Sri Lanka’s recent Euro Bond issue: Success at a premium?
File picture of cars at Hambantota port.
As widely reported in the national media, the Central Bank of Sri Lanka (CB) recently raised US$1.5 billion on behalf of the government by issuing 10-year International Sovereign Bonds. According to the CB media release dated 28 October, the annual interst (coupon) rate on these bonds is 6.85 per cent. As bonds were sold at par, the actual interest cost to the government as well as the potential return to the investors until the maturity of the bonds (yield-to-maturity) is 6.85 percent. At first, this bond issue can be considered a success. The issue was oversubscribed by 2.2 times, with bids worth $3.3 billion from 290 investors from US, Europe and Asia. And the CB was able to sell the bonds at par (face value). As the CB has claimed, this outcome also seems to reflect the trust and the confidence international investors have in the creditworthiness of the country.
However, in order to evaluate the financial success of the bond issue, one needs to consider at least two other important indicators: the total cost incurred by the Government in issuing the bonds (issuing costs) and the relative yield by international standards. Neither the CB release nor the Sri Lankan media has reported any information on the issuing costs. These costs normally include fees paid to rating agencies; fees and commissions paid to lead and joint managers, book-runners; commissions paid to underwriters; and expenses incurred on various other services and promotions such as ‘road-shows’. We checked the Bloomberg to find the fees relevant to the issue, but for some reason the information was not available. In the absence of relevant information in the public domain, it is not possible to comment on this aspect of the bond issue.
Relating to the second indicator, the standard benchmark used in assessing the cost of sovereign bond issues is the US government 10-year Treasury bond yield. The Sri Lankan 10-year bond carrying a 6.85 per cent coupon interest was sold at par. Therefore, at the moment the bond’s yield-to-maturity (YTM) is also 6.85 per cent. The benchmark US government 10-year bonds’ current (as of 31 October 2015) YTM is 2.146 per cent. Thus, the Sri Lankan bond’s YTM is 4.704 per cent higher than the YTM of the US Government Bonds. The question is whether this difference (the additional risk premium of 4.704 per cent) in the YTM is excessive. In order to shed some light on this question, we present a brief theoretical discussion on borrowing, lending, bond yield and bond pricing.
The principle of risk-return trade-off is fundamental to any financial decision. In lending, the lenders (the buyers of bonds in this case) expect a return (a risk premium) over and above the risk-free rate of return that is commensurate with the perceived risk and make their bids accordingly. In borrowing, the borrower (the Government in this case) is expected to offer a return (interest) over and above the risk-free rate of interest which is commensurate with the perceived risk of the investors.
Risks
The bids and offers in the financial markets essentially reflect the perceptions on risk-return trade-offs of the buyers and the sellers. However, this straightforward, objective consideration can be affected by many other factors, such as, information asymmetry, opportunistic behaviour of agents, market imperfections and impediments, temporary market sentiments. Finance literature is abundant with research that examines potential moral hazard problems and ‘game theoretic’ behaviour of agents who involve in debt and equity contract negotiations.
Let us assume that the agents of the Government for the bond issue (CB, Joint -Lead Managers, Bookrunners, Underwriters) acted in good faith to maximise the benefits to the principal (the Sri Lankan Government) and the credit ratings given by the rating agencies (Fitch, Moody’s and Standard and Poor) reflected the true creditworthiness of the Government. This assumption is reasonable because the agents presumably wanted to maintain their good reputation and international financial market are competitive. In this context, the price of the bonds and the coupon interest rate are likely to have been decided purely by the competitive market participants and forces.
The ratings given to the bond issue by Fitch Ratings, Moody’s Investors Service and Standard and Poor were ‘BB-’, ‘B1’ and ‘B+’, respectively which are below the investment-grade. The bonds issued with similar ratings are popularly called ‘junk bonds’ in financial markets. Investors in junk bonds naturally expect a higher (higher coupon interest and/or discounted prices) commensurate with the higher risk.
Conceptually, the pricing (initial issue price as well as prevailing secondary market price) of a bond depends on the market’s required rate of return from the particular bond. As cash inflows to the investor from the bond (coupon interest + settlement of the principal) can be accurately calculated, the pricing of the bond solely depends on the required rate of return (RRR) of the market from the particular bond. A simplified formula of bond pricing is shown below:
Price of a bond = Coupon Interest over the life of the bond discounted by the RRR +
Par Value of the Bond (i.e., principal) at maturity discounted by the RRR
In the above formula, the only unknown variable is the RRR, which can be defined as follows:
RRR = Default-Risk-Free Rate of Return + Default Risk Premium + Interest Rate Risk Premium + Liquidity Risk premium, etc.
Since we can observe the price of the bond in the market and since we know the cash inflows to the investor from the bond, we can calculate the RRR of the bond. The RRR of the bond is the Yield-to-Maturity or YTM (mathematically, Internal Rate of Return) In other words, YTM of a bond reflects the current RRR of the particular bond.
Current bond yields (i.e., YTM) of US Government’s bonds can be considered as a proxy for the ‘risk-free’ interest rate for US$ denominated comparable international bonds. Being ‘Risk-free’ essentially means that the bonds are ‘default risk-free’ as the US Government is almost certain to honour the payments of coupon interest and the principal on due dates. Even US Government bonds are not completely free of other risks. For example, their prices in the secondary market are subject to interest rate volatility risks.
For instance, if the market interest rates increase, the bond prices will decrease and the existing bond holders will face a loss at least in a relative sense when compared with the other available contemporary investment opportunities. The worst-case scenario is that bond holders have to accept a capital loss if they decide to sell the bonds before their date of maturity. Accordingly, the YTM of US Government bonds includes an interest-rate risk premium (but does not include a default risk premium). As US Government’s outstanding bonds are readily re-saleable in the secondary bond market, the investors may not expect an additional premium from US Government bond to cover liquidity risks.
Liquid secondary market
As mentioned, the current YTM of US Government 10-year bond is 2.146 per cent. We can take this as the bench mark for default-risk-free interest rate for US$ denominated sovereign bonds such as the one recently issued by the Government of Sri Lanka. What is meant by this is that Sri Lankan government bonds could pay a coupon interest of 2.146 per cent and make the investors satisfied provided that the Sri Lankan Government bonds are considered completely default-risk-free (and liquidity-risk free) by the investors. However, if the Sri Lankan government bonds have a liquid secondary market, that is, the bonds can be bought and sold readily in the secondary market, the bonds would be liquidity-risk free as well. The fact that the Sri Lankan bonds were sold at par with a coupon interest rate of 6.85 per cent tells us that the market required an additional risk premium of 4.704 per cent (6.85 – 2.146). This additional risk premium covers a default risk premium plus, probably, a liquidity risk premium. Conceptually, it may also include a premium to cover any other risks pertaining to the Sri Lankan sovereign bonds which are not priced in the benchmark US$ Government Bonds.
The question is whether this additional risk premium of 4.704 (i.e., the additional YTM offered to the investors of the government bond) is low, reasonable or high. In order to shed some light on this issue, we present below the current YTM of some selected US$ denominated sovereign bonds issued by developing countries. Current (as of 31 October 2015) YTMs and additional risk premiums included in selected, US$ denominated, 10- year Government Bonds issued by developing countriesAs explained before, if we take USA sovereign bond YTM as the benchmark for default-risk-free sovereign bonds, the recent 10-year Sri Lankan bond’s YTM of 6.85 per cent indicates an additional risk premium of 4.704 per cent.
Both the YTM and the additional risk premium of the Sri Lankan bond are higher than the average YTM (6.006 per cent) and the average additional risk premium (3.860 per cent) for the selected developing countries shown in the above list. These differences, though not large by absolute sense, can be considered significant when we consider the improvement in the perceptions of the international financial markets on the Sri Lankan economy following the recent regime change and prevailing historically low interest rates in global capital markets.
Vietnam – A success story
The Vietnam Government’s first international bond issue in 2005 worth $750 million was considered as one of the most successful sovereign bond issues. The bond issue won the title of ‘Best Asian Bond’ in the investment bankers’ poll conducted by EuroWeek. The bond issue was rated as Ba3 (non-investment grade or junk bond status) by the Moody’s Rating Agency. The bonds were issued with a coupon interest of 6.875 per cent to yield a YTM of 7.125 per cent. The risk premium in excess of the US government bonds was just 2.564 per cent. At that time, US and the world had a high interest rate environment compared with the current low interest rate environment. The bonds were bought by investors that rarely buy non-investment grade bonds. EuroWeek (2015, issue 943) commented “A lot of investors bought the bond because they believe Vietnam is an emerging economy with great potential …”
Conclusions
The decisions involved in an international bond issue are never clear-cut but are a very difficult balancing act. It is not possible to predict accurately the response the market will have for a particular bond issue. In order to sell all the bonds on ofer and raise the targeted funds, the issuer has offer an attractive yield to potential investors. However, we need to bear in mind the fact that, unlike in share markets, bond dealers in markets, particularly market makers have a larger capacity to influence both the indicated price and bid prices.
The actual yield required from the bond by the market (6.85 per cent) was less than the indicative yield (7 per cent) provided to the market by the issuer. This means that the bonds had a higher demand from the market than the agents of the Government had initially expected. On behalf of the Sri Lankan Government, the agents have decided to accept the yield (YTM) required by the bids on the table at the close of the offer. Since the bonds were sold at par, the coupon interest rate attached to the bond is same as the market’s required rate of return at that time. One of the ways to decide whether the Government ended up paying a high coupon interest is to observe the YTM of the bond when it is being traded in the secondary bond market. If the secondary market YTM of the bond is higher than the coupon interest rate (and price of the bond is lower than the face value) , then the coupon interest being paid for the bond is lower than its (current) market required rate of return, and vice versa. At the moment (7 October, 2015) the asking price and the bid price for the bond is 99.833 and 99.457 respectively (Source: Bloomberg). These prices indicate that the market at the moment requires a slightly higher YTM than 6.85 per cent. Although it is too early to pass judgement, it is fair to say that the bond seems to have been correctly priced.
It also needs to be mentioned that bond financing, unlike borrowing from the World Bank, IMF or bilateral donors, does not have any hidden strings attached. Another advantage that can be attributed to international bond issues is that the issuing Governments become subject to the unbiased monitoring and evaluation of the international capital markets. Such monitoring and evaluations are likely to help inculcate financial discipline within the Sri Lankan Government.However, relying on international bonds denominated in foreign currency can become a heavy burden in terms of interest payment and the repayment of the principal amount. The other concern is as to how the proceeds of this capital raising would be utilised. If this money is utilised for consumption purposes rather than investment purposes, then there will be a never-ending vicious cycle. At the maturity of the bond in 10 years the government will have to roll-over this bond by issuing another international bond, perhaps at a much higher rate of interest.
We also need to be aware of the foreign exchange and other risks the country gets exposed to when international bonds are issued. The regular coupon interest payments until the maturity and the repayment of the principal on the maturity of the bond (on 3 November 2025) need to be in US$. Issuing an international bond is the easier part if the issuer is prepared to offer a coupon interest and/or accept a price to match the required rate of return (YTM) prevailing in the international bond market. Many countries with lower credit ratings have done so. Latin American countries and several other countries that were on the edge of default have issued international bonds. It is important for Sri Lanka to develop a strong local currency bond market where local and international buyers can have confidence to invest long-term funds. To have a proper yield curve for pricing and re-pricing of fixed income instruments such as bonds, it is important to have a market with maturities from 1 month to 30 years. Currently, Sri Lankan bonds are of short-term and medium-term durations.
(The writer can be reached at samson@deakin.edu.au)