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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 governments 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 governments 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
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.]