ksh7.05 trillion ($47.31 billion), of which 29.3 percent were government securities.
Government domestic debt stood at Ksh4.73 trillion ($31.74 billion), of which 84.74 percent (Ksh3.45 trillion-$23.15 billion) was Treasury bonds.
Commercial banks controlled 46.17 percent of the government’s domestic debt – about Ksh1.59 trillion ($10.67 billion) worth of Treasury bonds.
The central bank held the policy rate at 10.5 percent in its latest monetary policy review to anchor inflation and reduce pressure on the exchange rate, which has fallen to a low of Ksh149 against the US dollar.
But the government’s appetite for revenues to fund operations has turned the Treasury bond market into a theatre where investors, especially banks and pension funds, are angling for higher returns on their investments.
National Treasury’s director in charge of debt management Haron Sirma blamed the state of affairs in the bonds market to tight liquidity and investors’ apparent lack of funds to invest in long-term debt instruments.
“Market liquidity conditions in the market are too tight. Under such conditions, higher interests do not necessarily yield better performance in subscriptions,” says Dr Sirma. “Investors have little money to place long term.”
Economists say investors in bonds are now looking for returns that are commensurate with the risks they are taking to invest in long-term paper, and if they don’t succeed they go back to short-term instruments – Treasury bills.
“Investors feel that the interest rates are not high enough or commensurate with the risks. They want higher rates, hence the undersubscription of the long-term treasury bonds,” says Prof Iraki. “They prefer short-term Treasury bills, which are perceived as less risky.”
Undersubscriptions
Recently, the CBK reopened two bonds of two years and five years, only to register huge undersubscription.
The two bonds received bids worth Ksh12.3 billion($83.5 million), against the offered Ksh35 billion ($234.89 million) – a 35.1 percent undersubscription.
The government accepted bids worth Ksh6.3 billion ($42.28 million), translating into an acceptance rate of 51.3 percent.
The weighted average yields for the accepted bids came in at 17.7 percent for the two-year bond and 18 percent for five-year bond.
The coupon rate for the two-year and five-year bonds were set at 17 percent and 16.8 percent respectively.
“Investors have expectations for higher interest rates and are therefore playing on the shorter end,” observes Ken Gichinga, chief economist at Mentoria Consulting.
As a result, the Treasury bond yields have jumped in the past one year, upsetting expectations of investors expecting investment protection in risk-free government bonds.
“The price of bonds decreases as interest rates rise, so many bondholders are at risk of booking losses,” says Gichinga. “The situation can be resolved by reducing the government borrowing programme, which will lead to lower interest rates.”
The yields on a 10-year Treasury bond has surged by 150 basis points to 15 percent in June this year, from 13.5 percent in June 2022, before further increasing to 15.9 percent on October 6, according to the CBK Yield Curve.
On the other hand, the yields on a five-year bond jumped by 220 basis points to 14.5 percent in June from 12.3 percent last year, before jumping to 17.99 percent on October 6, 2023.
Failure to strike a business balance between the government and the investors on the pricing of long-term bonds has resulted in under-subscription of the Treasury bonds in recent months.
Investors are wary to commit their funds with the government on the long term for fear of duration risks and the uncertainties related to the government’s debt repayment capacity in view of the negative credit ratings.
Below target
CBK disclosures show that the first half of 2023 recorded more undersubscriptions, with four of the six months falling below target, while the yield curve shifted upward, implying higher domestic borrowing costs.
“Holders of government bonds subject to mark-to-market valuation under IFRS requirement also face unrealised losses than can easily crystalise in the event of liquidity stress,” says the CBK.
Overall, interest rates on government securities increased in 2022 and the first quarter of 2023. Treasury bill rates for all the maturities averaged nine percent in 2022, compared with an average of 7.7 percent in 2021.
The weighted average interest rates for both T-bonds and bills rose to 11.1 percent in 2022, compared with 10.1 percent in 2021.
Kenyan banks are struggling with twin problems related to a surge in bad debts and the valuation losses on bond holdings as a result of a higher interest rate regime.
Over the past five years, commercial banks have witnessed a faster rate of accumulation of bad loans compared with that of profit accumulation.
The level of NPLs increased by 63 percent to Ksh503.24 billion ($3.37 billion) in 2022 from Ksh308.76 billion ($2.07 billion) in 2018 compared with the profit before tax which grew by 58 percent to Ksh240.38 billion ($1.61 billion) from Ksh152.33 billion ($1.02 billion) in the same period.
The banks’ profitability is mainly attributed to strong growth in interest on loans and advances, and on government securities.
The two sources (interest on loans and government securities) accounted for 72.9 percent of total income in 2022.
“These are key to stable earnings base and therefore enhanced ability for banks to build more capital through retained earnings,” says CBK.
“Interest income from loans and advances has however been declining steadily since 2019 but has increased for government securities.”
