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March 24, 2015The Central Bank of Sri Lanka held a 30year 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.
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 governments 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.
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.
Lets 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. Lets 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
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