Issuance and Trading of Government and Corporate Fixed-income Instruments

Sovereign vs. Corporate Debt Issuance Process

There is a clear distinction between corporate and sovereign debt issuance processes. Corporate debt issuance tends to be opportunistic and is managed by investment bank underwriters on behalf of the issuers. On the other hand, sovereign debt typically follows the form of a public auction, often led by the National Treasury or finance ministry.

When a government announces a debt auction, it opens the door for prospective investors to place either competitive or non-competitive bids. A competitive bidder specifies both the price they are willing to pay and the number of securities they wish to acquire. Should the auction’s final price exceed the bidder’s set price, the competitive bidder walks away empty-handed. In contrast, a non-competitive bidder forgoes the price-setting privilege and agrees to whatever price the auction settles at, but with the assurance of always receiving the securities.

Competitive Bid Processes

There are two primary mechanisms for the competitive bid process: the single-price auction and the multiple-price auction. Both processes require the issuer to rank bids based on their prices. Bids are selected from the highest until the entire issuance amount has been met. In a single-price auction, each winning bidder pays an identical price and receives the same coupon rate, regardless of their initial bid. The multiple-price auction, in contrast, might result in varied prices among bidders for the same bond issue. While the single-price approach could lead to a lower cost of funds and a diverse investor base, the multiple-price auctions might end up with a concentration of large bids.

Single-price Auction Phases

1. Announcement by the government debt management office detailing the bond issue.
2. Submission of bids, either competitive or non-competitive, by dealers, institutional investors, and individuals.
3. Acceptance of all non-competitive bids; ranking of competitive bids from the lowest yield. Determination of the cut-off yield.
4. Delivery of securities to the successful bidders in exchange for proceeds.

Role of Financial Intermediaries in Sovereign Debt

Sovereign governments often appoint a group of primary dealers, financial intermediaries mandated to participate in all auctions. These primary dealers can also be counterparts for central banks in open market operations and help facilitate foreign central bank transactions. Additionally, investors might also directly participate in auctions through specific national platforms.

Trading of Sovereign vs. Corporate Debt

Sovereign debt, once issued, is primarily traded on Over-The-Counter (OTC) markets through financial intermediary brokers/dealers. However, in some places, like Australia, it is traded on exchanges. In most markets, the sovereign issuer is the primary borrower, and their securities are the most liquid in the fixed-income category. The most recent sovereign debt securities, termed “on-the-run” securities, stand out for their liquidity, making them pivotal for benchmark yield analyses. These contrast with older, less frequently traded “off-the-run” securities. Due to their high liquidity, some “on-the-run” securities are traded on electronic platforms managed by private entities.

Investors in Sovereign Debt Vs. Corporate Debt

Sovereign debts often attract investors with varying non-economic objectives. For instance, the Federal Reserve uses US Treasuries for monetary policy, while certain governments use them as dollar reserves. Some entities, like banks and insurance companies, may need to hold Treasuries to meet specific regulatory requirements. Such factors can reduce sovereign borrowing costs compared to the private sector, especially for issuers with a reserve currency. Reserve currencies are those held by central banks globally, e.g., the US dollar, Euro, pound, etc. They are used for international trade and financial transactions.

Question 1

Which category of sovereign debt securities is known for their high liquidity and is essential for benchmark yield analyses?

1. Off-the-run securities.
2. On-the-run securities.
3. Exchange-traded securities.

Solution

The correct answer is B.

“On-the-run” securities are the most recent sovereign debt securities, known for their liquidity, making them pivotal for benchmark yield analyses.

A is incorrect: “Off-the-run” securities are older and less frequently traded.

C is incorrect: While some sovereign debt might be traded on exchanges (e.g., in Australia), this choice does not pertain to the liquidity and benchmarking aspect described in the notes.

Question 2

Which type of auction might result in varied prices among bidders for the same bond issue?

1. Single-price auction.
2. Non-competitive auction.
3. Multiple-price auction.

Solution

The correct answer is C.

The multiple-price auction might result in varied prices among bidders for the same bond issue.

A is incorrect: In a single-price auction, all winning bidders pay the same price.

B is incorrect: Non-competitive bidders agree to pay whatever price the auction settles at; therefore, there is no variation in price among them.

Question 3

Where are most sovereign debt securities primarily traded after issuance?

1. Stock exchanges.
2. Over-the-counter (OTC) markets.
3. Online public auction platforms.

Solution

The correct answer is B.

Sovereign debt, once issued, is primarily traded on Over-The-Counter (OTC) markets through financial intermediary brokers/dealers.

A is incorrect: Though some sovereign debt, like in Australia, is traded on exchanges, the majority is traded OTC.

C is incorrect: Online public auction platforms might be used for issuing or buying the debt but not primarily for trading after issuance.