Tuesday, April 12, 2016

Bond market scandals in Sri Lanka

Just over a year ago a great controversy erupted over the an issue of bonds by the Government of Sri Lanka. The bonds were bought by a company controlled by the son-in-law of the Central Bank Governor which obtained a large chunk of the bonds on offer at premium interest rates.

At the time there were some doubts as to whether there was some innocent explanation:  a case of poor judgement, inadverdent communication of sensitive information or coincidence.

Hearing of what appears to be a massive spurt in corruption over the last few months one is unlikely to give the Yahapalanaya government the benefit of the doubt. When the same scandal reappears not once but twice (in January and March 2016) one can only conclude that this Government is irredeemably corrupt.

An analysis of the first bond scandal from March 2015 appears below. Sadly, the identical thing appears to have happened again in January and March this year. The news reports linked to above present only the bald facts in a neutral style and fail to convey properly the nature of the fraud. (This may be partly due to the lack of detailed information on the auctions, which the Central Bank is refusing to release).

In a nutshell, the scam is that the government appears to be paying interest rates of up to 2% higher on bonds. It does not sound like a lot but on billions of rupees over the period of the bond it is massive.  

The piece below was written in March 2015 and explains the nature of the problem. The same problem reappeared in January and March 2016.

Sri Lanka Bond Market Scandal
In an obscure and little understood corner of Sri Lanka’s tiny financial markets a scandal is unfolding that has shaken the credibility of the Central Bank and undermining perception of the Government. The financial jargon of ‘yields’, ‘basis points’, ‘cut offs’, ‘short selling’ has left journalists and the general public struggling to understand the issues.
Therefore, a quick introduction to bond auctions is in order.
When a bond is issued through an auction the rate of interest is not determined beforehand. Instead, the Central Bank only gives an indicative rate at which they expect offers. Dealers have to offer bids at whatever rate they deem fit. As the Government needs to raise funds at the lowest possible rates, bids are awarded in ascending order, starting from the lowest rate. An example is illustrated in the table below

Amount to be raised (Rs.) 1,000,000

List of Bids Received

Amount bid







Say the Government wishes to raise a million rupees and invites bids. Six bidders respond, at various rates. The Government awards the bids starting from the lowest until the required amount of funds is reached. In the example the bids sent by A, B and C are accepted and the others rejected. The last rate at which a bid is accepted is referred to as the ‘cut off rate’.
What happened in the actual auction for the 30 year bond ?
The Government announced an issue of bond for Rs.1 billion at an indicative rate of 9.5%. They received a total of 36 offers to a value of Rs. 20 billion. The Government accepted bids up to the value of Rs.10bn, 900% more than what was originally offered, with the final cut off being set at 12.5%, significantly higher than the 9.5% originally indicated.
The questions this raises are:

  1. Why did they accept Rs.10bn when the issue was only for Rs.1bn? If there was a need for funds why not simply have a larger issue? To an extent bidders will determine the rates to be offered based on the quantum of funds being raised, suddenly expanding the size of an issue catches them off-guard.
  2. If a rate of 9.5% was indicated prior to the auction, why accept bids at significantly higher rates? A difference of half a percentage would not have caused much comment but a 3 percentage points is very significant.
According to leaked data now in the public domain about 5 billion rupees appeared to have been allocated to Perpetual Treasuries, with 2bn being bid directly and 3bn through the Bank of Ceylon. Dealers are mystified as to why Perpetual needed to submit some of their bids through the Bank of Ceylon when they could have submitted them directly. Was this an attempt at disguise?
All of Perpetual’s bids accepted were at 12.5%, the cut off rate. There were obviously bids at even higher rates, but this is not the issue, the problem is why they chose to accept higher rates. The amount originally offered would have been fully subscribed at lower rates. Most bids accepted from other dealers were between 9.50% and 10.50%. Having lent at lower rates, these dealers are now effectively at a loss.
In their defence, the Government had signaled previously that the interest rates were expected to rise and there was wide market expectation of an increase. What caused the shock was the unusually sharp increase.
Also in the Government’s favour is the average rate at which the bond was issued: at 11.73% ,roughly in line with previous issue in May 2014 which was done at 11.25%. Although interest rates on shorter term debt had fallen significantly in the intervening period, there had been no other issues of 30 year bonds. (interest rates rise in proportion to the tenor-the period for which it is issued, so it is not possible to directly compare rates on a one year treasury bill with a 30 year bond).
Nevertheless other deviations from common practice have also raised questions.
Although there is no written rule, dealers are generally expected to place bids of around 10% of the value of an issue. For an issue of Rs.1bn, bids in the range of Rs.100m would be expected from each dealer. The question is what prompted Perpetual to offer a single bid of Rs.3bn for an issue that was originally supposed to be only Rs.1bn?
Information has also emerged that the same party was aggressively selling the 7 year bond in the market in the weeks prior to the 30 year bond auction. If interest rates are expected to rise then it makes sense to dispose of bonds carrying lower interest rates and to hold the money until the rates rise. This is normal market behaviour and with rates widely anticipated to rise many traders would have sold some of their bonds. What has raised eyebrows is the aggressiveness with Perpetual had disposed of large volumes of the 7 year bond.
From their activities in the market it is clear that they had formed a strong view on interest rates and were acting accordingly, the question being raised by others is whether there was anything more to this than a sharp traders instinct.
The critical attribute of a strong market is credibility: participants need to trust the system, that they will all be treated fairly and that no one will be cheated, something neatly captured in the motto of the London Stock Exchange “Dictum Meum Pactum” (My Word is My Bond).
The Government needs to get to the bottom of this urgently to restore confidence in the financial markets.

No comments: