Whither the long bonds?
The Finance and Investment Column
Stabroek News
July 16, 2004
This column provides informative commentary on financial matters.
In most countries, the government is free to borrow money in its own (domestic) currency. It will choose the term of the repayment and then will raise the funds, usually by way of auction. The money that will be raised will reflect the price the market is willing to pay for a given repayment schedule. Though the way in which prices are quoted and the names of the instruments may vary by term and from country to country, the underlying principle is the same - the government is borrowing from those who wish to lend it money.
Lending to the government in the local currency is seen as the most secure form of investment in that currency. As the government can always print more money, it is virtually impossible for it to default on its domestic debt. So the returns on government securities are often termed to be "risk-free." Risk-free in this context is a bit misleading, because there is a risk that inflation erodes the value of the investment in real terms. But in fixed terms i.e. the amount of money you will get back, you are almost certain of the return.
Short-term government debt is issued in the form of Treasury Bills. These are typically instruments of less than one year which are sold at a discount and redeemed at par. For example, I may bid $96,000 and receive $100,000 in one year's time, though the capital gain is treated as income for tax purposes (and in Guyana is subject to withholding tax). Treasury Notes (T-Notes) are of longer term (typically between 1-7 years) and are expressed in terms of the amount that will be repaid at the end of the period (called the nominal amount). They bear interest payments, often referred to as the coupon (usually paid semi-annually at a fixed rate), which are paid on the nominal amount (not the amount paid to purchase the note). So if I hold $100,000 of T-Notes with a 5% coupon maturing in 2006, I receive $5000 interest each year and $100,000 at the end of the term, even if I only paid 95,000 to purchase the notes. Bonds are longer term instruments that behave much the same as T-Notes though they may have more exotic features like being callable i.e. the government can repay the nominal amount early and clear the debt, thereby denying the holder of any future interest.
The main risk to the holder of longer term notes and bonds is unexpected inflation. Locked into a 5% interest rate for 20 years, any unexpected inflation will quickly erode the returns in real terms long before the capital is repaid. Bonds and T-Notes prices are usually expressed in terms of amount per 100 nominal and exclude the proportion of interest accruing to the next coupon date. In order to provide ease of comparison between different coupons and maturities analysts work in terms of the redemption yield. This is the annualised equivalent rate of return over the lifetime of the bond which equates the purchase price (including accrued interest) to the coupon and capital repayments. This may be a bit of a mouthful to non-analysts, the easiest way to think of the redemption yield is as the rate of interest which would be required to be earned on a bank account in order to meet all the coupon and capital repayments as they fall due if the purchase price were deposited today. The redemption yield may not be the actual return received because the reinvestment conditions when the coupons are paid are not known today.
Such is the confidence of investors of the ability of the US government to control inflation that they are prepared to accept a mere 5.24% on 20-year paper. Ten years ago the figure was more like 6.7%. The very low yields on long bonds partly reflect the current disfavour for the stock market following the sell-off in equities and recent lows in short term rates; indeed, current five-year yields are little more than 3.6%.
(Source: www.ustreas.gov)
Closer to home it is interesting to analyse the Trinidad & Tobago (TT) government's debt since it is a major trading partner of Guyana. Useful analysis can also be made because TT also raises debt in US$ - the difference or spread between US$ and yields on US$ bonds issued by the TT government for similar terms gives an idea of the credit risk associated with the TT US$ debt. Differences between TT$ yields and US$ treasury yields can be used to work out the cost of hedging the TT$ versus the US$.
Sources: www.myccmb.com and www.ustreas.gov
Moving on to Guyana we immediately notice that there are only three terms of debt available - none of which exceed one year in term. This makes long-term comparisons almost meaningless; although it is possible to extrapolate beyond one year, there are considerable practical difficulties in doing so, as most curve fitting procedures will give unstable results; and since it is not possible to actually hedge by buying a bond of that duration, an extrapolated figure is at best a guess.
The forward rates which are implied by yields on short-term TT$ debt being higher than those on G$ show a deprecation of the TT$ against the G$ with time. To this analyst this comes as a surprise. Those who believed that the G$ would slide versus the TT$ could have picked up almost a percentage point in yield by selling G$ T-Bills and investing in short-term TT$ bonds plus any currency appreciation on top.
It is clear that the excess liquidity in the banking system is distorting the returns available on G$ debt - excess demand for these instruments is driving yields to historic lows. One wonders how long it will be before investors begin to look elsewhere for returns. At present, the net annual cost (ie after allowing for the retrieval of withholding tax) of servicing the debt is around G$1.6 B per annum (based on G$50 B in issue) of the tax-payers' revenue. If demand for T-bills fell so that rates increase to their 30-year average of 12.25% the annual cost of servicing the debt would increase to around G$5 B per annum.
If the government were to issue longer term debt, undoubtedly the annualised yield it would have to pay today would need to be higher than current T-Bill yields, to compensate investors for reduced liquidity and risk of unexpected inflation. However they would be locking into historically low rates, and if short-term interest rates rise above the level at which the government locked in, the savings to the national coffers would be significant.
Although issuing a long-term bond is more administratively complicated than a T-bill, other than the possible fiscal benefits there are many other advantages. Budgeting for the expenditure on interest and capital repayments will be known well in advance rather than once the T-bill auction has taken place. Insurance companies and pension schemes will have a hedge for some of their long-term liabilities, and also a benchmark against which to price them. By listing the debt on the local stock exchange, an active secondary market could be encouraged, allowing the government to assess what yields the market requires, which will aid in planning interest rates for new issues. And just like T-bills, longer term debt can be used to sterilise excess liquidity. Moreover, rather than locking it up for a few months at a time, the government may have access to the capital for years so the potential is there to invest in new projects and infrastructure which generate increased tax revenues through growth in the economy.
The main disadvantage often cited is that you are locked in to paying more if interest rates fall. This need not be the case, since some bonds can be made callable, which would allow the government to refinance at lower cost if rates did fall further. The current low interest rates may not last forever; it would be a shame if it took a rise in interest rates before it was realised something could have been done to take advantage of them.