Banks and pension funds blocked from juicy infrastructure bonds

Institutional investors such as pension funds, commercial banks and insurance companies could soon find themselves locked out of lucrative infrastructure bonds in a proposed radical change to participation rules in Kenya’s debt market.

This would mean that institutional investors could be effectively prohibited from participating in an investment instrument that typically attracts massive appetite due to its tax-free status and relatively higher interest rates compared to standard bonds of similar maturities or closely comparable.

Infrastructure bonds enjoy tax-free status under paragraph 59 of the First Schedule of the Income Tax Act and this provision is aimed at raising funds for development projects across the country.

Other bonds attract a withholding tax of 10 percent for those with a term of more than five years and 15 percent for those maturing within five years.

The Treasury has presented the proposal to the National Assembly as one of the reforms planned for the fiscal year from July 2024 to June 2025, as the government seeks to make significant changes to the country’s domestic debt market.

“The National Treasury intends to undertake reforms in the restructuring of primary market activities to reduce borrowing costs and promote market activity. To manage competition between tax-free infrastructure bonds and Treasury bonds, it may be beneficial to restrict infrastructure bonds to retail investors,” says National Treasury in 2024/25 budget summary presented to the National Assembly Tuesday afternoon.

This marks the latest move to reform the bond market in favor of retail investors after the Central Bank of Kenya – the government’s fiscal agent – ​​halved the minimum investment in infrastructure bonds to Sh50,000 in November of the year. past.

The public debt is dominated by banking institutions and pension funds that hold 45.75 percent and 29.44 percent respectively. Insurance companies and parastatals own 7.15 percent and 5.25 percent respectively, while the “other investors” category, which includes retail investors, owns 12.41 percent.

The last infrastructure bond the government issued was in February, in which it sought to raise Sh70 billion at an interest rate of 18.5 per cent, but ended up attracting a staggering 288.7 billion bids. This points to the appetite with which the market is targeting infrastructure bond issuances and is credited with strengthening the Kenyan shilling over the past two months due to the strong offshore flows it has reportedly attracted.

However, players in the investment and brokerage sector have questioned the wisdom of potentially limiting infrastructure bonds to the retail market. They argue that one of the long-term impacts of this measure could be to undermine the strong foreign capital inflows that have characterized the adoption of infrastructure bonds.

“To the extent that the National Treasury’s strategy of limiting infrastructure bonds to the retail segment would be vital to reduce tangible taxes forgone by institutional investors, I believe the strategy will generate more costs than benefits in the long term,” said Ronny Chokaa, a Senior Research Analyst at stockbroker AIB-AXYS Africa Limited.

“Incentives to support infrastructure development would be diluted, discouraging much-needed foreign direct investment. Given increased capital mobility and intense global rivalry for the marginal investable dollar, higher taxes will surely redirect portfolio flows elsewhere, where real returns are higher.”

An analysis in this publication indicates that the government is forgoing at least Sh23.5 billion annually in tax incentives to infrastructure bond investors. The Treasury further says it is implementing a detailed domestic debt issuance schedule to stabilize demand and ensure auctions meet target issuance size. Additionally, the government says it is creating a benchmark bond program aimed at addressing domestic debt portfolio fragmentation.