On the bond fracas and on 19A

Self-inflicted wounds of bourgeois democracy

When money is parked for longer terms a higher return is expected as a premium for risk taking.

by Kumar David
March 28, 2015, 12:00 pm
Understandably the public is ultra sensitive, having survived a corrupt
morally decadent regime, to any and every shortcoming of the new one.
Fair enough and I encourage vigilance after a long period in which
Rajapaksa putrefaction fed on the cowardice of the populace. Thats the
truth. Edward Saeed remarked that the intellectual must "Speak truth to
power" but he forgot to add the same injunction about speaking truth to
the people. I devote this piece to two hot issues. First, what the numbers
say about the Central Bank bond issue. Second, roadblocks in 19A speak
truth to friends and comrades whose speechless, spineless dumbness
when Candidate Sirisena was twofaced about abolishing the Executive
Presidency, has created to an impasse. Those who stayed silent then, that
is the 99% on "our side," are now necessarily speechless when Champika
Ranawaka declares that Candidate Sirisena never promised to abolish EP.
First the bond issue. Assume two examples both with 12.5% coupon
(annual interest rate) but with (a) 5-year and (b) 30-year maturity terms.
I have not heard of such high rates for sovereign Lankan bonds in recent
debates; the highest is the Prime Ministers mention of an 11%, 10-year,

Central Bank issue. A 12.5% coupon is high for sovereign (government or

Central Bank) paper; however long term bond yields need to be high to
compensate borrowers for risk taking. A typical yield curve is shown.
Companies go broke, revolution or war destroys governments, or as in
Greece the unexpected happens. Thirty years! Good heavens, two years
was too long for our Astronomer Royal; or was he on the bankroll of the
Imperialists? Anyway the issuer pays 12.5% whether for five or 30 years
and from the point of view of the public purse its all the same provided
bonds are sold at par and one can be confident that in the long-term
interest rates will not decline.
Lets take another step and say an investor bids Rs 91 for a par 100 bond
and a hard-up seller says "OK give me the 91 bucks and take it; after all I
dont need to give you the 100 for 30 more long years". Accepting a bid at
Rs 91 reduces collection though interest has to be paid on the face value.
Therefore the effective interest rate goes above 12.5% - in the present
case the de facto rate goes up to 13.73%. If an investor purchases a
12.5%, 30-year, bond at Rs 91, he is really collecting interest at 13.73%
(12.5 divided by 0.91). What the PMs inquiry committee needs to probe is
whether a 30-year term at a real interest rate of 13.73% is unusual. To put
it another way, should not the actual interest-payable on a 30-year
sovereign bond be lower than 13.73%? Each one percent of ten billion is
one hundred million per year for 30 years; the actuarial soundness of the
decision must be challenged.
However theres another way to look at it, that is from the point of view of
the investor. What will bond (a) be worth after five years? Assume interest
is not taken but reinvested at the same interest rate (or accumulates and
compounds with the bond issuer, if allowed). In five years the nest-egg is
worth 100 multiplied by 1.125 five times over. (Remember the compound
interest formula in school?) This works out at Rs 180.2, or a profit of Rs
80.2 over five years. This averages at 16% a year not 12.5%, thanks to
compounding and as compensation for taking a risk for a modest five year
period.
Heres the catch. Take (b), the 30-year case, sit tight without touching the
interest and let it compound in the same way and at the same rate. What
will it be worth? In 30 years the Rs 100 is worth 100 multiplied by the
1.125 factor 30-times over. Wow, this works out at Rs 3,424 or a hefty
profit of Rs 3,324 on Rs 100 investment! As this is over 30 years, to find
the average annual rate of profit divide by 30; it is 111% per annum. The

12.5% annual interest rate seems to have skyrocketed to over 111% per
year. Now include the effects of securing the 100 par bond at Rs 91; all
else is the same, so a profit of Rs 3,324 is made on Rs 91 investment. The
average annual compounded rate of profit will be even higher; 122%
(3,324 divided by 30 and divided again by 0.91).
The windfall is in nominal cash-of-the-day. If inflation is a steady 5% then
the earnings have to be discounted. A crude but reasonable method is to
discount money at 5% for 30 years to compute its present value. If we do
this, then Rs 3324 has a present value of Rs 769; divide by 30 and 0.91 as
before and the return to the investor is 28% (not 122%). Still, doesnt
28% average annual return, net of inflation, incorporate too generous a
risk cushion on a sovereign bond? That question too the investigators will
have to answer.
However what is far more disturbing is the following which I have been
informed of with confidence by a correspondent whose name I do not have
permission to reveal. Let me quote:
"Kumar
The bid prices have not been adjusted to one single cut off point in this
auction. There are auctions where they do that. Here, they have
eliminated bids below Rs.90.2 and accepted all bids above Rs. 90.2 up to
Rs. 119 at THE ACTUAL PRICES BID BY THE DEALERS. In this process the
amount purchased was increased fromthe pre-announced Rs. 1 Billion to
Rs. 10 Billion. The lowest priced bid of 3 Billion by the Bank of Ceylon lying at the cut-off point - is reported to be on behalf of Perpetual.
The high yield of up to 13 percent for Perpetual and the relatively high
weighted yield of 12.5 percent dropped the prices of existing bonds bought
previously and pushed traders into losses. You can see the pressure on the
President that led to a probe within three days".
Not only is this method of acceptance (as opposed to the usual Dutch
Auction where all bidders pay at the same rate as the lowest bid accepted)
grossly unfair between traders but revealing only at the auction itself that
Rs 10 billion and not Rs 1 billion was to be accepted placed any bidder with
inside information at an enormous advantage.

The numerical examples are didactic and illustrative; not to be taken as a

case study of the current controversy. I have no opinion on the insider
dealing allegation and await the report. I do wish, however, that the Prime
Minister and Ministers would stop ferreting out old buddies, school mates
and ideological fellow travellers and instead put men and women of
sterling integrity in key positions. Lack of variety, and the absence of even
one person well known to be nobodys yes-man on this panel, dents its
credibility. Of course I do not question the integrity of the three appointed
members; but thats a different matter. I have never heard of these blokes
before; oh yes I can hear you mutter "Thats a big plus in their favour!"
Two big bugs in 19A
19A has been gazetted and may be pushed through with or without
electoral reforms; 40 or 50 UPFA MPs will sell their mothers, sisters and
country down-river than lose their pensions rights. If a 2/3 majority is
unlikely, Nimal Siripalss and Ven. Athureliyas opposition may signal an
attempt to deny a 2/3 majority, parliament should be dissolved forthwith
and President and Prime Minister ask for a peoples mandate. They must
declare that they will treat the results of the parliamentary election as
equivalent to the outcome of a de facto referendum. They must campaign
together.
Funnily, the UPFA is better off with a proportional system than first-pastthe-post (FPTP) because it can smuggle a lot of garbage into the former
list. Under FPTP individual candidates are well known to locals, so crooks,
cronies and thugs (that is most) will be decimated. But this is not what I
am griping about today. Today may be my last chance before 19A is
enacted to lament that the elected-President cum elected-Parliament
dichotomy is a decoction for deadlock, and secondly to moan that the socalled Council of State (CoS) is a toothless rubber stamp. I dealt with both
last week ("Elected Presidency: Double-bubble toil and trouble") but they
are critical concerns and need repetition; time is running out. It will also
earn me the future right to proclaim I told you!
Patali Champika Ranawaka ignores Candidate Sirisenas Memorandum of
Understanding and frequent public declarations which knowingly conveyed
a commitment to the people that he would abolish EP. Was Candidate
Sirisena twofaced on this issue? Yes, but is not what he promised the JHU
behind closed doors but what he indubitably conveyed to the people that
counts. No more about Patali Champika Ranawaka; he does not matter. My

grudge is with Sirisena and Ranil though both will firmly ignore it.
The immediate point is that 19A is the harbinger of a log jam. An elected
president who controls parliament is a potential tyrant like Mahinda
Rajapaksa; the worst excesses of that era can reappear under some
dreadful future incumbent. If however the opposition controls parliament,
the national leader, the President, is an immobilized dummy. Dont be
misled by the prevailing good relations between Ranil and Sirisena, the
outcome of unusual antecedents, or by the fact that the incumbent
president is playing a mostly ceremonial role. Constitutions must not be
designed for individual circumstances; they must survive into the generic
future. Not specifying the Head of Government will make current confusion
and the possibility of future conflict worse. The Head of Government must
be specified as the Prime Minister.
Thirty-six members of CoS are chosen by the PM and the Leader of the
Opposition over a cup of tea, twenty by other parliamentary leaders - the
nine outsiders are Provincial Chief Ministers. My calculator says this
assembly is 86% handpicked. Dear God must just two people nominate 36
of 65 members (55%) to the Second Chamber? Take a doomsday
scenario; imagine Mahinda Rajapaksa as PM or Leader of the Opposition.
He will in effect name about 18 CoS members. Since the past is our guide
they will be relatives, hangers-on, flunkies and junkies.
I will not go to extremes; I concede that some people of goodwill and
distinction will also be included; nevertheless they too will be preferred
cynosures of two individuals who between them already dominate the
other Chamber. The concept of a Second Chamber is good, so let it be
filled by peoples nominees not a cacophony of flunkies. How should it be
set up? Well whats the point of wasting my breadth, whos listening?
Posted by Thavam