Thursday, December 31, 2015

Why the rush in selling the Floating Rate Notes?

Over the past 12 months €2.5 billion of bonds issued as part of the IBRC liquidation in February 2013 have been purchased by the National Treasury Management Agency from the Central Bank of Ireland.

The IBRC was the entity formed when the carcasses of Anglo Irish Bank and Irish Nationwide Building Society were merged in 2011.  A year earlier a massive creditor bailout was engineered using €31 billion of Promissory Notes.  Under the structure the money to repay the creditors of these failed institutions (mainly deposits) was borrowed from the Central Bank of Ireland under the guise of Emergency Liquidity Assistance (ELA).

Under the terms of the Promissory Notes this ELA was to repaid in tranches with payments of €3.1 billion to be made in March of each year beginning in 2011.  There was a lot of confusion about this structure but as shown by Prof. Karl Whelan it would have taken payments of €3.1 billion each year up to 2022 to repay the ELA used to bail out the creditors of Anglo and INBS availed of using the Promissory Notes.

Under the Promissory Note structure, the key interest rates were:

  1. The ECB’s main refinancing rate as this was the external cost to the broad government sector of the funding accessed through ELA, and
  2. The rate on new government borrowing as this became the financing cost as each annual payment of €3.1 billion was made.

There were many issues with the Promissory Note structure but chief among them was the pace at which relatively cheap funding through the Central Bank was to be converted to more expensive funding through the NTMA.   That is, each €3.1 billion payment meant that less debt was being financed at the lower ECB refinancing rate and more debt was being financed at the higher government borrowing rate.

The €3.1 billion payment was made in 2011 and was fudged in 2012.  In February 2013 the Promissory Note structure was cancelled and in its stead the Central Bank was given €25 billion of long-dated, floating-rate Irish government bonds and could use the proceeds from these to settle the remaining liabilities outstanding created when the ELA that was issued in 2010.

The new structure was an improvement on what preceded it.  The main reason for these was that the pace at which debt was moved from the ECB refinancing rate to the government borrowing rate was slowed down.  Under the Promissory Note structure the debt spent an average of c.7 years being financed at the ECB rate.  Under the initial terms of the Long-Term Bond arrangement this was increased to c.15 years. 

And as the ECB rate has since reduced to 0.05% the external cost to the State of the debt created under the original Promissory Notes is relatively miniscule (0.05% of €25 billion is €12.5 million).

When the new structure was put in place it was said that:

The Central Bank of Ireland will sell the bonds but only where such a sale is not disruptive to financial stability. They have however undertaken that a minimum of bonds will be sold in accordance with the following schedule: to end 2014 (€0.5bn), 2015-2018 (€0.5bn p.a.), 2019-2023 (€1bn p.a.), 2024 and after (€2bn p.a.).

These terms were used to estimate the interest savings that the new structure would generate.  Instead of having the debt financed at the ECB rate paid off by 2022 (and replaced by higher costing debt funded by borrowing undertaken by the NTMA) this was not supposed to happen until 2032 when the last of the long-term bonds was to be sold by the Central Bank.

Under the original terms, a minimum of  €1 billion of the bonds were to be sold by the end of 2015.  The only update we get from the Central Bank on the bonds is in its annual report published each May.  However, as the press release linked above show the NTMA has bought €2.5 billion of the bonds in the past 12 months and subsequently cancelled them, with €2 billion in 2015 alone.  The Central Bank may have sold more of them this year but that is probably unlikely.

From the Central Bank’s 2014 annual report we do know that the only sale in 2014 was the €0.5 billion bought by the NTMA.  This is extracted from Note 15 to the report.

FRN Sales

During 2014 the Central Bank’s holding of the bonds reduced from €25.0 billion to €24.5 billion because a €0.5 billion sale. The same note tells us that:

During 2014, the Bank sold €500 million nominal of the FRNs (2038 FRN) realising gains amounting to €180.3 million.

The price paid for the bonds was around €680 million, with €500 million going to reduce the Central Bank’s liabilities to the Eurosystem (the process that saw the money “created” in 2010 is reversed with the money now “burned”) while most of the €180 million will be returned to The Exchequer as part of the Central Bank Surplus.

We know that the NTMA bought a further €2 billion of these bonds in 2015 but we don’t yet know the price paid.   From the table above we can see that, at the end 2014, the Central Bank valued the €24.5 billion of the bonds it held at €33.6 billion. 

Given that the yields on Irish government bonds were relatively stable in 2015 it would seem that the price paid by the NTMA for the €2 billion of the bonds it bought this year was probably around €2.7 billion.  Thus, there will have been a further €2 billion reduction in the Eurosystem liabilities of the Central Bank while most of the other €700 million will return to the Exchequer.

But the key question is: if only €1 billion of these bonds had to be sold by Central Bank by the of this year why have €2.5 billion of them being sold – and why has the NTMA bought them?

There are a couple of ways to approach this.  First, let’s also not that in 2014 the Central Bank sold €2.3 billion of the 2025 government bond that was created as part of the fudged 2012 Promissory Note payment.  Going back to Note 15 in the 2014 Annual Report of the Central Bank we are told:

In 2013 the Bank acquired €3.5 billion nominal of the 5.4% Irish 2025 Government Bond following the IBRC liquidation. During 2014, the Bank sold €2,300 million (2013: €350 million) nominal of the bond realising gains amounting to €537.6 million (2013: €24.8 million). As at 31 December 2014, the 5.4% Irish 2025 Government Bond was valued at €1.2 billion giving rise to an unrealised gain of €290.5 million (2013: €292.7 million) as at that date.

The Central Bank received around €2.8 billion for selling €2.3 billion of the bond.  But why didn’t the NTMA buy this bond as it has done with the others.  The reason is that this is a fixed coupon bond.  Although the annual coupon rate is 5.4 per cent the yield for the purchaser was much lower (probably around 1 per cent) as the purchase price was significantly greater than the face value. 

There was little to be gained by the NTMA buying this bond.  Most of the 5.4 per cent coupon will be covered from the gain realised by the Central Bank by selling to a third party. 

So why is the NTMA willing to buy the other bonds? Because they are Floating Rate Notes.  Unlike the 2025 bond above there is an element of interest rate risk associated with these bonds.  The Central Bank could sell these bonds to a third party but the NTMA risks paying higher interest to this third party in the future if interest rates rise.

As this useful note tell us:

The FRNs pay interest at a rate equal to the 6-month euribor rate plus a fixed spread which differs between the bonds of different maturities but has a weighted average of 2.62%.

Here is the history of the 6-month euribor:


It can be seen how exceptionally low the current rates are.  But if the rate was to rise to say 3 per cent then the interest cost on the floating rate notes would rise to an average of 5.6 per cent and would rise even more with further increases in the 6-month euribor.

However, all this tells us is that if the Central Bank is to sell the bonds then it is probably in our interest for the NTMA to purchase them (unless you think the 6-month euribor will stay below 1 per cent for the next decade).  It doesn’t answer the key question as to why the bonds are being sold ahead of the agreed schedule. 

In its own 2014 report the NTMA said:

Following discussions with the Central Bank of Ireland, €500 million nominal of the 2038 bond was bought back and cancelled by the NTMA in December 2014.

It could be that the accelerated sales are at the behest of the NTMA rather than the Central Bank (which faces pressure from the ECB to sell the bonds – monetary financing and all that).  Of course, we don’t really know but we do know that the current low borrowing costs for the government can be used to justify the sales. 

Back in September the NTMA issued 15-year debt at a yield of 1.8%.  If the ECB rate was to rise above 1.8% then the NTMA buying the bonds could lead to savings as the 1.8% financing cost locked in now would be below the financing cost if the Central Bank still held the bonds in circumstances where the ECB rate was higher.

And it is this justification that is offered by the Central Bank:

What implications do such sales have for the overall position of State’s finances?

One way of thinking about the Exchequer’s position in this regard is to consider the disposal by the Central Bank of FRNs to the NTMA. For example, in December 2014, the NTMA bought €500m (nominal) of the 2038 FRN from the Central Bank for a cash price of €680m. The €680m was, of course, funded by the NTMA in the market, at the current low interest rates, but the additional €180m has augmented the 2014 profit of the Central Bank, the bulk of which will be distributed back to the Exchequer as surplus income. So the Exchequer is now servicing the €500m at current market yields with the bulk of the €180m being returned to it in cash. Thus, from the point of view of the Government's budget, the disposal can be seen as a refinancing of part of Government debt at current market rates, which are much lower than the rates which prevailed when the FRNs were issued.

As long as the Central Bank is the holder of the FRNs, and as long as the effective cost of funds to the Central Bank (in practice, the ECB Main Refinancing Rate or ‘MRO’ rate, currently 0.05 per cent.) is below the coupon on the bonds, there will be some net interest contribution to the Central Bank’s profits. Since most of the Central Bank’s profits are remitted as surplus income to the Exchequer, it might appear that a relatively slow pace of disposal would benefit the Exchequer. The eventual impact will, of course, depend on a range of factors, including future interest rates, which cannot be predicted with accuracy.

Nevertheless, when interest rates on new issues of Government debt were much higher than they are today, refinancing would have seemed relatively expensive and this would have supported the idea that slower sales might be beneficial to the Exchequer. However, the current low cost of refinancing by the NTMA, though still somewhat above the Central Bank's effective cost of funds, reflects the exceptionally low level of interest rates and it could, therefore, be below the cost of the same refinancing at some point in the future. As a result, any small short term gain to the Exchequer resulting from slower refinancing could be more than offset by a higher cost of refinancing in the future.

The same point was made here.  But the reality is we simply can’t tell with any certainty what, if any, the benefits would be.

The best situation would be if the debt didn’t exist at all. Next best would be for the Central Bank to hold the bonds until maturity ensuring that the net cost remains at the ECB refinancing rate which will always be below the government’s borrowing cost. 

But because the bonds are to be sold we are in a grey area as interest rates and the government’s borrowing cost are likely to be higher in the future.  We could save by refinancing the debt at the lower rates that currently prevail.  This is a justification for the accelerated sales but there are questions that remain:

  1. If there are benefits from doing this now why move €1.5 billion ahead of the minimum sale schedule for the end of 2015? Why not more?
  2. Will the accelerated pace of sales continue in 2016?
  3. Why are the shortest dated of the bonds (the 2038s) being cancelled first rather than the longest dated (the 2053s) or a combination of bonds?
  4. If there are accelerated sales now does that mean there can be a sales “holiday” in the future if there is a period of high interest rates and/or an abnormally high spread between the 6-month euribor and the ECB’s main refinancing rate?
  5. What pace of interest rate increases are needed for a breakeven point of these transactions to be reached? And what profit is possible if interest rates go above that? And,
  6. If the Promissory Notes still existed would we be making accelerated payments on them?!?

No comments:

Post a Comment