‘Decent’ robbery
Quite often I had come across questions related to “bond markets” – a topic that many are not familiar with. I thought of discussing this topic because it is an integral part of our current debt crisis.
What is a bond? How does it work? And how does a country get into trouble with bonds? These are typical questions that many would ask but not get clear answers. Let me deal with some of these questions today and explain the answers in a simple language. Bonds also carry a black mark in Sri Lanka due to the infamous “bond scam” a few years ago, but it is not part of our discussion today.
Debt instruments
Bonds are issued by either governments or corporates (as well as some other entities like municipalities in some countries), when they want to borrow money in the socalled capital market. Alternatively, there are other ways to find capital from bank borrowings or listing company shares on the stock exchange.
Before the current ICT age, bonds were issued as printed certificates. In this automated age, however, they are mostly scripless, while transactions take place through computer networks.
If you do an internet search on bonds, you may be able to view the images of bonds issued in many different countries in the world. When you examine an image as such, you may notice three important things on a bond: (a) the value of the bond, which is called the face value or par value, (b) the interest rate paid to the bondholder, which is called the coupon rate and, (c) the date of maturity of the bond.
The face value is the amount of money borrowed by the issuer of the bond from the lender who purchased it. From the lender’s point of view, it is a financial investment which would give him a return. This return to investment depends on the coupon rate which is paid to the bondholder periodically. On the date of maturity, the face value can be redeemed by returning the bond to the issuer.
International Sovereign Bonds
On behalf of the government, the bonds are issued by the Treasury and, hence they are called Treasury Bills or Treasury Bonds. The difference between the two types is that the Treasury Bills are shortterm debt instruments with the maturity period less than a year, while Treasury Bonds are long-term debt instruments with maturity period longer than a year.
Apart from the Treasury Bills and Treasury Bonds (which are also called government securities), governments can also issue international sovereign bonds (ISBs). They are denominated in international currency such as the US dollar.
While the Sri Lankan government has been issuing government securities, a large part of them are held by, in addition to the Central Bank, the governmentowned banks and the government-managed pension funds. The total face value of the government securities is the amount of domestic debt that the government owes to these bondholders.
Since 2007, Sri Lanka also started issuing ISBs denominated in US dollars, while foreign private lenders including the banks have purchased them. The ISBs constituted part of the foreign borrowings, while other parts are multilateral and bilateral borrowings. After 12 years of issuing ISBs, Sri Lanka had borrowed in total US$ 17.5 billion by 2019.
Primary and secondary markets
Bond is a tradable asset. Fresh issuance of bonds raises capital to the issuer, while this initial issuance takes place through auctions. The dealers can submit their bids with proposed interest rates, while at the auction the most favourable bids will be selected.
The dealers can sell their bonds to the public in the secondary market through dealers themselves or via exchange overthe-counter (OTC). There is no new capital raised in the secondary market. The question is now, what are the gains for the sellers and the buyers in the secondary bond market, and how are the gains determined?
In the secondary market, the price of a bond may be different from its “face value”, depending on the demand-supply conditions. Accordingly, the yield to maturity or the market-determined interest rate may also be different from the “coupon rate”.
For instance, if a bond is highly demanded in the market, its price must rise, and the interest rate must fall. If the bond is not so demanded, then its price must be lower, and the interest rate higher. We must not forget that under different circumstances, just like in any other market, here too the demand-supply conditions can be manipulated so that the interest rates can be influenced.
Risk and credit rating
One of the most important factors that affect the bond market is the risk factor. The level of risk affects the investor confidence, influencing demand-supply conditions, and thereby the bond price and the interest rate. Will the issuer be able to honour the debt repayment and settle the dues of the bond at its maturity?
When the EU member country, Greece was caught up in a sovereign debt crisis about 12 years ago, investor confidence deteriorated; every bondholder wanted to get rid of the bonds they held by selling them, but nobody wanted to buy them. Consequently, bond prices plummeted, and interest rates skyrocketed to over 35 per cent, whereas the average interest rate for the EU remains less than 5 per cent.
As per the international credit rating agencies, different countries in the world are classified according to their credit worthiness. The three major classifications based on credit rating are (a) investment grade, (b) speculative grade and (c) default. Risk is lower for the A-grades, which create high demand. Risk is higher and falls into “junk” category for B-grades and C-grades.
When the countries slipped along these grades, the risk of investing in the respective sovereign bonds rises, and finally fall into the default category. Sri Lanka was in the B-grades until 2019 and slipped into C-grades and, thereafter to “default” category in April 2022.
Accordingly, Sri Lanka’s ISB prices in the international bond markets declined and the interest rates rose rapidly, as they were also reflected in the government security markets too. Reuters news agency reported on November 22, 2023, even after entering a IMF programme, Sri Lanka’s ISB prices in the secondary market were less than half of their face value.
Robbing lawfully
When bond prices are plummeting in high-risk situations, it is weird that the bond markets may open opportunities for some to make more money in the bond markets than under normal situations. In fact, it is the “plummeting bond prices” that would bring the fortune to them!
If you are sure that “there is no risk” and a particular bond series will be redeemed on the maturity date even by borrowing from somewhere else, then you have opened the treasure box; buy the bonds at less than half the price (which others don’t buy) and redeemed it by getting the full face value; you must have increased your wealth in millions in no time!
The only problem is that you should be “somebody” to do that, because an average investor has no information to assure that the bond will not be defaulted on the date of maturity. If you have the required power and authority, then you also have the tools to push the bond prices further down in the market. For instance, you could say that “we can manage our debt and there is no need for any external arrangement”. Overnight the bond prices would collapse further, resulting in a further increase in your fortune.
The gain from the fortune is personal, but its bitter consequences may be on the entire nation and, perhaps, for generations. However, it is difficult to argue that there is anything unlawful but morale decay in finding one’s fortune in the bond markets even at the expense of a nation’s destiny.
The only problem is that you should be “somebody” to do that, because an average investor has no information to assure that the bond will not be defaulted on the date of maturity. If you have the required power and authority, then you also have the tools to push the bond prices further down in the market
(The writer is Emeritus Professor of Economics at the University of Colombo and can be reached at sirimal@econ.cmb.ac.lk and follow on Twitter @SirimalAshoka).