DDO – A new deceptive bond placement at a loss to the EPF. Let us examine

This article is to provide several issues of the DDO governance relating to the exchange of Treasury bonds with the EPF as revealed from the CB press notices and to highlight the financial loss to the EPF against the general notion of no loss spread by the authorities.

The press notice issued by the Public Debt Department on 14 September

It provides the details of 12 new Treasury bonds privately issued under the DDO as shown below. See the press notice https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/press/pr/press_20230914_settlement_of_exchange_of_accepted_eligible_treasury_bonds_for_twelve_new_step_down_fixed_coupon_treasury_bonds_pursuant_to_the_dod_optimisation_programme_e.pdf

Highlights of the issuance area as follows.

• The issuance is back-dated to six days from 15 January 2023 to 15 June. 2023.

• Bonds are due to mature on 12 dates from March 2027 to February 2038.

• Each bond carries two coupon rates, i.e., 12% up to 1st semi-annual coupon due in 2026 and 9% for the remaining maturity periods of bonds beginning the 2nd semi-annual coupon in 2026 to 2038.

• The face value of each bond issued in exchange for the same face value of converted bonds is Rs. 267,038.5 mn. Therefore, the total DDO covered in the press notice is Rs. 3,204,462 mn worth total face value of 12 new bonds exchanged for the same face value of converted Treasury bonds.

• The press notice did not reveal details of relevant bond investors. It appears that these are the DDO bonds issued to the EPF offer.

The press notice issued by the Communication Department on 14 September

This press notice clarifies the factors considered by the Monetary Board in making the decision on the participation in the DDO for the EPF. See the press notice. 

https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/press/pr/press_20230914_participation_of_the_employees_provident_fund_in_the_domestic_debt_optimisation_programme_e.pdf

Highlights of the press notice are as follows.

• Out of total Treasury bond portfolio of the face value Rs. 3,220 bn of the EPF, Rs. 2,667,512,169,237 face value of Treasury bonds were offered for the DDO (Rs. 149,890,740,000 in excess of the minimum participation requirement of 78%) and the government has accepted the same for exchange with new Treasury bonds.

• Out of the two options offered in the DDO, the EPF is financially better off by having the option of the exchange of the Treasury bond portfolio with new bonds at the existing tax rate of 14% on taxable income applicable to the Treasury bond portfolio than the other option to continue with the existing Treasury bond portfolio at 30% tax rate.

• This position was established with a statistical projection on the annual rate of return on the EPF Treasury bond portfolio under two DDO options as depicted in the following chart.

• The assumptions used for the projection are as follows.

• The Monetary Board has determined to accept the DDO exchange offer due to following reasons.
• The government’s decision to guarantee a minimum 9% annual interest from 2023 to 2026 on balances of the EPF members.
• Higher rate of return on the DDO Treasury bond portfolio as projected though prudent and realistic assumptions than the DDO option with 30% tax.
• The sustainability of public finance restored with the ability to service its debt consequent to the proposed debt exchange and the other reforms being implemented by the Government.
• A high risk of the Government not being able to fully service the obligations on the pre-exchange bonds held by the EPF leading to very serious adverse consequences to the EPF unless debt sustainability is restored without undue delay. 

A Few Comments

The comparison of the two press notices reveals the deceptive nature of the DDO on the EPF as highlighted below.

• The Communication press notice states the face value of Treasury bonds offered for the DDO as Rs. 2,667,512 mn (Rs. 2,667.5 bn). However, as per the press notice of the Public Debt, it has issued 12 new Treasury bonds for the face value of Rs. 3,204,462 mn (Rs. 3,204.4 bn). As the total EPF Treasury bond portfolio is Rs. 3,220 bn, it appears that the government has covered the latest face value of the EPF Treasury bonds portfolio in the DDO, not the face value of Rs. 2,667,512 mn offered by the EPF for the DDO. There cannot be other superannuation funds involved in this issuance so far.

• The guarantee of 9% of annual interest to EPF members for the period 2023-2026 is not a big deal for the Monetary Board to consider because the new DDO bonds receive 12% coupon rate for the same period. As the EPF’s annual cost is less than 1% of the investment portfolio, the payment of 9% interest out of 12% return is easy in finance. However, it is difficult to state whether 12% of coupon payable on DDO bonds is higher without knowing the aggregate coupon received on existing bond portfolio before DDO.

• Projections on the rate of return on the EPF Treasury bonds portfolio under two options are meaningless. As simple arithmetic can be used to compare the financial outcome of the two options, complicated projections as presented by EPF financial experts are not necessary. 
• The rate of return on the DDO portfolio after 14% tax would be around 10.32% for 12% bond period (2023-2026) and around 7.64% for 9% bond period (the rates of return net of 14% tax on coupon income). 
• Similarly, the EPF could easily calculate the rate of return on existing Treasury bonds portfolio for alternative option just by subtracting 30% tax from the actual bond coupon income (combined) each year.
• The public cannot estimate it as the EPF has not disclosed the existing profile of Treasury bonds (i.e., bond-wise face value, coupon and maturity). However, the overall gross rate of return on EPF average investment portfolio in 2022 has been around 10.3% after 14% tax. If the 30% tax is applied, the rate of return would reduce to around 8.3%. Therefore, the DDO portion at 12% coupon for the period 2023-2026 is definitely profitable to the EPF as compared to the other option. However, it is not clear whether 9% DDO coupon period is profitable to the EPF. For example, DDO 30% tax is profitable to the EPF if the year 2022 is considered. If there is another tight monetary period with 30% yields in the future, the EPF will be better off with DDO option at 30% tax. The EPF fund managers could easily estimate the annual series of rates of return on the EPF existing Treasury bond portfolio at 30% tax without any assumptions on interest rates and reinvestments in the future for comparison purpose. Further, it is needless to state that the assumptions used for future interest rates and reinvestments in the EPF projections are unrealistic and unnecessary. Therefore, the Monetary Board’s determination that the assessment considered for the determination is based on prudent and realistic assumptions is grossly incorrect and deceptive.

• The reference to the guarantee of 9% annual interest to EPF members for the period 2023-2026 through legislation is unwarranted and meaningless as 9% interest is not an issue as the EPF receives 12% coupon income on the total DDO Treasury bond portfolio for the same period whereas the interest rate paid in the recent past also has been around 9%-9.5%. Therefore, the distribution of a much lower return to members as compared to 12% coupon income is a serious governance concern. This seems to be purely EPF politics. If the EPF is managed professionally, the guarantee of return to members does not arise. 
• Both press notices do not reveal the present profile of the existing Treasury bond portfolio of the EPF (bond-wise coupon, face value and maturity). The EPF should be holding Treasury bonds of different maturities with coupons higher than 12% and 9% issued in the past. Therefore, DDO seems to have extended the maturities of the existing bonds in conversion to new bonds at new coupon rates of 12% and 9%. Further, the press notices do not mention whether the new DDO bonds are tradable for investment and liquidity purposes as provided for in the section 5(1)(e) of the EPF Act. Therefore, the EPF may have lost the opportunity of investment and liquidity management in a market environment during the DDO period.
• The reference to the Monetary Board as the custodian of the EPF is false. As per the section 5(1)(c) of the EPF Act, the Monetary Board has the custody of only moneys of the EPF and not the EPF per se where the the Minister and Commissioner of Labour have wide powers on operating and projecting of the EPF. As such, the Monetary Board only has the financial management function for the EPF which is not the custodian function of the EPF.
• Reference to the debt sustainability and high risk of fully servicing the obligations on the pre-exchange bonds held by the EPF are baseless. Debt unsustainability may be a concept applied for foreign debt due to the failure of the Monetary Board to maintain a foreign currency reserve sufficient for periodical debt services whereas governments do not have to default on debt in sovereign currency because they can rollover debt through the creation of money, given the government’s sovereign monetary powers and the private sector’s willingness to rollover government debt as the risk free part of its asset/savings portfolio. That is the reason why the government has offered to swap foreign debt with local currency debt as part of the foreign currency debt restructuring.

Concluding Remarks

• The claim that there will not be a loss to the EPF from the DDO is baseless. As the purpose of the DDO is to restructure the government domestic debt stock in a manner financially beneficial to the government to ease the burden of the present debt stock, there cannot be any DDO or debt restructuring without a financial loss to the EPF or creditors. This principle is applicable to any debt restructuring exercises pursued by governments or businesses.

• The proposed DDO targeting Treasury bonds held by superannuation sector alone cannot make the domestic debt sustainable as claimed in policy statements because Treasury bonds held by the superannuation sector constitute only 24.7% of domestic debt stock. Debt unsustainability concept is applicable to foreign debt as the CB/Monetary Board has failed to supply foreign currency to service foreign debt. The unsustainability or default of domestic debt is an unwarranted and baseless hypothesis because debt in sovereign currency always can be rolled over at contemporary interest rates.

• As the DDO assessment considered by the Monetary Board is deceptive, financial loss to the EPF is clear from the lower coupon rate of 9% for the period 2027-2038 and the maturity extension of the face values of existing bonds through the new bonds.

• The government should release the maturity-wise information on pre-converted Treasury bond portfolio of the EPF to enable the public to assess the comparison between the two DDO options with the present position. The set of information publicly available at present is not adequate to assess the exact nature of the financial loss to the EPF on the DDO. As such, rosy statements made by the authorities are baseless.

• The misuse of the EPF for debt and monetary management outside the market mechanism has been the routine in the past. Therefore, the DDO is not a stranger, but another hidden device for same purpose.

• The Monetary Board talking about the debt unsustainability and risks of default shows its unfitness and impropriety as the debt manager and fiscal agent and adviser for the past 73 years. Therefore, the Parliament must investigate how public finance/debt has had to confront the present havoc despite the 73-year long role of the Monetary Board. Therefore, the Parliament/government should find solutions for the debt management outside the proposals/recommendations made by the Monetary Board as such proposals always tend to hide its unfitness and impropriety.

• Overall, the government must use liability management techniques to restructure debt stock to resolve any unsustainability issues in a market environment for long term benefits and, therefore, the use of such methods of default and abuse of state powers is unprofessional and undemocratic.

(This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public consequent to the global Corona pandemic, subsequent economic disruptions and shocks both local and global and policy failures.)

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 12 Economics and Banking Books and a large number of articles published. 

The author holds BA Hons in Economics from University of Colombo, MA in Economics from University of Kansas, USA, and international training exposures in economic management and financial system regulation)