Tax payers were not disadvantaged

The PEACE Bond issue, involving the P1.4 billion peso fund raised by CODE–NGO, has become a controversial issue facing the Macapagal Arroyo administration. Critics have alleged that there was an anomaly involved in the sale of the bonds, allowing CODE-NGO to generate a fantastic windfall and leading to significant losses on the part of government. Several arguments have been raised on both sides but we believe that one crucial question has not been adequately addressed in the crossfire. This question, to our mind, holds the key towards developing a dispassionate and rational perspective on the whole issue.

This crucial question is: What was the appropriate value of these bonds when they were issued in October last year?

First, the pertinent facts:

The Bureau of Treasury sold (through a bidding process) 10-year zero-coupon bonds with a face value of P35 billion to a bank (RCBC) which acted on behalf of CODE-NGO. The bonds were sold at a total price of P10.2 billion, thus implying a yield of 12.75 percent per annum. The bonds are effectively tax exempt and eligible as liquidity reserves for banks and quasi-banking institutions. Simultaneously, or within a very short period of time, CODE-NGO sold the bonds to RCBC Capital at a gross profit of P1.8 billion or a total consideration of P12.0 billion. At this price, the implied yield of the bonds to the end-buyer (RCBC Capital) goes down from 12.75 percent to only 11 percent.

Given the above details, we can restate the question: Was the appropriate value of the bonds upon issuance P10.2 billion or P12.0 billion? Or, alternatively, was the appropriate yield of the bonds 12.75 percent or 11 percent?

Before explaining why this question is of crucial importance, we have to note that the difference between the two yields is very significant and non-trivial in a reasonably efficient financial market. For a sovereign issue to experience this yield movement on the same day or within a very short period of time, a major market-shaking development has to happen. No financial market professional worth his salt can glibly claim that this is a normal occurrence in the financial markets. Thus, if this wide a yield movement takes place without the occurrence of a major market-shaking event, then the conclusion is that either the issuer paid too high a yield or the final buyer overpaid for the bond and is now suffering below-market yields. As far as we can recall, the Philippine financial market was relatively calm when the Peace Bonds were auctioned. Clearly, therefore, one of the yields was wrong. Which is which? 12.75 percent or 11 percent?

The importance of this question is this: If 11 percent was indeed the appropriate yield for the bonds, then the Department of Finance / Bureau of Treasury committed a serious mistake in the sale of the bonds and were remiss in their duty to protect the interests of government. Notwithstanding the openness of the auction and without having to allege that it was rigged (as, indeed, we do not have reason to believe that the respected professionals in the DOF/BTR would commit such a crime; besides, the accusers have not presented any iota of evidence that there was such rigging), one could nevertheless argue that they should have devoted more time and effort explaining the features of the bond to more market participants in order to achieve the lower yield. If this were the case, then the critics are right and we, as taxpayers, should all join in condemning the issue as a major anomaly.

On the other hand, if the appropriate yield of the bonds was 12.75 percent, then clearly there could have been no anomaly involving government funds and the only logical conclusion is that RCBC overpaid for the bonds. In this case, the extraordinary profit enjoyed by CODE – NGO could not have come from government and, therefore, there would be no basis whatsoever to allege a public anomaly nor would there be any reason to condemn the heads of the DOF and the BTr guilty of any wrongdoing. No doubt, there would still be great public interest in the issue but the public debate would take on a completely different tone and context. Rather than agitation and outrage, there would simply be great curiosity as to why RCBC overpaid for the bonds. If any, the sparks will fly not in the halls of Congress but in the boardroom and shareholders’ meeting of RCBC.

Having stated the issue as simply as the foregoing, we now proceed to analyze the features of the bond to determine its appropriate value. First, we would like to note that the main features that enhanced the value of the bond were the tax exemption and the liquidity reserve eligibility. The insurance eligibility did not add any additional value to the Peace bond because this is normally extended to any government security anyway. Second, we also wish to note that the zero-coupon feature did not add any value to the bond. Normally, a zero-coupon bond issued by the same issuer and with the same tenor would trade at a slightly higher yield than an ordinary coupon-bearing bond.

Thus, conservatively (from the issuer’s standpoint) we can compare the Peace Bonds with the regular 10-year Treasury note. At the time of the auction, the regular 10-year T-notes were trading in the secondary market at a yield of 16.9 percent. Since the regular 10-year T-note is subject to the 20 percent final withholding tax , the after-tax yield of the 10-year T-note was 13.5 percent. Thus, if the Peace Bonds had no other enhancement aside from the tax exemption, then it should have traded at around 13.5 percent or higher, not 12.75 percent and DEFINITELY NOT 11 percent. The question, therefore, is what is the value of the liquidity reserve eligibility? Is it approximately 0.7 percent or is it 2.5 percent?

One analysis by a Peace Bond critic argued that the reserve eligibility allowed RCBC to substitute the Peace Bonds for the short-term reserve-eligible T-Bills, which yielded approximately 8 percent then. It continued to argue that the differential between the yield of the Peace Bond and the short-term T-Bill represented the gain of RCBC. We think that this is very faulty analysis. We do not think that we have to explain at any length why one cannot compare the yield of a 90-DAY T-Bill with that of a TEN-YEAR Bond. Even those with very little background in Finance would readily appreciate that the liquidity and interest rate risks offered by both instruments are vastly different. Even if, after acquiring the Peace Bonds, RCBC proceeded to shed off its short-term liquidity and replaced this with the Peace Bonds, the yield differential could not be considered as "profit". That differential is a risk premium for the additional liquidity and interest rate risks that RCBC would have taken.

In fact, we speculate that RCBC could not simply have replaced its short-term liquidity with the Peace Bonds. The maturity profile of a Bank’s balance sheet is a function of its liquidity preference and its interest rate outlook and not simply of what the Central Bank allows it to do. Even if the BSP were to declare tomorrow the scrapping of the liquidity reserve requirement, the banks would not shift their short-term reserves to long-term government securities. The banks would still maintain a comfortable liquidity buffer but what they will do is convert their reserve-eligible T-Bills into regular T-Bills, the yield of which is 0.5 percent higher than that of the reserve-eligible T-Bills. This additional yield of 0.5 percent enjoyed by regular T-Bills over reserve-eligible T-Bills is the only value enhancement offered by the reserve eligibility feature. Thus, deducting this from the 13.2 percent after-tax yield of the regular 10-year T-notes, the fair yield of the Peace Bonds at the time of issue was approximately 13 percent.

Based on the foregoing, it is our conclusion that the 12.75 percent original yield of the Peace Bonds was favorable to government and that it was RCBC, not government, that bore the cost of the P1.8-billion windfall that was enjoyed by CODE – NGO by suffering an inordinately low yield on this instrument when they bought the bonds on a secondary basis from CODE - NGO. Whether this resulted from philanthropy and social spirit, miscalculation or contractual constraints that required RCBC to provide fees to CODE-NGO even in a transparently bidded auction where they would have been entitled to participate anyhow, or a combination of the above, is a private matter. Now, looking at this issue in its entirety, we believe that it was inappropriate, if not outright wrong, for CODE – NGO to have attempted to conduct this transaction on a negotiated basis, as they themselves have admitted. We believe it is fair to surmise that, if there was no auction, the government would have ended having to bear the cost of the CODE – NGO windfall. Thus, instead of being pilloried and maligned, the DOF and the BTr deserve our congratulations and commendation for having resisted the strong overtures of CODE – NGO to conduct a negotiated sale. In particular, we have to thank Treasurer Sergio Edeza for having been so clear and unswerving in his position on the matter, and for taking only the highest interest of the Republic into account in his actions. Clearly, the government did not lose a single cent in the transaction, thanks to their efforts.

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