A Primer on Treasury Bonds Part III: Primary

Auctions and Private Placements

April 7, 2015
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, todays 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 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

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 governments 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 singleprice 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.]