GLOBAL FINANCE & MARKETS | GOVERNMENT BOND MARKETS ADVISORY SERVICES Bond Buybacks and Exchanges Background Note May 2015 Background Note1 This note on bond buybacks and exchanges is part a series of background notes produced under the World Bank Group Government Bond Markets Advisory Services Program as a by-product of its strategy to support the development of liquid local currency bond markets. Topics selected have been a key focus in Advisory Services’ work area because of their catalytic impact on debt market development. Six notes have been produced so far: Domestic Syndications, Bond Buybacks and Exchanges, Securities Lending and Related Standing Facilities, Primary Dealer Systems, Electronic Trading Platforms, and Repo Markets. Bond buybacks and bond exchanges are an essential component in the management of public debt because they can be used to pursue a wide variety of objectives. The objective of this background note is to review the various functions of these important liability management instruments and to illustrate their usage with some country examples. Production of this background note was led by Olga Akcadag. Baudouin Richard was the primary author, working in collaboration with Anderson Caputo Silva, Olga Akcadag, and Indhu Raghavan, all of the World Bank Group Government Bond Markets Advisory Services Program Team. The authors wish to thank Thordur Jonasson, Senior Financial Sector Expert, MCMDM, IMF, and Mike Williams, Senior Consultant, WBG, for reviewing the note. A special thank you to country questionnaire respondents,2 David Anderson, who edited this background note, and Aichin Lim Jones, who provided the design and layout. 1 This background note has been prepared to support World Bank Group technical assistance programs for the development of local capital markets. This note is a work in progress because data intended to show practical examples of country practices are still being collected. Comments to baudouin.richard@live.be, asilva3@worldbank.org, and oakcadag@ifc.org are welcome. 2 Including the Hungarian Government Debt Management Agency (AKK), Ministry of Finance and Public Credit Mexico, Ministry of Economy and Finance Morocco, Ministry of Finance Poland, and National Treasury of South Africa . Contents i Contents Abbreviations and Acronyms...................................................................................III 1. Introduction..........................................................................................................1 2. Definition of Bond Buybacks and Exchanges........................................................3 3. Functions of Bond Buybacks and Exchanges.........................................................5 3.1. Bond Buybacks and Exchanges Increase Market Liquidity.................................... 5 3.2. Bond Buybacks and Exchanges Stimulate the Build-up of Benchmark Bond Issues.................................................................................................................. 6 3.3. Bond Buybacks and Exchanges Enhance Liquidity in Other Ways........................ 6 3.4. Bond Buybacks and Exchanges as Risk Management Tools................................... 7 3.5. Bond Buybacks and Exchanges May Correct and Take Advantage of Market Distortions...................................................................................................... 7 3.6. Bond Buybacks and Exchanges Come to the Rescue of the Market during Periods of Stress........................................................................................................... 7 3.7. Bond Buybacks and Exchanges May Reduce the Reported Debt Servicing Cost or Decrease the Reported Debt/GDP Ratio..................................................................... 7 3.8. Bond Buybacks and Exchanges Have Other Benefits............................................ 8 3.9. Preconditions for Using Bond Buybacks and Exchanges....................................... 9 3.10. Conclusion......................................................................................................... 9 4. Types of Buybacks...............................................................................................11 4.1. OTC Buyback.................................................................................................... 11 4.2. Reverse Auction.................................................................................................. 11 5. Types of Bond Exchanges.....................................................................................13 5.1. Tender at a Fixed Spread..................................................................................... 13 5.2. Auction............................................................................................................... 13 5.3. Combination of an Auction and a Tender........................................................... 14 ii Bond Buybacks and Exchanges 5.4. Two Separate Auctions......................................................................................................................................... 14 5.5. Bilateral Exchange............................................................................................................................................... 14 6. Risks Common to Bond Buybacks and Bond Exchanges................................................................................... 15 7. Respective Advantages and Drawbacks of Bond Buybacks and Exchanges......................................................... 17 8. Procedures.......................................................................................................................................................... 19 8.1 Timing of the Announcement............................................................................................................................... 19 8.2. Eligible Participants............................................................................................................................................. 19 8.3. Price-Setting Reference........................................................................................................................................ 20 8.4. Accounting.......................................................................................................................................................... 20 9. Prevailing Practices in OECD Countries............................................................................................................ 21 10. Importance of Communication........................................................................................................................ 23 11. Policy Issues...................................................................................................................................................... 25 11.1. Legal.................................................................................................................................................................. 25 11.2. Institutional....................................................................................................................................................... 25 12. Sound Market Practices.................................................................................................................................... 27 12.1 Bond Buyback and Exchange Policy................................................................................................................... 27 12.2. Calendar............................................................................................................................................................ 27 12.3. Organization of Bond Exchanges....................................................................................................................... 28 12.4. Organization of Bond Buybacks........................................................................................................................ 28 12.5. Choice between Bond Buybacks and Exchanges................................................................................................ 28 References............................................................................................................................................................... 29 Appendix 1 Accounting for Capital Gains and Losses. Illustration: Belgium......................................................... 31 Appendix 2 Benchmark Features and Development Techniques............................................................................. 33 Appendix 3 Country Questionnaire on Bond Buybacks and Exchanges, May 2015............................................... 35 Abbreviations and Acronyms iii Abbreviations and Acronyms BDA Belgian Debt Agency DMO Debt Management Office GDP Gross Domestic Product GEMM Gilt-Edged Market Maker NPV Net Present Value OECD Organisation for Economic Co-operation and Development PD Primary Dealer 1. Introduction 1 1. Introduction Bond buybacks and exchanges are liability management tools widely used in government securities markets to manage refinancing and liquidity risks. In addition to their capacity to pursue different objectives, they are closely linked to the implementation of a benchmark issuance policy, which is itself one of the prerequisites for an efficient government securities market. Bond buybacks and exchanges are therefore usually implemented at a relatively early stage in the life of a market to support and accelerate its development. This is possible because using these tools may require only focused capacity building at the start. This background note focuses on the use of bond buybacks and bond exchanges in the domestic government securities market. The objective is to provide an overview of their functions and of the procedures that facilitate their implementation, using country examples as illustrations. The note is organized as follows: First, it defines bond buybacks and exchanges, and it makes an inventory of the functions that they can fulfill. It then describes the different bond buyback and exchange methods. It also analyzes their respective risks and advantages, and it reviews some of the procedures involved. After summarizing the results of a recent survey of the prevailing practices in Organisation for Economic Co-operation and Development (OECD) countries, the note underlines the importance of market communications and concludes with a summary of sound market practices. 2. Definition of Bond Buybacks and Exchanges 3 2. Definition of Bond Buybacks and Exchanges Bond buybacks enable issuers to retire an outstanding debt before its maturity date against a cash payment. Bond exchanges achieve the same result but in combination with the issuance of a new debt. Both transactions are liability management operations. They provide no additional funding, but they affect the composition of the debt portfolio by restructuring an outstanding debt.2 3 Additional funding can be generated in some occasional cases of liability management operations, for example, by doing off-market interest rate swaps. However, the additional funding is normally not the objective of the transaction, and the amount of new funding generated is usually quite small. 3. Functions of Bond Buybacks and Exchanges 5 3. Functions of Bond Buybacks and Exchanges 3.1. Bond Buybacks and Exchanges Increase Market Liquidity The principal functions of bond buybacks and exchanges are to enhance market liquidity and to mitigate refinancing risks. These two functions are closely connected. On the one hand, retiring illiquid off-the-run bonds from the market offers additional issuance opportunities, which enables the faster building of benchmarks. On the other hand, the gradual buyback of bonds as they approach maturity mitigates the refinancing risk and, as a result, enables the issuance of benchmarks of a larger size. In both cases, market liquidity is enhanced. Bond buybacks and exchanges have a wide array of other potential uses. The availability of additional opportunities for issuance enables increased stability and regularity in the issuance calendar. The ability to retire from the market undervalued bonds and to refinance high-coupon bonds enables the correction of market distortions and the ability to book budget savings. Bond buybacks and exchanges can contribute to stabilizing the market during periods of stress by restoring price transparency. Last but not least, bond buybacks can offer profitable opportunities to invest surplus cash. The list is not exhaustive (see appendix 3). 6 Bond Buybacks and Exchanges 3.2. Bond Buybacks and Exchanges outstanding amount and a short remaining life to maturity Stimulate the Build-up of Benchmark is tantamount to refinancing part of the maturing bond Bond Issues ahead of time. The refinancing and interest rate risks7 of Benchmark bonds increase the liquidity of the government the DMO are reduced as a result. Thus, an issuer can build securities market because they are widely traded. benchmarks of a larger size. Benchmarks also enhance the price transparency of other Retiring illiquid off-the-run bonds from the market to bonds issued within the same maturity range. The specific stimulate the creation of benchmarks is a widespread features and usefulness of benchmark bonds are reviewed practice. For example, Denmark made recurrent use of in more detail in appendix 2. bond buybacks in the early 2000s to keep issuing in spite Benchmark bonds create two risks for a debt management of a budget surplus. The U.K. DMO has a permanently office (DMO): a refinancing risk and an interest rate risk. open window to buy back “rump bonds.”8 The Republic The two risks are connected. Benchmarks are typically of Korea has a standing program for exchanging off-the- bond issues with a large amount outstanding. Thus, a run bonds against on-the-run bonds. When the euro was sizeable funding requirement is created when a benchmark introduced in January 1999, the Dutch DMO made an bond matures, potentially jeopardizing the ability of the exchange of “legacy bonds”9 for an amount equal to 20 DMO to borrow the needed amount without disrupting percent of its total bond portfolio, reducing in the process the market.4 Last, the issuance of the large amount needed the number of maturities outstanding from 39 to 15. In to refinance a maturing benchmark can affect the desirable most mature markets, DMOs systematically start buying regularity in the DMO’s issuance calendar. For these back or exchanging benchmark bonds ahead of their reasons DMOs and certainly cash managers prefer a debt maturity date (usually 12 months before). Generally up to portfolio with a smooth5 maturity profile. 40 or 50 percent of the benchmark size is refinanced ahead of time. Bond buybacks and exchanges support the issuance of benchmark bonds in two complementary ways: by retiring 3.3. Bond Buybacks and Exchanges illiquid off-the-run bonds and by retiring bonds with Enhance Liquidity in Other Ways a short remaining life to maturity. First, retiring illiquid Retiring illiquid off-the-run bonds from the market can off-the-run bonds supports the issuance of benchmarks contribute to market liquidity in two additional ways. by creating an additional funding need that can be met The reduction in the number of maturities outstanding by issuing a standard instrument. The latter is typically reduces the fragmentation of the market, and it enhances a current benchmark because the objective is to secure a price transparency. Bond buybacks and exchanges enhance liquidity premium6 for future reopenings as investors are price discovery as trading is concentrated across fewer lines willing to pay a higher price for securities that can be easily of outstanding bonds and pricing is constantly updated. traded in the secondary market. As a result, benchmark Regular bond buybacks and exchanges enhance trading bond issues can be built up faster. This is particularly activity as dealers adjust their positions based on new useful in periods of limited borrowing requirements. supply and demand. Dealers purchase off-the-run bonds Second, the gradual retirement of bonds with a large more actively when they are confident that they can liquidate their position. 4 The DMO also faces the risk of higher interest rates at the moment of refinancing 5 “Smooth” does not mean “even.” As a consequence of the time value of money, the present value of longer maturities is smaller than their nominal amount. Therefore, bonds can be issued for larger amounts as their maturity lengthens. 6 See section “Importance of Market Liquidity” for details. 7 See the IMF–World Bank Revised Guidelines for Public Debt Management for a detailed discussion of risks encountered in public debt management 8 A “rump” gilt is one declared by the DMO, in which gilt-edged market makers are not required to make two-way markets. The current list of rump gilts is published on the DMO website (www.dmo.gov.uk). Rump gilts are those that have been reduced in size to less than £850 million (nominal) in issue. The government will not sell further amounts of “rump” gilts to the market, but the DMO is always prepared, when asked by a GEMM, to bid a price of its own choosing for such gilts. 9 Legacy bonds are those denominated in the former national currencies of the member states of the European Monetary Union.. 3. Functions of Bond Buybacks and Exchanges 7 3.4. Bond Buybacks and Exchanges as Figure 3.1. Building Benchmarks Can Risk Management Tools Reduce NPV of Debt Bond buybacks and exchanges enable decreasing the Yi ld refinancing and interest rate risks. The refinancing (or roll- “Ch p to th Curv ”, over) risk is the risk that debt will have to be rolled over from inv stors’ p rsp ctiv B at an unusually high cost or, in extreme cases, cannot be rolled over at all. The interest rate risk aspect applies in this A case to reduced repricing risk by reducing concentration in maturities and consequently interest rate pressures “D r or Exp nsiv to th Curv ”, from inv stors’ p rsp ctiv stemming from large volumes at specific points in time. ( . . b nchm rks - pr mium for liquidit ) Bond buybacks and exchanges decrease the refinancing and Tim to m turit interest rate risks directly when they are used to smoothen the maturity profile of the debt portfolio (section 3.2). T k dv nt of ch p/d r spr d in They also decrease risks indirectly because they enhance bond sw p - sw ppin A into B s v NPV liquidity in the secondary market. Liquidity increases Note: NPV = net present value. market demand for the issued securities, which decreases execution risk. It also enables lengthening the average life 3.6. Bond Buybacks and Exchanges Come of the debt portfolio by issuing longer maturities, which to the Rescue of the Market during Periods decreases both refinancing and interest rate risk. of Stress During periods of stress, liquidity has to be reallocated 3.5. Bond Buybacks and Exchanges May between instruments and funding sources. Turkey provided Correct and Take Advantage of Market an illustration in June 2001. The DMO exchanged $8 Distortions billion short-dated nominal domestic debt into dollar- Bonds sometimes trade at a yield higher than normal indexed lira debt or floating-rate lira debt. This had the above the curve. This can happen for different reasons: effect of simultaneously reducing a liquidity overhang in the coupon of the bond is out of the market, the bond is the domestic market and removing net currency exposure seldom traded because its outstanding amount is too small, in the banking system (see box 3.2). its maturity is unattractive for the market, or its holdings are concentrated in a few hands, and so on. 3.7. Bond Buybacks and Exchanges May Reduce the Reported Debt-Servicing Cost With a bond buyback or exchange, the distortion in the curve can be eliminated and a cost savings can be made or Lower the Reported Debt/GDP Ratio in the process. As an illustration, when converting from a The reported debt-servicing cost is reduced when a bond less liquid into a more liquid bond, there is a net present bearing a high coupon is refinanced at a lower market rate. value (NPV) benefit that can be shared with the market to This involves two transactions. First, a DMO issues a new encourage them to convert. This is the case even where the bond. Second, the DMO either uses the proceeds to buy coupon of the target bond is higher (which it often will be back the old bond, or alternatively it offers the new bond with an upward sloping yield curve). The NPV benefit is in exchange for the old one.10 represented in figure 3.1 by the difference from A to the curve and B to the curve. 10 As an illustration, in 2006 Colombia combined auctions and tenders to extinguish high-coupon debt and consolidate different long-dated maturities into one single issue. 8 Bond Buybacks and Exchanges Box 3.2. Country Illustrations of the Use of Box 3.3. Economics of Bond Buybacks and Bonds Buybacks and Exchanges in Times Issuance of Crisis Assumptions Old Bonds New Bond Brazil In May 2006, the DMO conducted Repurchased Issued simultaneous auctions to buy and Nominal 100 100 sell certain government bonds to amount provide price parameters to the Coupon 8% 4% market in unstable market conditions. Maturity 10 year 10 year In September 2008, the DMO performed four buyback auctions to Per the bond price calculation formula, the current price of allow investors to unwind positions the old bond is 132.44 (=present value at 4% of a stream of 10 annual cash flows of 8 and of 100 in 10 years) Hungary In Q2 2009, the DMO launched Cash flows Cash Coupons At a buyback program for an amount Maturity equivalent to $2.5 billion. The Repurchase of (132.44) 8% = 8 100 program was successful, and it old bond enabled the Government Debt Management Agency (ÁKK) to restart Issuance of 132.44 4% = 5.30) (132) regular bond auctions in April 2009. new bond Net 0 2.70 (32) Poland In October 2008 and January 2009 Analysis the DMO organized switch auctions for some illiquid consumer price (32) = future value at 4% of the annual saving of 2.70 over index–linked and floating-rate bonds. 10 years The same technique can be used to reduce the debt to gross In both cases, the reported budget deficit is decreased by an domestic product (GDP) ratio. This is possible when the amount equal to the coupon differential. Simultaneously, bonds being repurchased or exchanged trade below par. however, the amount of the outstanding debt is raised by The accounting impact of this transaction is the mirror an amount equal to the premium of the price of the old image of the repurchase of a bond with a high coupon. bond. In the absence of a distortion in the curve that could Thus, the benefit is also optical in the accounts. be taken advantage of, the net result is thus financially neutral on the issuer’s actual funding cost. The impact of the two operations (new issuance and bond buyback 3.8. Bond Buybacks and Exchanges Have or bond exchange) net out (see box 3.3). Therefore, the Other Benefits benefit is optical in the accounts. Yet another potential benefit, specific to bond exchanges, is to help investors restructure their portfolio in an efficient manner.11 The advantage for the issuer is to increase investors’ market participation. It also helps to preserve market stability when the composition of an index changes. Bond buyback and exchange operations also enable DMOs to obtain high-quality information on the depth and breadth of the market for various securities. They provide 11 Brazil achieved the same objective during extremely volatile market conditions by holding simultaneous buying and selling auctions of the same securities (in May 2006 and October 2008) to provide price parameters to the market (box 3.2). The initiative was successful because it enabled some investors to perform coordinated portfolio reallocations, while making other investors confident in maintaining their position. . 3. Functions of Bond Buybacks and Exchanges 9 DMOs with feedback from market participants, which an embryo of activity in the secondary market to make it they can use to adapt their borrowing programs, bringing possible to execute the transactions. lower cost and volatility. Last but not least, they can be a way to stimulate the motivation of primary dealers to 3.10. Conclusion perform by offering them the exclusive direct access to A common feature of bond buybacks and exchanges is exchange and reverse actions. to increase market liquidity both directly and indirectly. They increase market liquidity directly by supporting the 3.9. Preconditions for Using Bond creation of benchmarks and by reducing the number of Buybacks and Exchanges outstanding bond issues. They increase market liquidity Using bond buybacks and exchanges has three main indirectly because dealers take positions more actively preconditions. The issuer has to have a debt management (particularly in purchasing off-the-run bonds) if they strategy to define the desirable adjustments in the know that they can liquidate their holdings in the future composition of the debt portfolio. The issuer also has to in regular bond buybacks or exchanges (see table 3.1). have an issuance strategy to provide a framework for the Globally, bond buybacks and exchanges lower the funding execution of the transactions. Last, there has to be a least cost of the issuer. Table 3.1. Buyback and Exchanges: Summary of Advantages Retired bond Impact Consequences Illiquid • Creates a funding need • Benchmarks can be built up faster • Cleans the yield curve • Issuance activity can be more stable • Reduces fragmentation and regular • Can also smoothen maturity profile if • Increases price transparency large bond or heavy refinancing period • Increases market liquidity • Reduces risks (refinancing and interest rate) Large and close to maturity • Reduces risks (refinancing and interest • Larger benchmarks can be built up rate) • Higher return • Creates opportunity to reinvest cash surplus Undervalued • Generates cost savings • Potentially reduces NPV of debt when measured off the yield curve High coupon • Reduces reported debt-servicing cost Side benefits • Enhances trading activity • Enhances the quality of the issuer’s market information • Can: • Stimulate PDs’ motivation to perform by offering them exclusive access to bond exchange and reverse auctions • Help investors to restructure their portfolio • Contribute to stabilization of the market in periods of stress Note: NPV = net present value; PD = primary dealer. 4. Types of Buybacks 11 4. Types of Buybacks Buybacks can be done bilaterally or with a reverse auction. In the first case, buybacks are done one at a time over a certain period. In the second case, several buybacks may be done simultaneously. 4.1. OTC Buyback An OTC buyback can be done bilaterally or in the framework of a buyback window. Bilateral buybacks are concluded at a negotiated price. The price, generally not published, is negotiated by the issuer, either directly with the counterpart or using an intermediary. In the latter case, the issuer gives a mandate to a primary dealer to buy back a specific bond within a specified deadline. The DMO then sets the amount, the settlement date, the maximum price, and the intermediary’s fee. This procedure has been used in Italy, for example. Using an intermediary has the advantage of potentially minimizing the impact of the transaction on market prices. The drawback is a lack of transparency. A buyback window means that an issuer makes a standing offer to the market to buy back some securities. The offer is valid over a certain period. The price is published, and it is generally set for the duration of the window. 4.2. Reverse Auction A reverse auction is the mirror image of a standard auction. In a standard auction, the issuer sells securities and receives cash. In a reverse auction the issuer buys securities and pays cash. Reverse auctions seem to be predominantly of the multiple-price category. The reason is fewer potential counterparts because their number is limited to the investors holding the relevant securities. The willingness of investors to sell a security is also more difficult to gauge than their interest in buying it. The securities may be concentrated in a small number of portfolios and/or some investors may be reluctant to sell them because they are held against specific liabilities or otherwise fit in the portfolio.12 Therefore, issuers tend to find it safer to average out the prices offered by the market rather than agreeing to buy back all securities at the lowest accepted price. 12 The fit in the portfolio is mainly the result of insulation from market price movements, such as a hedge. 12 Bond Buybacks and Exchanges The timing of the announcement of a reverse auction buyback is that an auction helps create a marketing event. varies from a quarterly schedule (United Kingdom) down Their drawback is that they correspondingly increase the to three days ahead of the operation (Greece). Reverse issuer’s “reputational risk” if the operation is not successful auctions are generally announced a couple of weeks in (see table 4.1). advance. The advantage of a reverse auction over an OTC Table 4.1. Multiple and Uniform Price Auctions Advantages Drawbacks Multiple price • Issuer benefits from bids made at • Fewer participants at the auctions high prices (higher investor risks; winner’s curse, • Enhances the value of the status of loser’s nightmare) PDs (premium to expertise, advisory • Increased risk of collusion role) • More stable prices (due to the averaging-out effect) Uniform price • Larger number of participants • Loss of the advantages of multiple price system • More volatile auction results 5. Types of Bond Exchanges 13 5. Types of Bond Exchanges Bond exchanges can be done in five ways: a tender at a fixed exchange ratio, an auction, an auction combined with a tender, two separate auctions, and a bilateral exchange. 5.1. Tender at a Fixed Exchange Ratio The exchange ratio is set by the DMO. Different types of exchange ratios have been used: for example, a dirty price destination bond/dirty price source bond (Denmark, Ireland, Sweden, and the United Kingdom) or clean price destination bond/dirty price source bond (Belgium). Fixed-spread ratios are attractive to both investors and traders. Investors have no winner’s curse risk. Traders are effectively offered a call option at a fixed spread by the issuer. The market risk—the risk of an adverse change in market prices while processing the operation—is borne by the issuer. 5.2. Auction The exchange ratio is set by the market. Bids can be submitted according to two different formats. Either the DMO sets the clean price of the source bond and the market bids a clean price for the destination bond (e.g., Australia, Denmark, Hungary, Poland, Sweden, the United Kingdom), or the DMO sets the price of the destination bond and the market bids a clean price for the source bond (e.g.,, the Netherlands, Slovenia, Spain). The exchange ratio is generally calculated using dirty prices. The objective is to make a cash-neutral settlement. Market practice varies as to whether the auction is a single price (Belgium, Denmark, Spain, the United Kingdom) or multiple prices (Finland, Sweden, the United Kingdom). The advantage for the issuer of an auction over a fixed-price exchange is that the auction creates no market risk; the risk is borne by the bidders. The size of the transaction can also be larger than in a fixed price exchange because the issuer can adjust the price to the level asked by the market. 14 Bond Buybacks and Exchanges 5.3. Combination of an Auction and a 5.4. Two Separate Auctions Tender This procedure combines a bond buyback with the issuance This procedure splits the transaction in two steps. The way of new bond (one hour later in the case of Finland). The it is implemented in Colombia is used as an illustration separate execution of the two operations makes them more below. On day 1, a bond is issued via an auction. On day 2, straightforward for the DMO to process. It also makes the DMO announces a spread (= ratio) of an outstanding them attractive to a wider group of investors.13 The risk bond against the issued bond. A tender is then processed for the DMO is to have a funding shortfall if the amount for the outstanding bond at that spread with the same issued at the auction is smaller than the amount bought settlement date as the auction. back. This procedure is more flexible than a bond exchange auction for the market and for the issuer. The participants 5.5. Bilateral Exchange on day 1 do not have to hold the outstanding bond. The A bilateral exchange is the bond exchange equivalent spread of the outstanding bond is announced by the of an OTC buyback. In the euro zone, this procedure is issuer after the auction of the new bond. However, the used primarily by Greece and Sweden. Greece uses the procedure creates more uncertainty for the issuer because prevailing price in the secondary market with a scope for of the split of the transaction into two steps. This would negotiation depending on the characteristics of the bond represent a significant drawback because if the buyback being exchanged and the investment policy and needs of is unsuccessful, the issuer will have issued larger volume the counterpart. than what was required. For investors wanting to exchange their old bonds for new it also presents a risk, because if they are unsuccessful in either the sell or the buyback, they will need to adjust their positions in the secondary market, which implies a market risk that they would increase the borrowing cost. 13 A bond exchange attracts only those investors who are interested both in selling the old bond and in acquiring the new one (although a PD an intermediate between different groups). By contrast, a bond buyback attracts all investors interested in selling, and an auction attracts all investors interested in buying, the relevant security. The two groups of investors need not overlap. 6. Risks Common to Bond Buybacks and Exchanges 15 6. Risks Common to Bond Buybacks and Exchanges Three risks are common to both procedures: first, the risk of market price manipulation after the announcement of the operation; second, the budgetary cost if a premium has to be paid to obtain a significant amount of the source bond; and, third, the possibility of locking in an unattractive forward rate for the acquired bond. An additional risk is the lack of market interest. The DMO then has a “reputation risk” (image risk) if the operation is not successful. To manage market expectations, many DMOs announce that they have no target amount to exchange or buy back because their principal concern is to be of service to investors by offering them an efficient way to rebalance their securities portfolio. When retiring a bond from the market, a few DMOs inform the market that they will maintain a sufficient size of the outstanding bond to ensure a minimum tradability. Such an announcement is fair to the extent that a DMO may wish to avoid giving investors the sentiment that they are being trapped. At the same time, the announcement can be counterproductive because the risk of confronting an altogether illiquid market is an incentive for investors to sell the relevant securities. The offer of a buyback window for investors who want to sell after bond buyback and exchange operations have ended is perhaps a better procedure. It offers investors a way out, but the price is at the DMO’s discretion. 7. Respective Advantages and Drawbacks of Bond Buybacks and Exchanges 17 7. Respective Advantages and Drawbacks of Bond Buybacks and Exchanges Buybacks have two advantages relative to bond exchanges. They are an easier and more flexible procedure. They are also a more powerful instrument because they can attract a wider investor base. Any investor holding the relevant security is a potential seller. By contrast, investors participating in a bond exchange have to have an interest both in selling the source bond and in buying the destination bond (it requires an efficient PD system to make the link between the two categories of investors by standing in between them). However, buybacks create two risks for the DMO: a refinancing risk and an unknown exchange ratio when the bond buyback is followed by the auction of a benchmark to fund the operation. Bond exchanges also have some advantages. The issuer bears no refinancing risk. The investors have no execution risk because the reinvestment of their funds is automatic. Exchanges may help investors in restructuring their portfolio (e.g., when a bond is included in a bond index and is bid strongly as a result). However, an exchange alters the duration of the debt when the two bonds involved do not have a similar remaining life to maturity. Altering the duration of the debt portfolio through an exchange may be an explicit goal of the DMO (e.g., to lengthen the duration of the debt portfolio). However, it can also be an unintended consequence of the operation, in which case investors may be reluctant to utilize exchanges to avoid any unintended alteration of the duration of their portfolio. Bond exchanges are thus more complex transactions. 8. Procedures 19 8. Procedures An issue specific to bond exchanges is the number of bonds included in the exchange. Market practice varies from one source bond to multiple destination bonds (e.g., Belgium during the 1990s: one short-dated source bond against up to eight destination bonds) to a 1:1 ratio (the Netherlands, Sweden, the United Kingdom). A 2:1 ratio is applied in Ireland and Spain. Four procedural items are common to buybacks and exchanges: the timing of the announcement, the eligible participants, the price-setting reference, and the accounting. 8.1. Timing of the Announcement A widespread practice is to inform the market that the DMO is ready to repurchase bonds with a short14 remaining life to maturity (Belgium, Finland, Sweden, the United Kingdom) and/or to repurchase off-the-run illiquid bonds that have a relatively small amount outstanding (Italy, the United Kingdom). Other practiced procedures are an annual calendar of planned operations (Belgium up to 1998), three weeks’ advance notice (the United Kingdom), one week’s advance notice (Finland, Sweden), and two days’ advance notice (Ireland). 8.2. Eligible Participants The most common practice is to limit participation in a buyback or exchange event to the primary dealers (PDs). All holders of bonds must then submit their bids through a PD. However, there are exceptions. For example, in Denmark, all entities authorized to trade on the Copenhagen Exchange are eligible to participate. In Spain, all market members can participate, although some extra time to bid is given to PDs. In the United Kingdom there is a distinction between conversions, which seek to exchange all an outstanding bond and are open to all holders, and switch auctions, which are partial conversions only and aim to leave the source bonds sufficiently liquid; in those cases it is only PDs who participate. Full conversions have been done in the United Kingdom on an exceptional basis, and they seem to have been discontinued in the late 1990s. 14 Usually less than 12 months. 20 Bond Buybacks and Exchanges 8.3. Price-Setting Reference The impact of the coupons on the annual budget balance The reference is predominantly the observed market prices is the net of the annual coupons that are respectively saved (average of market quotes) over a certain period, making on the old bond and payable on the new bond. Therefore, allowance for the refinancing cost (particularly for short- the buyback or exchange of an old bond with a high dated bonds) and/or for internal analytics (cheap/dear coupon refinanced by a new bond with a lower coupon will analysis). narrow the budget deficit while the corresponding capital loss increases the amount of the debt. The fact that the initial impact of the buyback or exchange of a high-coupon 8.4. Accounting bond is a narrowing of the budget deficit may create the The securities are generally canceled. However, they can impression that the transaction is financially attractive. also be held with a view to being used by the DMO either Yet, in the absence of a market arbitrage (i.e., retiring an as collateral in the repo market (Belgium) or to alleviate underpriced bond from the market), the transaction is tensions in the secondary market (Spain). financially neutral (see box 3.3). In the euro zone, the European System of Accounts provides that the amount of capital gains and losses on bonds issued earlier and bought back or exchanged (hereinafter referred to as “old bond”) is recognized up front in the outstanding amount of the debt. This regime is consistent with the accounting of the public debt on a nominal basis, as opposed to a mark-to-market basis. The cancellation of the old bond is considered to be a financial transaction neutral to the budget balance. By contrast, the premium or discount on the new bond is accounted for as interest, and it is prorated over the life of the bond. The accounting procedure implemented at the Belgian Debt Agency for capital gains and losses is appended as an illustration (see appendix 1). 9. Prevailing Practices in OECD Countries 21 9. Prevailing Practices in OECD Countries The OECD15 conducted a survey in 2011 of 33 of its 34 member countries to enquire about their practices with respect to bond buybacks and exchanges. The main conclusions of the survey are summarized below. A significant majority of countries use bond buybacks and exchanges (29 out of 33 or 88 percent). The percentages mentioned below are expressed by reference to the 29 countries that use bond buybacks and exchanges. Bond buybacks are used more often than exchanges (85 percent versus 55 percent; many countries use both tools). Transactions are done on an ad hoc basis more often than on a regular basis (68 percent for bond buybacks and 61 percent for bond exchanges). Auctions are the most used mechanism for both bond buybacks and exchanges. For bond exchanges, auctions are used by close to 100 percent with a small number of countries using simultaneously other mechanisms.16 For bond buybacks, 54 percent use reverse auctions versus 46 percent OTC. Multiple-price auctions seem to prevail over uniform-price auctions (no global percentages are reported). Ad hoc transactions prevail over calendar announcements (61 percent for bond exchange, 68 percent for bond buyback). For bond exchanges, DMOs set the price of the source bond more often than the price of the destination bond (11 DMO versus five). The average reduction in the refinancing risk on the final maturity date of large benchmark bonds is between 30 and 40 percent of the total issued amount. 15 Working Party on Public Debt Management. 16 For example, Italy (e-trading platform) and Ireland (bidding window on Bloomberg and negotiated bilateral agreement). 10. Importance of Communication 23 10. Importance of Communication Good internal and external communications are a prerequisite for the success of the transactions. Within the government, the key requirements are internal approval and buy- in, uniformity of message, and consistency of the contemplated strategy with the overall borrowing plan and budget planning. Outside the government, the market has to be prepared and educated. Investors have to understand the DMO’s strategy, the instruments, and the benefits of the transactions for them. The DMO should consult the market, about both procedures in general and specific proposals, to keep abreast of its needs and expectations. A clear announcement of policy is particularly important. As an illustration, the Belgian Debt Agency (BDA) ensures that the market is well aware of two standing rules. First, any bond with a remaining life to maturity equal to, or less than, 12 months can be subject to repurchase or exchange by the government. Second, the BDA will assess the quality of the prices offered by the market by reference to the price levels prevailing in the market before the announcement of the transaction. The implicit message is that there is no point in trying to manipulate market prices. 11. Policy Issues 25 11. Policy Issues 11.1. Legal The public debt law has to include bond buybacks and exchanges among the authorized purposes for borrowing. The law should also define the objectives to be pursued by the transactions, preferably in an indicative manner. There are many possible objectives, and a limitative list might not be exhaustive. 11.2. Institutional The authority to execute the transactions has to be delegated by the Minister of Fiannce to the DMO. The delegation includes the determination of the objective pursued by any specific transactions being considered. This will in turn determine which securities should be retired from the market by priority and which mechanism should be used. In practice, the selection of the mechanism and of the relevant securities is often made following the same procedure as for bond issuance, and the pricing is decided by the same committee as the one in charge of pricing at the auctions. 12. Sound Market Practices 27 12. Sound Market Practices No “one-size-fits-all” procedure is found in government securities markets. Yet some procedures seem to often work well and can therefore be considered as sound market practices. The objective of this section is to review these procedures 12.1. Bond Buyback and Bond Exchange Policy The DMO is transparent about the objectives pursued and the mechanics of the procedure. Specifically, the DMO informs the market about three things: first, that the primary objective of these operations is either to increase market liquidity by issuing benchmarks to retire illiquid bonds from the market or to smoothen the redemption profile of public debt by reducing the amount outstanding of large bonds with a short remaining life to maturity; second, for illiquid bonds, that the securities selected for the operations will usually be chosen by the DMO after consulting with the market (i.e., PDs in countries that have a PD system); and, third, for bonds with a large amount outstanding and a short remaining life to maturity, the securities may begin to be bought back or exchanged a certain number of months (usually 12) before their maturity date.12.2. Calendar The decision as to whether transactions should be implemented on a calendar or on an ad hoc basis is country specific. Transactions on an ad hoc basis dominate in mature government securities markets presumably because few illiquid bonds are left in the debt portfolio and DMOs have the adequate means (technical and know-how) to buy back OTC bonds with a large amount outstanding and a short remaining life to maturity. They may nevertheless indicate their general intention in the annual strategy or financing plan, or in regular market consultations. For the other government securities markets, the number of bonds involved in the buyback or exchange program may help in making the choice. A calendar may be appropriate to streamline frequent transactions. If not, transactions done on an ad hoc basis have the advantage of providing flexibility. 28 Bond Buybacks and Exchanges 12.3. Organization of Bond Exchanges If the government has no surplus cash to invest and provided To begin by doing bond exchanges on a negotiated basis to the DMO is confident in its ability to raise the required test the market and establish the process can be a step worth amount of funding, a buyback can take place before a considering in some countries (e.g., it has been done in standard bond or bill auction. For example, Finland has Vietnam). Otherwise exchange auctions are the prevailing done buy backs in the morning followed by a standard procedure, with the DMO setting the price, preferably bond auction in the afternoon of the same day. Belgium of the destination bond (i.e., the benchmark that will be has done buybacks followed by an auction of T-bills on the issued in the framework of the exchange). The exchange next day with the same settlement date (buybacks are T+3 auction then takes place preferably after a standard bond and T-bills T+2). auction.12The choice between multiple-price or single- price auctions is country specific. On balance, the multiple- 12.5. Choice between Bond Exchanges and price system seems to prevail. However, in countries where Buybacks the standard auctions follow the uniform-price system, For bonds raising a refinancing risk, the maturity profile DMOs should consult the market about the potential of the debt seems to be smoothed18 most efficiently by advantages of standardization. No target exchange amount doing bond exchanges first and bond buybacks thereafter. is announced before the auctions. In countries with a PD Bond exchanges are a first choice because they create no system, the prevailing market practice is that only PDs refinancing risk. However, buybacks are a more powerful have direct access to the auctions. Other investors submit instrument, and they may thus be preferred as the maturity their bids through a PD. date of the bond approaches. For illiquid bonds raising no refinancing risk in the short 12.4. Organization of Bond Buybacks term, bond exchanges are the safest choice. They raise no Bond buybacks are negotiated bilaterally or structured refinancing risk for the DMO, and there is no urgency to as a reverse auction. The prevailing auction type is the retire the securities from the market. multiple-price system. However, in countries where the standard auctions follow the uniform-price system, DMOs should consult market participants about the potential merits of standardization, as for bond exchange auctions (see previous paragraph). In countries with a PD system, the prevailing market practice is that only PDs have direct access to the auctions, the same as for a bond exchange. 17 The price of the benchmark that will be issued in the framework of the exchange is easier to determine when the benchmark has recently been auctioned. 18 For example, exchanges during the first six months followed by buybacks during the next six months. Bibliography 29 References Blommestein, Hans, Mehmet Emre Elmadag, and Jacob Wellendorph Ejsing. 2012. “Buyback and Exchange Operations: Policies, Procedures and Practices amongst OECD Public Debt Managers.” https://ideas.repec.org/p/oec/dafaaf/5-en.html#biblio. Gravelle, Tom. 1998. “Buying Back of Government Bonds: Mechanics and Other Considerations.” Bank of Canada Working Paper 98-99. Bank of Canada, Ottawa. Holland, Allison. 2001. “Report on Bond Exchanges and Debt Buybacks: A Survey of Practices by EC Debt Managers.” UK DMO, London. Nielsen, Hanna. 2007. Liability Management Operations. Washington, DC: World Bank. Organisation for Economic Co-operation and Development. 2013. OECD Sovereign Borrowing Outlook 2013. Chapter VI: “Buybacks and Exchanges.” http://www. oecd-ilibrary.org/governance/oecd-sovereign-borrowing-outlook-2013/buybacks-and- exchanges_sov_b_outlk-2013-9-en. Proite, Andre. 2011. Liability Management under Stressful Scenarios: The Brazilian Experience. Brasília: Tesouro Nacional. UniCredit. 2007. EMU Debt Managers: Practice in Bond Exchanges and Debt Buybacks. Milan: UniCredit. Appendix 1: Accounting for Capital Gains and Losses. Illustration: Belgium 31 Appendix 1: Accounting for Capital Gains and Losses. Illustration: Belgium Example A new bond is issued at 98 to buy back an old bond at 104. The nominal value of both bonds = 100 The cash shortfall is financed by the issuance at par of a short-term security of 6. 1. Impact of the transaction on the amount of the debt outstanding: The amount of capital gains and losses If the debt had been accounted for on a impact the outstanding amount of the debt mark-to-market basis (which it is not), up front. This regime is consistent with the one would have had: accounting of the debt on a nominal basis: • New bond issued: 98 • New bond issued: 100 • Old bond cancelled: (104) • Old bond cancelled: (100) • New security: 6 • New security: 6 • Net: 0 • Net: +6 2. Impact of the transaction on the budget balance 2.1. Capital gains/losses: 2.2. Annual coupons: In the Eurozone, the European System of The impact on the annual budget balance Accounting provides that: is the net of the annual coupon saved on • The premium or discount on the issuance the old bond and payable on the new of the new bond is accounted for as bond. Therefore, the buyback of an old interest. Therefore, the premium/discount bond with a high coupon will narrow is prorated over the life of the bond. the budget deficit (while increasing the amount of the debt). • The cancellation of the old bond is a financial transaction that is neutral to the budget. Therefore, the capital gain/loss is recognized only in the calculation of the outstanding amount of the debt. Appendix 2: Benchmark Features and Development Techniques 33 Appendix 2: Benchmark Features and Development Techniques 1. Introduction Building benchmarks requires a comprehensive debt management strategy. Both issuance policy and liability management operations are involved in the process. For emerging markets, several reforms are typically required in both the primary and the secondary markets. 2. Importance of Market Liquidity A market is liquid when a large value of securities can be bought or sold promptly, at little cost and with no significant impact on market prices. In other words, a security is liquid when it can be easily converted into cash and vice versa. Investors are willing to pay a premium to buy securities that are liquid. They allow a more flexible investment strategy than securities that are difficult to acquire or to sell. Since the yield of a fixed-income security decreases when its price rises, DMOs have a vested interest in enhancing the liquidity of their government securities market because this reduces their funding cost. Several prerequisites have to be met for a market to be liquid. A security is liquid when it is widely traded. For a security to be widely traded, it must be easy for investors to find a matching trading interest. To simplify the matching of trading interests, the amount outstanding of the relevant security must be large, and the price must be easy to determine (“price transparency”). One of the advantages of issuing benchmark bonds is to enhance the price transparency of other bonds. 3. Definition of a Benchmark Bond A benchmark bond19 is a standard against which the yield of other bonds can be measured. For example, if a five-year bond yields 5 percent and a six-year bond yields 5.25 percent, and if the five-year bond is a benchmark, then the yield of the six-year bond can be expressed as “benchmark + 0.25 percent.” 19 The word “bond” is used here as a shortcut for “security.” A Tbill can also be a benchmark.. 34 Bond Buybacks and Exchanges The purpose of expressing the yield of a bond by reference 3. Ideally, a market-maker program should be put in place to a standard is linked to the difference between the level to maximize liquidity and price transparency. and the shape of a yield curve. The level of a yield curve is volatile as interest rates fluctuate up or down. By contrast, 4. Risks created by large benchmarks need to be managed. the shape of the yield curve (i.e., the spread between the The creation of benchmarks mechanically leads to a interest rates applicable to different maturities) is more concentration of maturities. This raises a refinancing risk stable. Thus, in the aforementioned example, the yield of because maturing benchmarks will need to be refunded. the six-year bond can actually be inferred (or at least closely It also raises an interest rate risk because large amounts approximated) from the yield of the benchmark bond, will need to be refunded at the same time and, thus, at irrespective of the level of interest rates. Most important, the same rate, this could be a problem if rates are high at the yield of the six-year bond can be assessed even in the that moment. absence of any recent trades in this bond. Bond buybacks and exchanges are efficient tools to mitigate Benchmark bonds enhance price transparency. the risks created by the issuance of large benchmarks. Both transactions help in leveling out the maturity profile of the debt. They enable DMOs to refinance ahead of time bonds 4. Main Features of Benchmark Bonds that will be maturing soon by issuing bonds with a longer A benchmark bond is always a widely traded bond, and a life to maturity. standard pricing reference has to be frequently updated. It typically has a large amount outstanding and a diversified placement in the market. A large amount outstanding 6. Market-Specific Questions for a Benchmark- Building Strategy increases the chances of finding a matching trading interest In practice, a benchmark-building strategy confronts and any one transaction will be more easily absorbed. DMOs with various practical questions for which the A security cannot be traded much if a large amount is answers are market specific, for example: concentrated in a few hands. A benchmark generally has a standard maturity date,20 and their maturity spacing 1. What should be the benchmark maturity dates? ensures that benchmarks are spread along the yield curve. The objective is to maximize the contribution of 2. What should be the benchmark size? benchmarks to price transparency. A benchmark can be a 3. How long can a bond remain a benchmark? reliable pricing reference only for neighboring maturities. Finally, a benchmark bond is usually21 the latest standard 4. What is the corresponding issuance policy? maturity still being auctioned (“on-the-run bond”). These 5. How can a concentration of maturities be avoided? bonds are the most traded.22 What is the best procedure for shifting illiquid bonds 6. 5. Steps Necessary to Create Liquid Benchmarks into benchmarks? with Large Amounts Outstanding and Balanced Distribution 7. How can the refinancing risk be best addressed? 1. The DMO must issue fungible securities, the amount of which can be increased over time with multiple auctions. 7. Conclusion It must also limit the number of its outstanding maturities Building benchmarks is crucial to increasing the liquidity to create large benchmarks. The financing requirements of the market to reduce the DMO’s cost of funding. of the government are not infinite. The process requires a comprehensive debt management strategy. It often requires the implementation of a set of Auction rules must be implemented to limit the 2. reforms. maximum amount of bids and allocations so as to ensure a balanced distribution. 20 For example, 3, 5, 10, 15, or 30 years. 21 A transition period may be needed for a bond to reach benchmark size. 22 There is also a technical justupon. This implies that the market price of the bond will be at, or close to, par. In general, only recently issued bonds quote at, or close to, par. Appendix 3: Country Questionnaire on Bond Buybacks and Exchanges, May 2015 35 Appendix 3: Country Questionnaire on Bond Buybacks and Exchanges23, May 2015 36 Bond Buybacks and Exchanges Appendix 3: Country Questionnaire on Bond Buybacks and Exchanges, May 2015 37 38 Bond Buybacks and Exchanges Appendix 3: Country Questionnaire on Bond Buybacks and Exchanges, May 2015 39 40 Bond Buybacks and Exchanges Note: BB = bond buyback; BX = bond exchange; DB = destination bond; DMO = debt management office; ER = exchange ratio; ETP = electronic trading platform; PD = primary dealer; RLTM = remaining life to maturity; SB = source bond. a. Outstanding bond being retired from the market. b. Bond being issued (new issue or reopening). c. ER is set by the DMO. d. Meaning the ER is one DB = < X > SB. e. Meaning the ER is one SB = < Y > DB. Appendix 3: Country Questionnaire on Bond Buybacks and Exchanges, May 2015 f. Meaning, first, DB is issued in auction; thereafter, DMO announces spread of SB vs. DB; tender process for DB with same settlement date as the auction. 41