government bonds - sharif
TRANSCRIPT
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Parthian Advisors
Government Bonds
February 2018
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• The uses of government bonds
• How government bonds are created and issued
• What happens when governments default on their
bonds or restructure bonds to avoid default
• The special role of government bonds in recapitalising
banks and resolving a banking crisis
• Why government bond returns should be indexed to
GDP changes, but are not
What we will cover
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Uses
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• A bond is a transferable loan
‒ Issued by the borrower (issuer) to the initial lenders
(investors)
‒ Arranged by investment banks who, in return for a fee from
the issuer, agree to find investors
• International bonds vs domestic bonds
‒ Domestic bonds are local currency denominated
• International bonds are usually USD or EUR
‒ Domestic bonds are marketed in one country
• International bonds are offered globally
Bonds basics
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• Transferability
• Capital market investors vs bank lenders
• Unknown investors vs relationships with bank
lenders
• Take it or leave it vs bilaterally negotiated
• Weaker lender protections vs stronger ones
• Bond investors do not negotiate bond terms – the
investment banks do it
• Many more bond investors than banks
• Negotiation time limited by need to take advantage
of market windows
Differences with loans
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Bonds
vsLoans
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• Before industrialisation, 90% of government budgets in Europe were spent on items related to war. Conquerors invaded and cities defended.
• War required large current sums, in excess of available resources.
• Some managed their finances poorly: Spain defaulted 13 times between 1500 and 1900.
• Some managed finances well: 18th century Britain had debt in excess of current views of sustainable levels (at 85% of GDP), but never defaulted.
• It’s approach was based on financial repression
• Government had privileged access to savings
• Interest rates were heavily regulated
• Usury laws
History
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1. Financing of current budget
deficits or long-term capital
projects, relieving pressure from
the banking system
2. Reducing need for foreign
borrowing, through a strong local
currency debt program
3. Providing a monetary policy
instrument to the central bank,
who can control the money
supply through open market
operations
4. Creating a domestic or
international yield curve across
maturities, to act as pricing
benchmark for private issuers
and new products
Uses
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5. Enhancing the domestic capital
market, as the largest issuer
6. Recapitalising banks with capital
adequacy problems, usually due
to NPL losses
7. Opening the international market
for corporate issuers
8. Accessing foreign investors via
local currency bonds
9. Mobilising small investors and
providing them a safe investment
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Accumulating unsustainable debt for the future
Enabling fiscal indiscipline
Accumulating overly large exposures to foreign
currencies
Crowding out private issuers from the capital
market
Creating a moral hazard by saving badly managed
banks
Attracting hot money to the domestic capital
market
They can create headaches too
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Potential
abuses
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World stock of financial assets and the share of government bonds
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22 24 31 38 40 43 45 47 4960 64 67
2 36
11 14 15 16 16 1515 14 14
2 35
66 7 7 8 9
9 10 10
711
16
2732
38 39 40 3737 38 39
813
14
2426
29 3237 42
45 46 48
11
17
36
45
55
6534
4854
4752
64
0
50
100
150
200
250
1990 1995 2000 2005 2006 2007 2008 2009 2010 2011 2012 2013Est
Stock marketcapitalisation
Public debtsecuritiesoutstandnig
Financial institutionsbonds outstanding
Nonfinancialcorporate bondsoutstandnig
Securitised laonsoutstanding
Nonsecuritised loansoutstanding
51
108
72
151
173
197
172
196207
213224
242
USD trillion
Sources: McKinsey Global Institute, Haver, BIS, DB estimates
DB Mapping the world’s Financial Markets 2014
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Government bond share of local and international bond markets
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100
80
60
40
20
0
0703 05 13110901
Estimated size of global debt securities market
Sources: Source: BIS Quarterly Report March 2014
USD trillion
Domestic
government debt
securities
International
government debt
securities
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Bond market investors
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2.3
2.6
2.2
6.3
28.0
28.9
35.2
11.7
0 5 10 15 20 25 30 35 40
ETFs
Hedge funds
Private equity
SWFs
Insurance funds
Mutual funds
Pension funds
FX reserves
Stock of Global Financial Assets
Sources: Deutsche Bank, TheCityUK, HedgeFundsReview, IMF
DB Mapping the world’s Financial Markets 2014
USD trillion
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Government bonds relative to other instruments in different regions
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10
2328
23
45
2935 32
18
4417
2
47
1
21
1
2
74
5 5
4
3 6
2
125
7
29
12
6
3
3 4
14
4
16
48
18
13
10
21 8
2026
17
2616 17
3935
4451
37 3934
UnitedStates
Japan WesternEurope
Otherdeveloped
China India MiddleEast and
Africa
OtherAsia
LatinAmerica
CEE andCIS
Stock marketcapitalisation
Public debt securitiesoutstandnig
Financial institutionsbonds outstanding
Nonfinancial corporatebonds outstandnig
Securitised laonsoutstanding
Nonsecuritised loansoutstanding
The structure of capital and banking markets varies widely between countries
Financial depth, year end 2010
Percent; % of regional GDP
Sources: Bank for International Settlements; Dealogic; SIFMA; Standard & Poor’s; McKinsey Global
Banking Pools; McKinsey Global Institute analysis - McKinsey Mapping global capital
markets 2011
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The issuance process
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The main parties
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Government Lead by the ministry of finance and central bank
UnderwritersBased on strength in the relevant market: USD, EUR, JPY,
other currencies, sukuk
Legal advisors Separately for the government and the underwriters
Rating agencies Driven by investor preference
Listing exchange Driven by investor preference and disclosure requirements
Trustee and
paying agentMarginal in peace, critical in battle
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The main processes
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• Review of information and meetings with the government
• Disclosure at the standard of the relevant market
• Liability document vs marketing document vs
embarrassment
• Ability and willingness to repay principal and interest on
time
• Investor presentations by the government and
underwriters
• Underwriters build a book of investor orders
• Interest rate decided based on the order book
• Signing of documents and issuance of bonds
Rating
Pricing
Closing
Marketing
Offering document
Due diligence
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Market timing and mentality: the Iraqi USD bond
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20
30
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60
70
80
90
100
110
WT
I o
il p
ric
e(U
SD
PB
L)
Period of turmoil
Fall of Mosul
Oil freeze
Liberation of Mosul
Oct 2015:
5-year Iraqi bond offered
B- credit rating
Market wanted an 11.5% yield
Govt chose not to issue
Aug 2017:
6-year Iraqi bond offered
B- credit rating
Issued with a 6.75% yield
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Default and restructuring
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• Default is a failure to pay. It happens when a government is effectively insolvent, but sometimes it is elective.
• Corporate insolvency involves pooling and pro-rata sharing of assets of the debtor among creditors. Courts can impose terms on creditors.
• There is no sovereign insolvency regime.
• Governments choose whom to pay and how much
• Politically infeasible to impose terms on governments
• No court to impose terms on creditors
• Sovereign immunity makes enforcement difficult
Default and state insolvency
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• Usual causes
• Over-borrowing
• Mismanagement of fiscal and monetary affairs
• External events
• Usual effects
• Economic devastation, collapse of local banking system, effect on companies
• Losses to creditors
• Slowing of economic growth
• Political tension
• Contagion effect on other countries
Causes and effects of insolvency
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State insolvency, 1980 - 2010
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Bank insolvency, 1980 - 2002
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Recent increases in government debt
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General approach for sovereign debt restructuring
• Paris Club
• 19 countries (US, Europe, Japan, Australia, Canada, Russia), and observers from IMF, OECD, EC and MDBs
• Commercial banks
• Bond restructuring
• IMF and structural reform programs
• Preferred creditors are treated differently
• Bond restructuring is usually via an exchange offer of new bonds for old bonds. Applies to foreign currency / foreign law bonds, not local ones.
• Often done before an actual default.
Restructurings
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• An anti-discrimination provision, usually ignored
• Usual: “The Bonds shall rank pari passu, without any preference
amongst themselves, with all other outstanding, unsecured and
unsubordinated obligations of the State, present and future.”
• Peru litigation (2000): To overcome sovereign immunity, Elliott
Associates, a US hedge fund holdout, pursued the intermediary holding
money – Chase as paying agent – via the pari passu clause. It won.
• Argued that pari passu applied to payments.
• Argentina litigation (2012): The Bonds shall at all times rank pari passu
and without any preference among themselves. The payment
obligations of Argentina under the Bonds shall at all times rank at least
equally with all its other present and future unsecured and
unsubordinated External Indebtedness…
• Flaw in the contract design and development process
Key legal choices - pari passu clause
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• Provision which allows a vote by majorities to bind minorities.
• Traditionally, bondholder rights were individual not collective
• Unanimous consent for modification
• Holdout problems and vulture investors
• Can facilitate or impede a restructuring during financial stress.
• Reduces cost of holdouts and official sector bailouts.
• Creates a moral hazard? Increases borrowing cost?
• Paper voting vs physical meeting
• Usually 75% by amount. Aggregated voting could allow 75% across all
series, as long as 67% of each series approves.
• Before the 2001 Argentina default, <10% of NY law bonds had CACs.
By 2003, >90% had it, pushed by the official sector and US Treasury.
Key legal choices - collective action clause
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• For international bonds, usually New York or English law
• Sometimes Swiss, German or Japanese law
• In Eurozone, often national law
• Government can amend national law to add or change terms.
• Can impede enforcement or recovery in case of a default.
• German law in 1933 converted foreign currency debts governed by
German law into Reichsmark debts
• Greece’s 2012 restructuring involved bonds governed by English law,
Swiss law, Japanese law, Italian law and Greek law
• The Greek law bonds had CACs added by legislation to allow the
restructuring to happen
• Neutral courts are usually chosen – English or New York
Key legal choices - governing law and courts
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Uses in bank recapitalisation
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• Following a banking crisis, which is often NPL-related, the
government may be the only option for rescuing the banking system.
• However, during a banking crisis the government is quite likely to be
in a difficult fiscal position and without sufficient resources to rescue
banks.
• The government can recapitalise banks with government bonds in
two ways:
‒ issuing special recap bonds to the market and using the
proceeds to purchase NPLs or new shares in the bank
‒ issuing special recap bonds directly to the bank in exchange for
NPLs or new shares (particularly useful if the government can’t
access the market)
• Alternatively, the issuer can be an AMC or deposit insurer, with a
government guarantee.
Special bank recapitalisation bonds
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Maturity: The bank will prefer earlier maturities and the
government later ones
Tradeability: The bank will want to sell the bonds soon to make
new loans, while the government may prefer to limit the bank’s
growth
Fixed vs floating rate: The government will prefer to fix its
interest cost but the bank may have basis risk with fixed rates
Interest rate: The bank will prefer higher income on the bonds
but the government will prefer to conserve resources
Tensions between the government and banks with recap bonds
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GDP-indexed returns
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A GDP-indexed bond has a return which is a function of changes
in the issuing government’s GDP:
• Fiscally friendly: a government pays more in times of high
growth, and pays less during slow or negative growth.
• Implied insurance for the issuer.
• Not the same as GDP-linked warrants
‒ Argentina, Bosnia, Bulgaria, Costa Rica, Greece
• Not the same as inflation-indexed bonds
• Discussed since 1980
‒ Shiller (Macro Markets, 1993) suggests a security representing a
perpetual future share of GDP (no principal).
‒ Would create a market for growth risk, and instruments to hedge
against growth risks.
GDP-indexed bonds
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• 𝐺𝐷𝑃 − 𝑖𝑛𝑑𝑒𝑥𝑒𝑑 𝐶𝑜𝑢𝑝𝑜𝑛 = 𝑚𝑎𝑥{ ҧ𝑐 + 𝑔𝑡 − ҧ𝑔 , 0 }
• ഥ𝒈: 20 year average annual growth rate of real GDP (fixed for each 5-yr bond)
• ത𝒄: 10 year average of straight bond coupons
A hypothetical GDP-indexed bond: The case of South Africa
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-3%
0%
3%
6%
9%
12%
15%
18%
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Real GDP growthrate (constantprice, localcurrency)
GDP-linked bondcoupons
Straight bondcoupons
In 1991, real growth was -1.02%; govt. would
have paid 7% less interest in GDP-indexed bonds
compared to straight bonds.
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Benefits to governments
• Avoidance of unsustainable debt, debt crises and default
‒ Depends on portion of debt stock that is GDP-indexed
• Pro-cyclical government fiscal position
‒ Now, maintaining access to markets usually requires fiscal
tightening during slow growth, and social welfare costs
Benefits to investors
• Overall exposure to a country’s growth
• Portfolio diversification – EM growth rates not correlated
• Fewer defaults, which destroy value
GDP-indexed bonds – why?
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Uncertain pricing
Illiquid
GDP data reliability
Novel
‒ Markets unfamiliar
‒ No obvious investor base
‒ No track record
‒ Rating agencies unfamiliar with them
Incentives:
‒ Underwriters are paid only on a successful sale
‒ Issuers prefer certainty of funding
Misalignment of interests of underwriters and issuer
GDP-indexed bonds – why not?
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Parthian AdvisorsCapital Markets & Investments
www.ParthianAdvisors.com
T: +98 21 8862 3899
F: +98 21 8862 3461
No. 4, West Zayandeh Roud Street, 3rd floor
North Shirazi Street, MollaSadra Avenue
Tehran 19916 14157, Iran
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