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Notes blossoming as stock market withers

More than four years ago, the official SAX index of the Bratislava Stock Exchange took a nose dive, gradually ceasing to fulfil its crucial role of allocating funds. For a short while it seemed that this role may be taken over by the bond market, but state securities soon usurped it in the name of financing a growing budget deficit.
With both the equity and bond markets in doldrums, Slovak companies have increasingly been forced to reel in fresh funds elsewhere. Although some firms have managed to find monies in promissory notes issued to foreign investors, the government's appetite for foreign funds snuffed out what was probably the last effective means left to allocate funds on a larger scale.

More than four years ago, the official SAX index of the Bratislava Stock Exchange took a nose dive, gradually ceasing to fulfil its crucial role of allocating funds. For a short while it seemed that this role may be taken over by the bond market, but state securities soon usurped it in the name of financing a growing budget deficit.

With both the equity and bond markets in doldrums, Slovak companies have increasingly been forced to reel in fresh funds elsewhere. Although some firms have managed to find monies in promissory notes issued to foreign investors, the government's appetite for foreign funds snuffed out what was probably the last effective means left to allocate funds on a larger scale.

The official SAX index is slowly but surely heading down to 100 points, its value at the time the bourse was established on September 14, 1993. The SAX skyrocketed soon afterwards, topping the 405 point mark in late February 1994 fuelled by foreign investment and privatization.

But now, things have cooled off significantly and trading is much thinner. Only a small number of shares change hands each day, mostly in anonymous trades. On June 3, there was not a single deal with listed stocks.

Direct trades dominate the market, representing some 99% of all trading. Stock prices have become blurry.

"Most of the transactions are direct trades administered to minimize the tax burden of domestic players, sales of stocks held by foreign investors, and occasional low-volume purchases for hedge funds," said Boris Procik, fund manager at J&T Asset Management investment company. "The stock market is not relocating funds."

High interest rates on the Slovak interbank market are partly responsible for the equity market's misery. When a relatively low-risk bank deposit or T-bond yields some 19%, stocks become unattractive. "I never saw a domestic investor buying stocks in expectation of higher yields compared to those offered by debt securities," Procik said. "[Our] capital market lives in its own world," he explained, pointing out that in Slovakia, equity and debt are not so strongly connected as in fully developed markets.

However, exorbitant rates are not the only reason why the stock market fails to catch any fresh wind in its sails. "The capital market is the cream on top of a functioning market economy," said Juraj Kováčik, an analyst at the P67 Value think tank. "If I were to help the market, I would stress the basic fundamentals of a market economy - transparency and fair play," he added, suggesting it was exactly the government's failure to build such an environment that was the primary reason for the equity market's current low liquidity.

Private investment crowded out

Procik added that this non- transparent business environment had created a breeding ground for several scandals involving investment funds in the past. "[As a result], the public either has cash at home or puts it in a bank," he said. "If a fund managed to capture this liquidity and invest it on the stock market, it would bring some vigor into the trading."

But for now, J&T Asset Management along with other investment management firms, have converted much of the equity previously held by their funds into state securities. Viktor Levkanič, an analyst at Slávia Capital, said the crown-denominated state debt was the prime mover of trading on the domestic financial market. "What we see is a classic effect of the state crowding out private investment," he said.

Levkanič continued that high yields on state debt and low stock market activity are two ends of the same stick. Since most domestic funds are drained to cover the budget deficit, he said, the interest rates increase and leaves little or no liquidity to relocate to corporations. "For the past few months, there was no primary issue of [corporate] bonds," Levkanič said. "The primary market for these bonds is virtually dead."

Agreeing with Levkanič, Kováčik pointed out the failure of a bond issue launched last September by Slovak shipbuilder Slovenské Lodenice. "I thought the company was relatively sound and the conditions for the issue were good," Kováčik said. "[But] the corporate bond market is not functioning probably due to high interest rates on state debt."

Along with domestic investors, foreigners also have veered from stock and corporate bond markets toward government debt. "In entering an emerging market, foreign investors prefer sovereign debt, then top corporate bonds, and only then stocks," Levkanič explained.

Promissory notes step in

With the stock market withering and state securities usurping a major chunk of the bond market and pushing rates higher, top Slovak companies are increasingly issuing promissory notes to foreign investors, who in this way participate in short-term financing of top Slovak companies. "The reallocation of resources is [conducted] from abroad," Kováčik said.

According to Levkanič, this scheme has proven possible only by offering short-term maturity, and only by firms with certain exports that would help offset any possible depreciation of the crown. In nearly all cases, the companies issue promissory notes with a maturity from 6 to 12 months. Such a note is then bought by a foreign investor and held to maturity or resold.

This way of financing has grown extremely popular. Last year, Slávia Capital drew from abroad funds worth almost 19 billion Sk for its domestic clients. "Promissory notes are now the most flexible tool with which to obtain funds for Slovak companies," Levkanič said.

The greatest advantage of promissory notes are their flexibility since a note issue can be administered in just two weeks and bear much lower interest than crown-denominated debt.

The main disadvantage, however, is that the notes' viability largely depends on how foreign investors view the overall picture of a given country. In other words, promissory notes are politically vulnerable.

"A decreased country rating, the political situation, and pre-election time are all factors that cause foreign players to decrease their limits in Slovakia," Levkanič said, adding that foreign investors are less interested in Slovak securities than last year, which makes it harder to place a note issue abroad.

The government's premiere $750 million Eurobond issue last May has not made it any easier for corporations to obtain funds via notes abroad.

"International markets priced the recent issue of state bonds some 3.5% above comparable [German] Bunds rates, which also hiked up interest rates on notes issued by domestic corporations," Levkanič concluded.

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