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A primer on Treasury Bonds

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The Central Bank of Sri Lanka held a 30-year Treasury bond auction on 27 February 2015. It offered to sell bonds with a face value of Rs. 1 billion carrying an annual interest rate of 12.5%. It received bids for about Rs. 20 billion and accepted about Rs. 10 billion. The auction accepted yields up to 12.50%. The average yield accepted at the auction was 11.73%. The above auction has become a subject of extensive public debate. The purpose of this article is to discuss the basics of government securities to help the public understand the economic meaning of the various concepts, terms and numbers associated with a bond auction. The information about this particular auction will be used for illustrative purposes, and I will discuss the concepts mostly in relation to Treasury bonds. What are government securities? Government securities are the debt obligations issued by the government to obtain funds necessary to pay for government expenditures. In other words, the government borrows money by issuing government securities. The two primary types of government securities are Treasury bills and Treasury bonds.                           What are Treasury bills? Treasury bills are short-term securities issued by the government. The short-term means a security having a maturity not excessing one year. They are issued in three maturities – three-month (91-day), six-month (182-day) and 12-month (364-day) bills. T-bills are issued on a discount basis. That means they are always sold at a price below the face value, and the government promises to pay back the face value at maturity. As a result, they do not pay a periodic interest. The rate of return to the investor from investing in a Treasury bill is the difference between the face value and the purchase price. For example, consider an investor paying Rs. 93.50 for a bill with a face value of Rs. 100 that matures in one-year. The investor receives Rs. 100 in one-year resulting in a gain of Rs. 6.50, which is the difference between the face value and the purchase price. This discount on this bill is Rs. 6.50 for Rs. 100 face value. This discount when expressed as an annualised percent of the purchase price is called the Treasury bill yield. In this example, the yield is about 7%. The one-year Treasury bill yield at the March 18 primary auction was 7%. The yield represents the rate of return to the investor and the borrowing cost to the government. Treasury bills are sold weekly through competitive auctions.     What are Treasury bonds? Treasury bonds, also known as government bonds, are long-term debt securities issued by the government. Any security with a maturity period of more than one year is a long-term security. The maturity period is the time at which the government will pay back the principal (face value) amount borrowed. The Sri Lankan Government has issued bonds with two, five, six, eight, 10, 15 and 20 and 30-year maturities. Bonds promise to pay to the investor a periodic rate of interest and the principal at maturity. The choice of the maturity of bonds to be issued must be based on many factors including inflation and interest rate expectations, market liquidity, costs and risks to the government and the government debt profile.     Who issues Treasury securities? Treasury securities are obligations of the Treasury of the Government of Sri Lanka. However, the task of issuing Treasury securities is handled by the Department of Public Debt of the Central Bank of Sri Lanka. In this way, the Public Debt Department performs an agency function on behalf of the Treasury. However, it is the Treasury that is ultimately obligated to pay promised interest and principal on government securities.     Why does the government have to issue bills and bonds? There are two main reasons for the government to issue bills and bonds. First and foremost, the government needs funds to pay for various expenditures on an on-going basis. They include any type of government expenditures such as recurrent expenditures like wages of government employees and capital spending like construction of roads, bridges and schools. Secondly, the government has to pay back interest and principal on previously issued debt. If the government’s revenue is not adequate to pay for the payments due on bills and bonds issued in the past, then the government will issue new bills and bonds and obtain money to pay them. This amounts to rolling-over or refinancing of government debt. Net new issuances of government securities add to the total government debt.     What is the interest rate on a Treasury bond? The interest rate, most commonly known as the coupon rate in the bond market, is the rate at which the government pays interest to the investor on a periodic basis. It is typically a fixed rate specified at the time the bond issue is announced and paid on a semi-annual basis. Consider the 30-year bond that is subject of controversy. The interest rate on this bond is 12.5% per year. Interest is always paid on the face value of a bond. In this case, the bond promises to pay 12.5% for each Rs. 100 face value, which amounts to an interest of Rs. 12.50. However, it is paid in instalments of Rs. 6.25 every six months. The 30-year bond will pay 60 instalments of Rs. 6.25 for each Rs. 100 face value. Thus, bonds provides a periodic constant cash flow to the investor. It is important to point out that the interest rate on a bond is not determined at the auction. Rather, it is pre-specified by the Central Bank before the auction. The interest rate should be based on economic and market fundamentals such as real economic growth, inflation, maturity and market liquidity. A higher interest rate means higher periodic interest costs to the government.     What is the yield on a Treasury bond? The yield is a different concept from the interest rate mentioned earlier, and it is really important to understand the difference. The yield, also called the yield to maturity (YTM), is the rate of return that an investor can expect to earn from a bond if the bond is purchased at the auction or market price and held to maturity. Let’s look at some numbers. Assume an investor submits a bid price of Rs. 118 per Rs. 100 face value. If the bid is accepted, then bidder has to pay that price to purchase bonds. Since the bond pays an interest rate every six-months at 12.5% per year, this bond will pay Rs. 6.25 for each Rs. 100 of face value for the next 30 years. In addition, the investor will receive the face value of Rs. 100 at the end of 30 years. To summarise, the cost of the bond is Rs. 118. The future cash flows from the bond are 60 instalments of Rs. 6.25 each and the face value of Rs. 100. When we calculate the rate of return from investing Rs. 118 now and receiving 60 instalments of Rs. 6.25 each every six months and the face value of Rs. 100 at maturity, that rate of return is called the yield.     The yield for this particular purchase is 10.52% per year. Let’s take another example. Assume a bid price of Rs. 90. In that case, the yield is 13.92%. As you can see, a higher price results in a lower yield and a lower price results in a higher yield. The Sri Lankan Government charges a 10% withholding tax on interest income at the primary issue. Therefore, the above yields represent before tax yields. The after tax yields, calculated by deducting 10% from the before-tax yields, for the two examples mentioned above are 9.5% and 12.5% respectively. What is generally reported are the after-tax yields.     At this 30-year bond auction, the government accepted bids at different bid prices from different investors. Therefore, we would like to know the average price and yield that resulted from the auction. As reported by the Central Bank, the average yield (after-tax) was 11.73%. The average yield is also known as the weighted average yield. This translates into an average price of this auction of about Rs. 96 per Rs. 100 face value. So, on average, the investors’ rate of return is 11.73%. The investors’ rate of return is the cost to the government. It costs the government on average 11.73% per year for Rs. 10 billion borrowed through this auction. Now you understand why the 11.73% number is reported in discussions relating to this bond issue. A higher yield means lower prices. Selling at lower prices than what would have been possible results in the government collecting less money from a bond issue and hence a loss to the government     Why is the interest rate different from the yield? You recognise that the 30-year bonds under discussion pay an interest rate of 12.5%. Yet, the investor buying bonds at Rs. 118 will only earn 10.52% (before tax). The reason is that the investor paid more than the face value of Rs. 100 to buy the bond. The government will only pay the face value of Rs. 100 at maturity regardless of the purchase price. This investor will therefore suffer a capital loss of Rs. 18 per Rs. 100 face value. When we subtract this capital loss from the interest income of the bond, the investor ends up earning a return of 10.52%. The bottom line is that whenever a bond is purchased at a price above the face value the yield is going to be lower than the interest rate. Let’s look at the investor paying a price of Rs. 90. Here, the investor is paying less than the face value of Rs. 100 to buy the bond. When the government pays back the face value of Rs. 100 at maturity, this investor will have earned a capital gain of Rs. 10 per Rs. 100 face value. If we factor in this capital gain in addition to the interest income, the investor will end up earning a rate of return of 13.92% (before tax) on this investment. The lesson here is that whenever a bond is purchased at a price below the face value the yield will be higher than the interest rate. It must be clear from the above discussion that the yield on a bond is the correct measure of the rate of return of a bond. Of course, if you pay Rs. 100 for face value of Rs. 100, then there is neither a capital gain nor a capital loss. In this case, the yield (before tax) will be the same as the interest rate.     How are Treasury bonds issued? Bonds can be issued in two primary ways. The first method is private placement. In a private placement, the Central Bank issues bonds to selected investors at an agreed upon price. The key here is that the price of the bond, that is the price the buyer will pay to the government, is not determined through a competitive procedure. The Central Bank of Sri Lanka has sold bonds through private placements in the past. The second method for selling bonds is through a competitive auction called the “primary auction.” Selling through competitive auctions is regarded as the better method.     What is the primary auction? The auction in which government sells securities to the public is the primary auction. Number of auctions during a month or year depends on the timing of the governments’ funding requirements. The Central Bank publishes an auction notice in major newspapers at least two days before the date of the auction.     How does the primary auction work? An investor who wants to purchase government bonds at the primary auction has to submit his bids through a primary dealer to the Central Bank before 11 a.m. on the date of the auction. Thus, individuals and institutions cannot directly submit orders to buy government securities to the Central Bank. They have to first submit them to a primary dealer. The primary dealers collect bids from various parties and submit the bids to the Central Bank through the automated bidding facility. These bids include the bids on behalf of clients as well as primary dealers’ own bids to purchase on their own account. The minimum bid that can be submitted for the auction by a primary dealer is five million rupees, and anything above that has to be in increments of one million rupees. The Central Bank accepts bids in the descending order of bid prices. In other words, bids are accepted starting with the highest bid price until such price that the Central Bank considers acceptable given the bid prices and the amount of funds it needs to obtain from the particular primary auction. The Central Bank is not obligated to accept any bid, and in fact in some auctions it had rejected all the bids. A key objective of the government must be to obtain funds at the lowest cost possible, and this means selling government securities at the best possible prices. As stated earlier, in the 30-year bond auction in question, the government accepted bids from a high of Rs. 119.33 to a low of Rs. 90.17 resulting in an average price of Rs. 96.02 and an average yield of 11.72% (after-tax).     Who are primary dealers? Primary dealers are institutions which have been authorised by the Central Bank of Sri Lanka to participate in the primary auction. Presently there are 16 such primary dealers. They are Bank of Ceylon, Capital Alliance, Entrust Securities, Commercial Bank, First Capital Treasuries, Acuity Securities, NatWealth Securities, NSB Fund Management, People’s Bank, Sampath Bank, Seylan Bank, Wealth Trust Securities, Pan Asia Bank, Perpetual Treasuries, HSBC Bank and Union Bank.     What is the role of a primary dealer? They are a critical component of the bond market. The main role of the primary dealers is to participate in the primary auction for government securities conducted by the Department of Public Debt of the Central Bank of Sri Lanka and to maintain a secondary market for government securities.     What is the secondary market for government securities? The trading of government securities among investors is called the secondary market. This is analogous to trading of shares of companies among investors through stock brokers in the Colombo Stock Exchange. As mentioned earlier, primary dealers not only bid on behalf of clients but also bid to buy using their own money and thereby invest in government securities. As a result, they maintain an inventory of government securities enabling them to make a secondary market for government securities. They stand ready to sell government securities to investors and buy government securities from investors. By standing ready to buy and sell government securities, primary dealers help create liquidity in the secondary market. In addition to primary dealers, licensed commercial banks also participate in the secondary market. Hopefully, this would have served to improve the public’s understanding of Treasury bonds and various views relating to the controversy. I will elaborate on further details relating to many aspects of government bonds in the future articles. (The writer is a Professor of Finance and Financial Economist. He can be reached at lalithsamarakoon@yahoo.com. Follow @LSamarakoon.)

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