EFB201 Lecture 6 – Government Debt Markets Reading – Viney chapter 10 Tutorial Questions –

1. EFB201 Lecture 6 – Government Debt Markets Reading – Viney chapter 10 Tutorial Questions – Viney chapter 10 Essay Questions 1-8

2. Outline Background Treasury Bonds Treasury Notes State Government Securities Overseas Government Securities

3. Background All governments need to fund their capital expenditures and recurrent (day-to-day) operations. They issue debt securities to raise these funds. A fiscal policy deficit in Australia is typically funded by the issue of Treasury bonds, which are medium- to long-term coupon securities. Day-to-day operations are mainly funded by the issue of Treasury notes, which are short-term discount securities.

4. Under monetary policy the central bank adjusts the liquidity level in the financial system to influence short-term interest rates. The payments system facilitates the flow of funds through the financial system and the economy. The government must manage its financial position, including the timing of its cash flows and the financing of capital expenditures. The matching principle sees the government match short-term liquidity requirements with the issue of short-term debt securities and long-term capital expenditures and other commitments with the issue of long-term debt securities.

5. Liquidity short-falls occur when there is a mismatch between timing of government intra-year expenditures and the receipt of revenue. A capital expenditure short-fall occurs under a budget deficit. A budget deficit occurs when a government’s expenditure exceeds its revenue in any particular period.

6. The Commonwealth government’s financial position has changed considerably over the last few decades: Budget deficits occurred in the financial years from 1991–92 to 1995–96 due to an economic recession requiring increased government spending to support the economy. Budget surpluses occurred from 1996–97 until 2007–08 following the government’s implementation of the ideology of a smaller government and privatisation of government institutions, such as Telstra. The global financial crisis saw the budget move back into deficit in 2008–09.

7. Prior to the global financial crisis, the government policy of budget surpluses and government debt reduction introduced an unusual problem into financial markets: the potential for a limited supply of government securities. The government overcame this problem by introducing the following policy to maintain a debt issuance program: 1. Long-dated Treasury bonds would now be issued at least every second year to ensure there are sufficient securities issued to support the 10-year bond futures contract. 2. On alternative years a mid-term Treasury bond would be issued to cover the short end of the Treasury bond yield curve.

8. A limited supply of government securities creates a problem as market participants use them for a wide variety of reasons: 1. Liquidity management – the active secondary market in government securities makes them very attractive to investors. 2. Portfolio investments – government securities pay a rate of return so investors may hold them as part of a larger portfolio. 3. Risk management – government securities are regarded as risk-free so if included in a portfolio will lower the overall portfolio risk.

9. 4. Payments system requirements – they can be used to ensure financial institutions can meet their obligations in their exchange settlement accounts. 5. Prudential supervision – the high liquidity of government securities allows financial institutions to use them to manage their liquidity risk. In additional they have a zero risk weighting in the capital adequacy requirement. These reasons ensure there will continue to exist a deep and liquid Treasury bond market in Australia.

10. The government needs to manage its day-to-day liquidity requirement. The government’s main source of funds is taxation receipts. However, timing of these receipts is not perfectly matched to the timing of certain fixed expenditures of government. For example, the government makes regular fortnightly payments to pension and benefit recipients. At other times it will have sudden and unexpected demands for liquidity, such as making cash payments to victims of a natural disaster. Issues of Treasury notes, short-term interest rate securities, are used to ensure daily liquidity requirements can be met.

11. Treasury Bonds Treasury bonds are the interest coupon securities issued by the Commonwealth government. Currently the main type of treasury bonds issued are bonds which pay a periodic fixed-interest coupon and the principal is repaid at maturity. Treasury notes are the short-term interest rate government security that is issued. The Australian Office of Financial Management (AOFM) is responsible for managing the government’s debt programs.

12. The holder of a Treasury bond receives a fixed coupon payment, normally every six months, and at the maturity date the face value and the last coupon. The risk faced by the bond holder is that if market yields on similar maturity bonds increase, the price, or value, of the bond will fall. Since 1984 Treasury bonds have been inscribed stock, not bearer bonds. When inscribed stock is issued the investor who buys one of these bonds will receive a receipt instead of a physical bond and their ownership is recognised electronically with a registry. There is no ownership record of bearer bonds. Holders of bearer bonds simply detach the printed coupon from the bond and present it for payment.

13. The advantages of issuing inscribed stock are: 1. It is less costly to maintain an electronic register of bond holders than to print and distribute physical bonds. 2. Ownership of bearer bonds is not registered anywhere, allowing nondisclosure for tax purposes. Similarly, bearer bonds may facilitate money laundering. 3. Inscribed stock cannot be stolen, destroyed or misplaced. This is because the ownership right to coupon payments and face value is registered at an inscribed stock registry. When inscribed stock is sold in the secondary market, the ownership of the bond is transferred in the registry.

14. Primary Market Australian Treasury bonds are issued through a tender system. The Federal Treasurer decides on the timing of each tender, and the maturities, coupons and quantities of bonds to be marketed.

15. Under the tender process: Bids are submitted electronically by registered bidders through the AOFM tender system; the minimum bid must have a face value of $1 million, and thereafter be in multiples of $1 million 2. The bonds have a fixed interest rate but bids are made in terms of yield to maturity up to three decimal places 3. Bids are accepted in ascending order, that is the lowest bid yield (so highest price) is accepted first.

16. There are a diverse group of investors in government securities. A proportion of each issue can be allotted to the Reserve Bank at the weighted average issue yield. The Reserve Bank uses its portfolio of government securities to alter overall maturity composition of bonds on issue and affect the amount of liquidity in the financial system. 2. Banks are large holders of government securities in order to manage their operational liquidity and prudential liquidity. 3. Insurance offices, other financial institutions and public authorities also hold government securities as part of their liquidity management strategies.

17. Secondary Market Treasury bonds can be traded on-exchange or over-the-counter transactions. On-exchange transactions are conducted through a broker on the ASX. However, the volume of on-exchange trades is very low compared to over-the-counter trades. Investors undertake transactions in the secondary market to meet the following requirements: Funding requirements: Financial institutions borrow large amounts of funds to provide loan facilities to customers. When all these funds have not been lent out government securities are an attractive investment vehicle for the short-term excess funds.

18. 2. Liquidity requirements: Corporations buy and sell government securities to manage their day-to-day liquidity requirements. 3. Reserve requirements: Some countries require banks to hold a proportion of their assets as government securities. Australian financial institutions are not subject to these requirements but hold government securities in order to manage their liquidity to the satisfaction of the prudential supervisor. 4. Interest rate expectations: If market participants expect interest rates to fall they may increase their holdings of long-term fixed-interest government securities to take advantage of potential future capital gains.

19. 5. Managing the maturity profile of a bond portfolio: Some fund managers, such as superannuation funds, maintain a particular average maturity of bonds in their portfolio. So they will buy and sell bonds to maintain this average.

20. Treasury Bond Pricing When Treasury bonds are traded in either the primary market or the secondary market they are quoted in terms of their redemption yield or yield to maturity. As the coupon cannot change, the price of existing bonds will change if the current market rates change. Therefore, the rate of the fixed coupon will generally be different from the actual yield to maturity. The bond’s price (P) will be the present value (PV) of the future cash flows, coupons (PVc) and face value (PVf): P = PVc+PVf

21. PVc = C×[(1–(1+i)-n)/i] • PVf = FV×(1+i)-n • wherei = current yield for the periodn = number of future coupon periodsC = periodic fixed coupon paymentFV = principal or face value of the bond • When the bond is not purchased on a date a coupon is • paid the following adjustment will need to occur: • (PVcoupons +PVface value)(1+i)k • wherek = number of days elapsed since the last coupon • payment divided by days in the coupon period

22. Example:- An existing Treasury bond has been issued with • a face value of $1 million. The bond pays half-yearly • coupons at a fixed rate of 7%pa and matures on 15 • November 2014. The bond is sold on 15 July 2011 and the current market yield for similar Treasury bonds is now • 8%pa. The price for this bond will be: • C=$1,000,000×0.07/2=$35,000 • i=0.08/2=0.04 • n= 7 coupons will be paid between 15 July 2011 and 15 November 2014 • k=61/184 as 61 days have elapsed since the last coupon date and the coupon period is 184 days. • PVc= $35,000×[(1-(1+0.04)-7)/0.04] = $210 ,007.91 • PVf= $1,000,000×(1+0.04)-7 = $759,917.81 • P = ($210,007.91+$759,917.81)(1+0.04)61/184 • = $982,619.54

23. Treasury Notes The main type of short-term security issued by the Australian Commonwealth government to manage its ongoing liquidity position are Treasury notes (T-notes): The government, through the AOFM, may issue from time to time T-notes with differing terms to maturity. The term of T-note issues coincide with the main revenue receipt dates of the government during the year. T-notes, as with Treasury bonds, may be issued by tender in the primary market. The tender arrangements are similar to those for Treasury bonds

24. Treasury Note Pricing • T-notes are short-term discount securities sold at a price • below their face value. • P = FV/(1 + (yield × DTM/365)) • where • P = price • FV = face value • DTM= days to maturity • If held to maturity, the return to the holder is the • difference between the purchase price and the face • value received at maturity. • If sold prior to maturity, the return is the difference • between the purchase price and the price at which the • T-note is sold.

25. Example A bank is to bid at tender for $1 million of 182-day T-notes at a yield of 5.50% per annum. If successful the bank will pay the following price for the tender: $973,307 = $1,000,000/(1+0.055×182/365) The bank purchases the T-note and decides to sell it when it has only 74 days until it matures. T-notes are currently trading at a yield of 4.95%pa. The bank will obtain the following price for the T-note: $990,064 = $100,000/(1+0.0495×74/365)

26. The basic formula for calculating the holding period yield is: • (sell price – buy price)/buy price × 365/DTM • At the maturity date the sell price will be the face value. • If the security is sold prior to the maturity date DTM is • replaced by days held. • For example, the yield on a T-note with a face value of • $1 million, a current price of $975,400 and 182 days to • maturity is: • ($1,000,000 – $975,400)/$975,400 × 365/182 = 5.06%pa • Using the previous example , the holding period yield = • ($990,064 – $973,307)/$973,307 × 365/108 = 5.82%pa

27. State Government Securities (Semi-Government Debt) • State governments are responsible for providing a wide • range of services, such as hospitals and roads. When • expenditures exceed receipts, state governments may • need to raise funds from the issue of debt securities. • Each state has formed a central borrowing authority to • undertake borrowings on behalf of the state government • and its instrumentalities, such as: • the New South Wales Treasury Corporation • the Treasury Corporation of Victoria • the Queensland Treasury Corporation (QTC)

28. Some advantages of having a central borrowing authority: 1. Economies of scale occur as instead of numerous state authorities and instrumentalities raising funds separately, a single issue can be made through the central borrowing authority. 2. The timing of the issues can be controlled so they occur at the most opportune time. 3. Potential for competition between different debt issuers in the same state is overcome. 4. The development of a secondary market is encouraged by the existence of large issues of instruments with identical features, as opposed to numerous small issues of instruments with non-identical features.

29. The central borrowing authority can choose to use public or private, underwritten or non-underwritten placements. Private placements are becoming more preferred as they do not involve the use of a prospectus so are quicker and less costly than public placements. Typically, each central borrowing authority appoints tender and dealer panels that are responsible for the placement of a new issue and for making a market in secondary transactions. Paper issued by central borrowing authorities will have an investment-grade credit rating that is generally sufficiently attractive to institutional investors, and so the issues are not underwritten. Medium- to long-term securities are often referred to as semi-government securities.

30. Overseas Government Debt Issues From an investors’ perspective, overseas government bonds may provide may provide differences in risk/return profiles compared to domestic bonds Government debt securities of different countries will have various credit ratings In addition, they may provide diversification benefits to domestic investors US government securities are seen as particularly attractive in times of financial crises