Timing is crucial in investing, as it can significantly impact potential profits and missed opportunities. According to Kanishke Mannakkara, CEO of CAL, the present landscape presents a compelling case for investors to act.
Improving macroeconomic trends, as indicated by carefully analysed interest rates and GDP growth in Sri Lanka, provides valuable insights that shape investment decisions at CAL. These insights have proven instrumental in generating attractive returns for CAL’s portfolio management business, particularly in government securities, and the investment bank hopes to unlock further opportunities with the closed-end fixed-income fund structured to provide market-beating returns, stability, flexibility, and tax advantages for investors.
Why Fixed Income?
Typically, government bonds have zero risk (earning this investment class the title of gilt-edged securities) and are a significant component of unit trust and wealth management portfolios. Given the Government’s confirmation that Domestic Debt Optimization (DDO) will not result in any impact on privately held Government Securities, we expect Government Bonds to once again fall into favour with wealth managers in Sri Lanka.
A typical bond investment strategy aims to generate steady income streams. Bonds pay interest to bondholders at a fixed or variable rate, offering a reliable source of income over time for investors who prefer a stable income stream.
However, government bonds are not immune to market forces. They are sensitive to changes in interest rates. When interest rates rise, the value of existing bonds declines, which could lead to capital losses. Conversely, when interest rates fall, the value of bonds increases, potentially resulting in capital gains. Therefore, investors must carefully consider the outlook for interest rates before deciding on their bond strategy.
Assessing the potential return and risk of government bonds, investors need to consider two key factors: duration and yield. The prices of longer-duration bonds tend to be more sensitive than shorter-duration bonds to changes in interest rates. Evaluating the yield in relation to the bond’s duration helps investors gauge the potential return relative to the risk involved.
Typically, the investment strategy for government bonds follows a buy-and-hold approach. Investors often hold these bonds until maturity, allowing them to receive the full face value of the bond at maturity and regular coupon payments along the way. However, it’s worth noting that investors also have the option to sell bonds before maturity in the secondary market, providing an opportunity to capitalize on capital gains or adjust their portfolio based on changing market conditions.
The effort to execute an effective bond strategy is beyond most retail investors busy with their day-to-day cares and careers, which is why investing in a unit trust managed by professional investors may be a better option.
In Sri Lanka, one notable avenue that has shown exceptional performance is fixed-income portfolios, particularly government bonds. Over the past few quarters, as interest rates have fallen sharply, these bond portfolios have demonstrated impressive results, generating both interest income and significant capital gains. As interest rates remain elevated, this favourable trend could continue with further potential for interest rates to fall in the future, making it an opportune time for investors seeking profitable investment options.
CAL has also observed a significant growth trend in the asset management industry, driven by declining interest rates that entice more investors to explore investment opportunities. As individuals seek higher returns, CAL’s assets under management (AUM) continue to expand, indicating the market’s viability.
Fixed Income Outlook
The outlook for fixed-income assets is particularly exciting. According to Mannakkara, Sri Lanka has experienced a transformative shift towards more orthodox economic policies in the past few months, setting the stage for a significant improvement in the macroeconomic landscape. Looking ahead, he anticipates a period of moderate to high growth in the coming quarters, with our forecasts surpassing those of the IMF and World Bank. “We expect the economy to commence growth from the second half of this year, and with ongoing reforms, we believe Sri Lanka can sustain a solid 3-5% economic growth over the next four to six years,” he says.’
CAL’s outlook includes predictions of rapid inflation moderation, potentially within the next three months, driven by base effects and a deceleration in price increases. It foresees a substantial decrease in interest rates, which have already declined by 600 to 700 basis points since the beginning of this year and anticipates the trend to persist. Notably, there have been structural shifts in the balance of payments with a recurring surplus of $200 to $300 million per month, which holds significance for the domestic economy. This surplus is attributed to reduced import demands and the resumption of tourism
Although a brain drain has had negative implications, remittances from overseas Sri Lankans are expected to increase, further contributing to the surplus. This positive development may lead to stable exchange rates and provide the government with the leeway to implement other necessary reforms, even if they are occasionally unpopular.
Recognizing the opportunities stemming from this situation, the IMF and other institutions have emphasized the importance of freer markets and state deregulation as crucial reforms. “We fully support these measures and believe they will unlock numerous prospects for businesses, investors, and our valued clients. As these reforms unfold, we anticipate that CAL, as an investment bank, will indirectly benefit across multiple sectors,” Mannakkara avers.
Opening the Closed-End Opportunity
The closed-end structure allows CAL to focus on its investment strategy, provide stability and flexibility, offer tax advantages, and cater to investors with a longer-term perspective.
The closed-end fund allows CAL to focus on a specific investment strategy, in this case, long-duration government securities. By having a fixed investment focus, it can tailor the portfolio to optimize returns in this particular area. A closed-end fund provides stability and enables CAL to raise a fixed amount of capital from investors during the subscription period. This provides stability to the fund’s capital base and allows fund managers to make strategic investment decisions without concerns about short-term liquidity requirements. Also, unlike traditional open-end unit trusts, a closed-end fund will not experience dilution due to new investments at lower rates, making it an attractive option for investors looking into their investments during the subscription period.
Once the subscription period closes, the fund operates with a fixed number of units. Unlike open-end funds, which continuously issue and redeem units based on investor demand, the closed-end structure provides flexibility for CAL to manage the fund’s portfolio without the need to buy or sell securities based on daily investor transactions.
After the subscription period, the units of the closed-end fund can be traded on the Colombo Stock Exchange, providing liquidity and flexibility for investors who wish to buy or sell their units. This secondary market trading allows investors to exit their positions before the five-year holding period concludes if they choose to do so.
The closed-end structure offers tax advantages to investors. Profits within the fund remain unrealized until the investor decides to sell their units, deferring tax payments. This can be advantageous in high-tax environments, as investors can potentially pay taxes at lower rates when they realize profits in the future.
The closed-end structure is suitable for investors with a longer-term investment horizon. As the collected capital is held in the fund for five years, it aligns with CAL’s strategy of focusing on long-duration government securities and capturing capital gains as interest rates decline over time.
With this fixed-income closed-end fund, CAL aims to open more opportunities for the retail segment aligning with its aim to expand its offerings beyond traditional institutional clients. By leveraging technology, CAL intends to provide seamless access to investment opportunities while optimizing its workforce. With an overall AUM of approximately Rs100 billion, the retail segment currently constitutes around Rs8 billion. CAL aims to further grow its retail market share through innovative products and efficient distribution channels.
Investors interested in the fixed-income closed-end fund can subscribe to units until July 18, after which the subscription period will close. The collected capital will be held in the fund for five years, allowing fund managers to make strategic investment decisions without concerns about short-term liquidity requirements.
The introduction of CAL’s fixed-income closed-end fund presents a significant development in Sri Lanka’s investment landscape. It caters to the retail market while offering an alternative investment avenue for individuals seeking higher returns compared to traditional fixed deposits or money market funds.
As CAL prepares to list the fund on the Colombo Stock Exchange later this year, retail investors will have the opportunity to trade units on the exchange, providing liquidity and flexibility for those who wish to exit their positions before the five-year holding period concludes.
CAL’s innovative approach, combined with favourable macroeconomic conditions, exceptional returns in fixed-income portfolios, industry growth driven by declining interest rates, the shift towards private wealth management, tax advantages, and technological advancements, presents a compelling case for investors to consider this opportune moment, Mannakkara notes.
“Our objective is to beat long-duration government security yields. That’s the fund’s objective. So, currently, those yields are in the teens. Our objective is to beat that as a CAGR over the five-year period, and with bank fixed deposit yields at around 10% for the same tenure, we believe our fund presents a healthy investment opportunity,” he says.