ECONOMYNEXT – Sri Lanka’s central bank denied charges of bond auction rigging amid renewed concerns that manipulation of long bond yields were giving windfalls to primary dealers.

A state-managed provident fund is also being used to ‘pump and dump’ gilts, causing massive losses to millions of private sector employees, according to market watchers.

"There are usually charges like this," Deputy Governor P Samarasiri told reporters responding to a query directed in Sinhalese to Central Bank Governor Arjuna Mahendran whether large volumes of high yielding bonds had been allocated to a primary dealer connected to his son-in-law.

"The main problem with these charges is that they are the ideas (adahas) of various individuals."

"Throughout the whole year these charges were made as ideas of various people. When they make the charges, they do it without the relevant data (niyamitha duthter har thorathuru)."

Similar Charges

Samarasiri said similar charges were made in 2015 against the central bank. In 2015, he said policy rates were cut in April and early this year monetary policy was tightened, which make rates go down or up

In 2015, the central bank was probed by the Parliament’s Committee on Public Enterprises after it emerged that Perpetual Treasuries, a company connected to Governor Arjuna Mahendran’s son-in-law was allocated billions of long bonds at high yields despite objections of officials at the Department of Public Debt.

The Parliament was dissolved shortly before the inquiry report was published.The officials were later transferred to other departments, along with many others. Governor Mahendran denied wrongdoing.

Samarasiri said since the firm owned by the Governor’s relative was a licensed dealer, it was entitled to bid at any auction, and the bond auction committee cannot see the name when making decisions.

Critics say bond auctions are effectively rigged because large volumes of bids are accepted at high yields after initially offering a smaller amount for sale. However, offering lower volumes and accepting higher volumes is not a new practice.

Secondary market rates then plunge giving large profits to dealers.

2030 Bonds

Renewed concerns over bond auction rigging emerged when 28.9 billion rupees of 2030 bonds (over 14-years) were sold at an average yield of 14.23 percent on March 29, sharply higher than the 11.66 percent at an auction on February 05, after originally offering only 20 billion.

Only 10 billion rupees were taken in 2020 bonds.

If Sri Lanka’s government believed its own claims that the budget deficit would fall over the next four years, it makes sense to issue shorter tenor bonds and roll-them over for longer tenors when rates fall after budgets stabilize, analysts say.

It is in the interest of the government to sell more short-term bonds and flatten the yield curve they say.

However, primary dealers can make large profits when the tenor is longer. A steeper yield curve will also help them make more profits.

The controversial March 29 auction took place hours before a monetary policy decision where there were expectations of a rate hike.

Shortly after the auction and after the monetary policy statement, the Central Bank called for investment advisors to sell up to 3.0 billion dollars in sovereign bonds, changing sentiments and sending yields plunging down.

It is not clear why the statement was not released before the auction.

By April 05, less than a week later the 2030 bond were trading at around 12.50 percent.

When interest rates rise, the price of a bond falls. When the government sells a bond at a high interest rate it is similar to selling stock of a company at a low price. When rates fall, the price of a bond rises, and a dealer can now sell the security at a higher price gaining a profit or capital gain.

For every billion rupees of bonds bought at the auction at 14.23 percent and sold at around 12.50 percent, a dealer would make a profit of 94 million rupees.

A dealer who held 10 billion rupees in bonds bought at 14.23 percent would get 940 million rupees in profits in a week, when rates fall to 12.50 percent.

It was estimated by some market watchers that the cut-off rate (the highest rate at which bonds were sold) could be as high as 14.80 percent for the 2030 bond. Bonds bought near or at the cut-off rate would give profits of around 120 million rupees per every billion rupees of bonds.

No Data

Samarasiri refused to release the names of the winning bidders to clear the controversy over who bought the bonds, saying revealing the names of the primary dealers was against the governing law of the central bank (Monetary law Act).

The ‘rigging’ aspect of the auction comes because the central bank accepts sharply more than the offered volumes, after initially saying that only a small volume will be accepted, misleading bidders into thinking that only a small volume would be accepted.

This is why in 2015 scandal, many primary dealers – other than those who allegedly had inside information that a larger volume would be taken – only bid small volumes.

Samarasiri says it is now indicated to bidders officially that higher volumes may be taken. However the quantum is not given.

In 2016, it was not only Perpetual Treasuries that bid for long term bonds at high yields, market participants say.

After the experience of the now famous original ‘bond scam’ auction in February 2015, other dealers were also looking out for repeat opportunities. This factor reduced the ‘rigged’ aspect of subsequent long bond auctions.

But critics say the large gap between auction rates and market rates indicates an inefficiency in the auction process, even if fraud is not taken into account.

However, Samarasiri denies that rates are manipulated and says the market determines the rate through the auctions.

He said the March bond auctions were among the most successful. The central bank has also rejected bids when high interest rates were demanded by dealers, he said.

With the central bank refusing to release data, there is no public information to decide whether any rejected bids or their average yields were in fact lower or higher than the bids that were eventually accepted later.

Samarasiri says total volumes to be taken are not communicated to everybody because full transparency may panic the market, sending rates even higher.

Volatility

But the concern – as shown by leaked information in the February 2015 auction – was that one or more dealers apparentlyknow how to bid. The dealers in the know bid large amounts for long bonds, while others bid small amounts, not really expecting them to succeed.

Financial analysts say it is not unreasonable for auction rates to be somewhat higher than the secondary market. Since large volumes are sold in one go, primary dealers cannot be expected to raise money, buy, hold, run an interest rate risk and distribute the bonds for nothing.

But the gaps seem to be large and profits reckoned in the billions.

Governor Mahendra severely criticized the previous administration’s practice of selling a small volume on auction and then selling bigger volumes at the auction rate through placements, where dealers also made small profits.

The practice was criticized because dealers were given bonds either at the auction rate or an administratively decided margin which could have led to corruption. Transparent bond auctions, which cannot be rigged as alleged now, is widely accepted to be the answer.

But selling bonds on ‘tap’ has been a practice for decades even during previous administrations headed by the United National Party.

Accepting non-competitive bids is also a practice in the US where there are single price auctions and in India, where multiple price auctions take pace.

Introducing non-competitive bids for the EPF would prevent it ‘missing’ bids and later buying bonds in the secondary market at high prices.

The concern is that the spikes are now very large giving windfalls to dealers at auctions which appear to be either manipulated or inefficient.

Governor Mahendran defended the volatility, saying large fluctuations were seen in the US 2-year bond over the past few months and international uncertainty added to domestic volatility.

"Let me make just one comment," he said. "I am not going to talk about the local bond auctions. If you look at the US 2-year bond that has fluctuated from 0.75 percent, 2.0 percent in the last three months and back down.

"Fluctuation is endemic to the markets in a period of volatility, when the Federal Reserve Bank is expected to raise interest rates further.

"There is a lot going on in the world. We are living in an uncertain world and it is reflected in the local market. I think to blame the staff of the central bank for making that volatility is very unfair.

"I am not going to get involved in the mechanics of this. I have taken a hands off policy and left it entirely to the professional staff. And by the way I commend these gentlemen.

"They have done a sterling job in my view. I have invested in several markets around the world, and I think they are adopting the best standards possible here. There is no question at all about their integrity.

"But please remember that these volatilities are reflective of a global environment which is extremely malign for emerging market instruments, bonds in particular.”

He said approaching the New Year large volumes of money was needed for salaries and bonuses. Port workers had struck demanding a bonus.

"They suddenly want a bonus," he said. "That money has to be found from somewhere. And these gentlemen are the ones that have to find the money. So please don’t accuse them of volatility and inefficiency. They are doing the best job possible under the circumstances."

Pump and Dump

It is also not clear whether some dealers are over-trading. However primary dealers have also got more aggressive in holding longer term bonds especially after an incident in early 2015 which critics say smacks of a pump and dump incident.

The Employees Provident Fund was mis-used during the Rajapaksa regime to pump and dump stocks, and was given the doubtful accolade of being the ‘buyer of last resort’. No one has so far been punished.

Early in 2015 concerns were also raised about the sale of 2041 bonds and their purchase by the Employees Trust Fund after prices rose sharply (the yield fell) within a short time.

It is easier to manipulate the price of an illiquid security than a liquid one where there are more buyers. In general longer term bonds are less liquid than short term ones.

It is also easier to manipulate a security when a large portion of the securities is held by one or a few holders, a situation known as ‘cornering’. Such tactics were common in the stock market around 2011.

On January 08 2016, the central bank sold 19.6 billion rupees of 2041 bonds at an average yield of 12.09 percent after calling bids for only 8.0 billion rupees of bonds.

All bids for 5-year bonds were rejected after calling offers for 2.0 billion rupees of such bonds. Over 13.5 billion rupees of 2030 bonds were also sold at a yield of 11.46 percent on that date.

In the next two weeks, yields fell sharply. The Employees Provident Fund was also seen buying bonds. Secondary yields fell as low as 10.8 percent.

At a weighted average yield of 12.09 percent the government will sell the bond to dealers at around 99.28 rupees for a 100 rupee security, without accrued interest (clean price) and around 99.51 rupees with interest.

By January 21 when the yield fell to around 10.80 percent, the price of the bond would have risen to around 111 rupees for every 100 rupee 2030 bond. For every billion rupees sold by a primary dealer at 10.80 there would be a profit gain of 110 million rupees.

If the EPF bought bonds at 10.80 percent, or as critics say the bonds were ‘pumped and dumped’ on the EPF it would have been paying 110 million rupees more for every billion rupees of bonds compared to the average auction rate.

If bonds were bought at yields of around 11.00 percent or higher the premium would be smaller.

Then secondary market yields went steeply up – presumably after EPF stopped buying.

Deputy Governor Samarasiri declined to give details of EPF bond purchases. He said the trades were made by the fund’s investment managers independently.

There is also market speculation that one state-run financial institution is also helping bailout dealers by purchasing bonds in the secondary market at high prices.

On February 05, there was another bond auction. This time 10.2 billion rupees of 2041 bonds were sold after offering to sell 5.0 billion.

This time the weighted average yield was 12.15 percent, higher than the Jan 08, auction. The cut-off is unknown.

Over 10.4 billion rupees of 2030 bonds were also sold after calling bids for 3.0 billion.

Again all bids for 5-year bonds were rejected after offering to sell 2.0 billion rupees worth. EPF had not been very active in the secondary market in earlier years. The EPF is allowed to buy directly at the auction.

Missed Bids

Governor Mahendran strongly defended the EPF in a February press conference saying the fund may be buying bonds in the secondary market because it got cash from time to time or it missed bids at auctions.

"Now if the EPF bids lower than its competitors in the market, it will lose out and won’t get full allocation on whatever it wants to buy," he said.

"And then it has to go into the secondary market. That is how any market player operates."

Mahendran also denied that the EPF had suddenly become unsuccessful in bond auctions, and were then buying bond at high prices in the secondary market.

"How can you say they were so unsuccessful? That is dependent on how skilful the managers are in getting allocation right? So they are bidding against the market.

"Now the market has a view. That rates are going up or down. In a volatile situation like now, because the currency is volatile etc, interest rates are sort of moving in both directions on a daily basis.

"I do not think the EPF is doing any worse than anybody else out there. How are you judging that they are doing badly? The point is they are giving 10.5 percent yield on their entire portfolio of 1.4 trillion rupees which to me is a remarkable attestation to their skills.

"These guys are superb. The EPF managers in my opinion are some of the best guys I have worked with in fund management."