In an article published in Postimehe, economics professor Raul Eamets criticized the government for granting long-term loans at a time when interest rates are high. Janno Luurmees, head of the Treasury Department of the Ministry of Finance, rejected the criticism and responded that issuing annual bonds would have a higher cost rate.
Because Estonia asked for a loan with a higher interest rate than Spain (3.35% versus 3.25%), even though rating agencies gave Estonia a better rating (Standard and Poor’s rating AA- vs. A)?
The credit rating plays an important role in determining the price of bonds, but it is certainly not the only factor that determines the cost to the issuer. Also important for investors are bond yields and liquidity on the secondary market, the reputation of the issuer, the transactions of other similar issuers and recently the geopolitical risk in our region.
In turn, the liquidity of bonds is influenced by the frequency and regularity of issuance and the volume of issues. For example, the volume of the Spanish issue that took place on the same day was 15 billion euros and offers were made for a total of 138 billion euros.
Therefore, as a rule, Estonian bonds are not compared to Spain or other large countries that issue large quantities of bonds.
The liquidity of Estonian government bonds is relatively low because we issue rarely and little, we are newcomers to the government bond market and our neighbor, unfortunately, is aggressive Russia.
All this translates into a higher risk premium compared to other similar countries.
Given that Estonia’s loan was oversubscribed seven times, can it be concluded that the country could have received a loan with a lower interest rate?
Bonds of Estonia and many other countries are valued at the interest rate of swap operations (midswap or MS) to which a country-specific margin is added.
The logic behind the valuation of the bond issued in January was as follows. On the day of issue, January 10, the yield on the secondary market of Estonian bonds redeemable in October was +0.63%.
Considering early investor feedback and the fact that the newly issued bond had a maturity of almost two years longer, an additional margin of 0.07% was added using bond yields from other similar countries as input.
In total, the cost rate of the new 10-year bond was MS+0.7%.
As a rule, investors are offered an additional reward (Newly issued prizes or NIP) for being willing to participate in the new issue (otherwise they would buy new bonds later on the secondary market and would not be motivated to participate in the new issue), but this time it dropped to zero during the offering due to the ‘high demand.
Why did Estonia decide to take a 10-year loan, even though it is assumed that interest rates will start to fall next year? Is it justified to take out long-term loans at a time when interest rates are high?
When choosing the maturity date of the bond to be issued, risk indicators and the composition of the already existing debt portfolio, the situation of the bond market in general and the expected demand of investors for the Estonian bond in particular.
A drop in short-term interest rates is currently expected in the market, but this information is already included in long-term interest rates. For some time now, short-term interest rates in the market have been much higher than long-term interest rates.
Issuing a one-year bond would have resulted in a higher expense ratio than issuing a 10-year bond.
Financial markets, and especially the international government bond market, are efficient and all known information is already taken into consideration in the average prices of financial instruments.
To illustrate, Luurmees provides an example:
Alternative 1: We issue a one-year bond today at a cost rate of 3.5%, assuming we can refinance it in one year at a cost rate of 2.5% based on today’s market expectations. This makes the two-year average expense ratio 3%.
Alternative 2: Since the market is efficient, we can at the same time immediately issue a two-year bond with a cost rate of 3%.
So, as far as we know today, both alternatives are the same and it doesn’t matter which one you choose.
If the actual cost rate after one year is different from the expected 2.5%, the two-year average cost of Alternative 1 will also be different. The cost rate of Alternative 2 will not change regardless of how the cost rate in year two differs from today’s market expectations.
Of course, one can take the position that the market has misjudged the future and bet money on it in the hope of making a profit, but this is a risk that should be avoided as much as possible in managing public money.
2024-01-26 08:40:00
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