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A Primer on Treasury Bonds – Part III: Primary Auctions and Private Placements

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The last article, “A Primer on Treasury Bonds - Part II: Economic of Treasury Bonds Yields” Daily FT, 31 March 2015 (read here), discussed how to disaggregate Treasury bond yields into economic components such as real economic growth, inflation premium and term spread, as well as how to evaluate the appropriateness of a given yield. Recent public debate has also involved methods of selling government securities. In order to facilitate public understanding of techniques and practices of selling government securities, today’s column is devoted to a detailed discussion of primary auctions and private placements. What type of auction method is used to sell Treasury bonds in Sri Lanka? The type of primary auction used to sell government securities by the Central Bank of Sri Lanka (CBSL) is known as the multiple-price auction or the discriminatory price auction. In a multiple-price auction, each winning bidder pays the price of his bid. As a result, winning bidders pay different prices depending on the price they bid. In contrast, the single-price auction, also known as the uniform-price auction, is where each winning bidder pays the lowest winning bid. In other words, in a single-price auction all winning bidders pay the same price to purchase securities. The price paid is equal to the market clearing price at which the government can sell the quantity needed. Both methods are widely used by central banks around the world. For example, France and Germany employ multiple-price auctions whereas the United States and Switzerland use single-price auctions. Some countries such as Japan, Canada, and the United Kingdom, use both methods depending on the maturity or the type of government securities issued. How does the primary auction work? Table 1 provides a hypothetical example of a primary auction for a Rs. 100 face value, 10-year Treasury bond carrying an annual interest of 10%. What this means is that a bond with a face value of Rs. 100 will pay an annual interest Rs. 10, paid in two installments of Rs. 5 each semi-annually, for 10 years and the face value of Rs. 100 at maturity at the end of 10 years. Suppose the Central Bank called for bids to sell bonds worth Rs. 1,000 million and received 10 bids from primary dealers and other authorised institutions for an amount of Rs. 2,000 million. Thus, the auction was oversubscribed by two times indicating excellent demand for the issue. In this example, the Central Bank received 10 bids. In reality, the number of bids will be higher since there are 16 primary dealers and the Employee Provident Fund who participate at the auction. Bidders submit the bid price per Rs. 100 face value (column 2) and the bid amount, called the amount tendered (column 3). Bids have been arranged in the descending order of prices. For instance, bidder 1 is willing to buy Rs. 100 million of bonds at a price of Rs. 103.18 per Rs. 100. The next highest bid is at a price of Rs. 102.21 for an amount of Rs. 50 million. The lowest bid is at Rs. 94.02 for an amount of Rs. 200 million. The cumulative amount tendered (column 4) simply adds up the amount tendered column across the bidders. As such, the last line of column 4 shows the total amount of bids received which is equal to Rs. 2,000 million. Each price corresponds to a yield, also referred to as yield to maturity or YTM. Yield is the total rate of return to the investor. Auction data always report the corresponding yield both before and net of the 10% withholding tax. In fact, the bid price exactly corresponds to the yield before tax shown in column 5. Yield can be calculated using a financial calculator or an Excel spreadsheet. In the financial calculator, we define the semi-annual number of interest payments as N, the price as present value with a negative sign (PV), the semi-annual interest cash flow as payment amount (PMT), the face value as future value (FV), and compute the interest rate (I). Then, the resulting number is multiplied by two to obtain the annual yield. For example, at the price of Rs. 103.18, the calculator inputs are PV=-103.18, N=20, PMT=5, and FV=100. When we compute I, the result is 4.75. If using Excel, you can use the RATE function with inputs Nper=20, Pmt=5, Pv=-103.18, Fv=100, and Type=0, resulting in a semi-annual yield of 4.75. In both cases, multiply the semi-annual yield by 2 to obtain the annual yield of 9.50%. However, given the withholding tax on interest, the yield net of tax (column 6) is a more useful measure of returns. The after-tax yield is equal to the before-tax yield multiplied by 90% to account for the 10% withholding tax. Therefore, at the price of Rs. 103.18, the before-tax yield of 9.50% becomes an after-tax yield of 8.55%. Similarly, the lowest bid price of Rs. 94.02 translates into a before-tax yield of 11% and an after-tax yield of 9.90%. For example, in the case of the most cited 30-year bond issue of Feb. 27, 2015, the CBSL accepted yields ranging from 9.35% to 12.50% resulting in an average yield of 11.73%. These are yields net of tax. We will also use the yield net of tax during the remainder of this article. The price and the yield are inversely related. A higher price leads to a lower yield, and a lower price results in a higher yield. As you see, yields increase as prices decline. Simply, an investor purchasing a bond at a lower price will earn a higher return and vice versa. By the same token, if the price paid is equal to the face value of Rs. 100, as in the case of bidder 4, then the yield before tax is exactly equal to the 10% interest rate on the bond. The rate of return to the investor also represents the cost to the government. The borrowing cost by selling bonds at a price of Rs. 103.18 is 8.55% whereas the cost increases to 9.90% if bonds are sold at the lowest price of Rs. 94.02. From the government’s point of view, a higher price means larger proceeds and lower cost. In the case of the first bid, the government receives Rs. 103.18 for a face value of Rs. 100. That means the government is selling a bond at a premium to the face value. If the government were to accept the last bid, then it would receive Rs. 94.02 for a face value of Rs. 100. In this instance, bonds are sold at a discount to the face value. The government’s primary objective is to maximise the proceeds, thereby minimising the cost of borrowing. The government benefits most from selling at the highest possible prices. The amount payable (column 7) shows the amount each bidder must pay the government to buy the amount of bonds bid if it is a winning bid. For example, the amount payable by bidder 1 is 103.18% of the bid amount of Rs. 100 million, which is equal to Rs. 103.18 million. But bidder 7 bid to buy Rs. 100 million worth of bonds only at a price of Rs. 98.15. As a result, if this bid is accepted, the amount payable to the government is only Rs. 98.15 million. The cumulative amount payable (column 8) simply adds up the amount payable across bidders. If the government were to accept all 10 bids, it would collect a total of Rs. 1,955.95 million.                         How would the Central Bank accept from among the bids? In this example, the Central Bank offered to sell bonds worth Rs. 1,000 million and received bids for Rs. 2,000. It has the option to reject all bids, accept the amount offered, or accept an amount either lower or higher than the offered amount. The key objective of public debt management is to obtain funds at the lowest cost possible, and this means selling government securities at the highest possible prices. But besides borrowing costs, the amount to accept depends on many other economic and market factors such as the government’s funding needs, the impact on the market interest rates, yield curve, market liquidity, and monetary policy considerations, among others. Both the Central Bank and the Treasury must be key players in this process. After all, the the Department of Public Debt is executing an agency function on behalf of the Treasury. 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. Let us assume that after examining the bids, the government decides to accept bids not exceeding the offered amount of Rs. 1,000. That would mean accepting the first seven bids with the lowest accepted bid being Rs. 98.15 with the highest accepted yield being 9.27%. In technical terms, Rs. 98.15 is the cut-off price and 9.27% is the cut-off yield. The total amount payable by the bidders or, alternatively, the total proceeds to the government by selling bonds with a nominal value of Rs. 1,000 million is Rs. 999.69 million. The remaining bids are rejected. The type of auction described above is called a multiple-price auction, the method adopted by the CBSL. In such an auction, each accepted bidder pays the price bid by that bidder. In the above example, each successful bidder pays a different price equal to the price of each bid ranging from Rs. 103.18 to Rs. 98.15 with corresponding yields ranging from 8.55% to 9.27%. As a summary measure of auction results, we would calculate the weighted average price and the weighted average yield from the accepted range of prices and yields. The weights represent the nominal amount of each bid accepted relative to the total amount accepted. When each price is multiplied by its weight and added together, we obtain the weighted average price. In this example, the weighted average price or simply the average price is Rs. 99.97 meaning that the government sold bonds on average at a price of Rs. 99.97. This average prices translates into a weighted average yield of 10% before tax and 9% after tax. The average cost of borrowing is 9% in this case. Alternatively, an auction where every successful bidder pays the same price is known as a single-price auction. In a single-price auction every bidder pays the cut-off price determined by the government. In the above example, the cut-off price is Rs. 98.15. If this auction were to be a single-price auction, each successful bidder would pay Rs. 98.15, and the government would collect Rs. 981.50 million. Primary auctions provide a transparent mechanism, an efficient system for price discovery, and avoids potential for misuse when executed in a professional manner. That is why auctions are the most widely used method by governments worldwide. In a market with a reasonably developed and competitive primary dealer system auctions tend to result in more competitive pricing. For the primary market to work efficiently, it is critically important for all players to have access to the same information and to simultaneously be fully-informed about pertinent information relating to auctions including any price guidance. What are private placements of  Treasury bonds? Private placements are non-public offerings. They are direct sale of securities to a limited number of qualified investors such as banks, savings institutions, pension funds, mutual funds, insurance companies, primary dealers etc. There is very little official information available on various parameters of private placements reportedly made by the Central Bank over the years. Therefore, I would discuss private placements in general terms so as to provide a broader idea of what is possible in private placements. In order to understand what could happen in a private placement, a bit of a refresher on bond terms is necessary. The terms of a bond, i.e. the essential features of a bond, include five things. They are the face value, the maturity, the interest rate, the yield or the market rate, and the price. The face value is always given, and we tend to talk about the face value in units of Rs. 100. The maturity has to be decided by the issuer and the buyer should be willing to invest in a particular maturity. The interest rate is the rate at which the government is willing to pay interest on the bond and that needs to be specified as well. The yield is the rate at which the investor is willing to buy a bond. The yield at which the investor is willing to buy a bond may not always equal the yield at which the government is willing to sell. Therefore, the yield also needs to be negotiated. Now, it should become clear that the three important terms that will need to be determined or negotiated in regard to a bond are maturity, interest rate, and yield. Of course, the amount of the offer will be negotiated as well. A private placement, therefore, will involve negotiating the key bond terms of maturity, interest rate, and yield between the government and the investor. The government could negotiate all three or just one or two of the terms depending on the public debt management, monetary policy, liquidity and other economic and market considerations. In practice, the government seems to set the maturity and the interest rate and negotiate the yield or the market rate at which the investor is willing to buy bonds. For example, the government might decide to sell 10 year bonds carrying a coupon rate of 10% and negotiate a yield closer to the yield rate prevailing in the market prior to the placement. What are the pros of private placements? Private placements of bonds do have a role in government financing, particularly in smaller economies such as Sri Lanka, and provide a number of advantages to the government. First, as clearly evident from the previous discussion, they provide more flexibility for the government in setting the terms such as maturity, interest rate, and yield, which can be useful under certain conditions. Second, when the government needs to borrow a larger amount than normal, private placements may provide a way to negotiate a yield with potential buyers in order to reduce costs to the government while minimising potential disruption to the market interest rates and the yield curve. This will become even more important when the government has a larger financing need and the market liquidity is low. Trying to raise large amounts at the primary auction in low liquidity environments could put upward pressure on interest rates. Sudden shifts in primary auction yields can be very disruptive to the financial system. Third, government funding requirements are not always predictable. Circumstances such as tax revenue shortfalls, expenditure overruns, interim budgets, changes in government policy after an election, and global and domestic financial and economic shocks may result in unexpected increases in funding requirements. Private placement is an important tool in situations such as these where the government has to meet unexpected funding shortfalls or emergency funding needs. Under such conditions, there may not be enough time to organise and conduct an auction or an auction may be deemed inappropriate due to market conditions. Fourth, private placements can be used to issue very long-dated securities such as 30-year bonds if it is deemed that there may not be widespread demand for such bonds at auctions leading to high yields and high costs to the government. Long-term bonds are generally more suitable and appealing to institutions such as pension and life insurance funds having long-term liabilities and bond funds with long-term investment objectives. The demand for long-dated bonds is not particularly deep in the Sri Lankan bond market. Fifth, private placements as well as syndications are useful for issuance of foreign-currency denominated debt, innovative or new products such as inflation-linked bonds, and first time issuances of various benchmark and long-dated bonds. Sixth, private placements become even more significant if the primary market is not well-developed, non-competitive and dominated by a few players or inefficient in other ways. What are the cons of private placements? There are significant disadvantages to private placements of bonds as well. First, they involve selling to a narrower investor base. This could weaken the ability of the government to negotiate favourable terms leading to higher costs to the government in terms of higher interest costs, lower prices or both, particularly when the government has a pressing funding requirement. Second, the government will be placed in a very precarious situation if private placements become the normal practice rather than the exception. In that case, private placements become the market expectation potentially leading to undesirable bidding practices depending on the interest rate outlook. It is possible that private placements could lead to lower competitiveness of auctions in rising rate environments if frequent private placements subsequent to primary auctions become the norm. Third, the flexibility afforded in private placements to decide on terms of a bond issue can lead to potential abuses and unfair practices. This is because the government has the ability to decide who will get the bonds and at what terms. How will the Central Bank determine the yield on a private placement? If the private placements are done at the weighted average yield determined at the most recent primary auction for the securities with the same coupon and maturity or at a yield closer to the prevailing secondary market yields, then that removes the possibility of privately negotiating a yield rate which is very different form market rates. On the other hand, if the yield is completely negotiated without properly benchmarking on market rates, then that opens room for potential abuses and biases. Furthermore, there is also the question of selection of investors for private placements and the allocation of amounts among them in a fair manner. If not properly executed within a carefully determined set of guidelines for investor selection and allocation, serious abuses could occur. A selected few obtaining bonds at favourable terms could disrupt the dynamics of the secondary market for government securities. The bottom line is that private placement is an important tool for raising funds. But they should not be the norm. They should be done within a framework of a properly formulated, approved and transparent set of guidelines. Private placement guidelines must cover matters such as determination of terms of the issue including yield benchmarks, investor selection and allocation, consistent with the overall debt management, monetary policy, and debt market development framework, in order to mitigate against potential abuses. Conclusion This article presented the workings of the multiple-price primary auction and the merits and demerits of private placements. In the context of the current debate in Sri Lanka, it is critically important that any issues with the existing auction and private placement mechanisms are fixed within a sound Treasury and public debt management framework to preserve and enhance the integrity of the Sri Lankan financial system. I hope to discuss the subject of public debt in the next article. [Lalith Samarakoon (B.Sc. Bus. Adm., First Class Honors, MBA (Finance), PhD (Finance), FCA, CFA) is a professor of finance and a financial economist. He can be reached at lalithsamarakoon@yahoo.com.]

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