LIABILITY MANAGEMENT OPERATIONS –
BASICS OF BOND BUYBACKS AND EXCHANGES
Joint IMF -WB TA Mission on LMO
Dhaka, January 22 – 30, 2024
CONTENTS
❑ Liability Management Operation (LMO) for Sovereign Debt Management
❑ Functions of Bond Buybacks and Exchanges
❑ Types of Buybacks and Exchanges
❑Implementing Buybacks and Exchanges
LMO FOR SOVEREIGN DEBT MANAGEMENT
WHAT IS LIABILITY MANAGEMENT?
❑A risk management tool, that changes the structure of the debt portfolio, which in turn affects
the risk of the debt.
• Not always intended to provide additional funding
❑The process of voluntarily changing existing debt profile to improve the composition of the
debt portfolio.
▪Market based operation reflecting market prices
▪Mutual agreement between the debtor and the counterpart
▪No imposition of financial loss to the original holder of debt
❑Should be part of overall risk management strategy of debt portfolio
• Not be undertaken opportunistically and based on market speculation
• Anchored on the Medium-term Debt Management Strategy
• Move from Planning to Implementation through Annual Borrowing Plan
TYPES OF LIABILITY MANAGEMENT?
❑ Reducing refinancing risk through buybacks and exchanges
• Smoothing the maturity profile, reduces both refinancing and interest rate risk.
• Although creation of large benchmarks can create future refinancing risks.
❑Reducing interest rate risk through interest rate swaps
• Transforming coupons from fixed to floating, or vice versa (interest rate swap,
FRAs)
❑ Reducing currency risk through currency swaps
• Hedging / changing the currency exposure of existing debt (FX forward, cross currency swap)
• Depending on the nature of the operations, it is possible to retire foreign currency
(international market) debt and replace it with local currency (domestic market ) debt.
FUNCTIONS OF BOND BUYBACKS AND EXCHANGES
FUNCTIONS OF BOND BUYBACKS AND EXCHANGES
Manage refinancing risk
(and extend maturities)
Buying back or exchanging debt that is maturing in
the near term – typically within two years – to
spread out the refinancing of large securities
Stimulate the creation of benchmarks
Create a financing need in support of benchmark
building by retiring older, less liquid securities to
issue on-the-run benchmarks
Support the market during periods of stress
Buying back debt to provide liquidity support during
liquidity crunch
Reduce interest costs
Buying back or exchanging debt with high coupon
rates for lower coupon debt, at the cost of increasing
the total debt outstanding
Improve portfolio composition
Retire small, illiquid lines of debt
CASH NEUTRALITY OF BUYBACKS AND EXCHANGES
❑Buybacks and Exchanges are mainly aimed at reducing refinancing risk by being Cash
Neutral
▪Does not change net financing for the sovereign but reduces gross financing needs for
the initial years
❑Buybacks and Exchanges can also be aimed at keeping the duration neutral for
investors
▪May have cash implications
❑Buybacks can be used to reduce debt stock of a sovereign
▪For sovereign with fiscal surplus, part of the surplus could be utilized for retiring debt
KEEPING BUYBACKS AND EXCHANGES CASH NEUTRAL
❑For buybacks, two separate transactions required with matching amount of new
issuance
▪Source bonds are retired (buybacks) and new (destination) bonds are issued in its place
▪Creates funding risk for sovereign when new issuance is undersubscribed
▪Creates market risk for sovereign with price movements between the two transactions
▪Creates reinvestment risk for investors if not successful in auctions
▪Allows investor diversification as existing holders may not reinvest while new investors
may hold new issuance
❑For exchanges or switches, a single operation allows change in bonds
▪Source bonds are exchanged for destination bonds
▪Investor composition remains unchanged
▪Avoids reinvestment risk for investors
MITIGATING REFINANCING RISKS: AN ILLUSTRATION
OF BUYBACKS AND EXCHANGES
REDUCING THE COST OF NEW FUNDING?
❑ Ex-ante liability management operations are neither costly nor cost effective
• Buying back or exchanging debt can incur transaction cost, but retiring old debt and
issuing new liquid benchmarks can be cost effective.
• Balance between the two will determine whether the exercise is cost effective.
❑ What about retiring old high coupon debt and replacing with new lower coupon
debt?
• Buying back or exchanging debt with high coupon rates for lower coupon debt can
reduce interest costs, at the cost of increasing the total debt outstanding
EXAMPLE – REDUCING INTEREST COST
Assumptions
Reducing
interest cost
vs.
Increasing
debt
outstanding
Old Bond Repurchased
Equivalent New Bond
Issued
Nominal
Amount
100
132.44
Coupon
8%
4% (market yield for 10 year)
Market Price
132.44
132.44 (at par)
Maturity
10 year
10 year
•
Reduction in interest cost equals the future value of the difference in
annual interest paid, i.e. FV of [8% of 100 – 4% of 132.44] = FV of [8 – 5.3]
= FV of [2.7] each year for ten years = 32.44
•
Increase in debt outstanding equals the additional nominal amount of new
bond necessary to repurchase 100 nominal amount of the old bond =
32.44
Buyback and Exchanges: Summary of Advantages
RISK, ADVANTAGES AND DRAWBACKS
Risks
Relative
advantages and
disadvantages
•
•
•
•
Market manipulation
Budgetary cost
Illiquidity of source bond
Reputational risk
Buybacks
Exchanges
Advantages
• Simplicity
• Wider investor base
• Typically cash neutral
Disadvantages
• Creates temporary
financing need
• More complex
• Requires a concurrence of
needs with the investor
TYPES OF BUYBACKS AND EXCHANGES
TYPES OF BUYBACKS
Over the counter
• Bilateral: negotiated price,
generally not published
• Buyback window: price
published and generally fixed for
the duration of the window
Reverse auction
Conducted similar to a regular
auction
• Single price
• Multiple price
TYPES OF BOND EXCHANGES / SWITCHES
Terminology:
• Source bond - the bond being being given up
• Destination bond - the new bond being issued
• Exchange ratio – of the price of the source stock to the destination stock
• Fixed-price exchange – exchange ratio set in advance
• The issuer bears the market risk that prices move between fixing the exchange ratio
and finalizing the exchange.
• Exchange auction – exchange ratio determined by bidders
• The issuer sets the price of the source (destination) bond and the bidders submit
prices for the destination (source) bond.
• The market risk is borne by the bidder.
TYPES OF EXCHANGES
Fixed price
• Issuer sets exchange ratio:
• Dirty price of destination bond / dirty price of source bond,
• Clean price destination bond / dirty price of source bond
Auction
• Uniform price or multiple price
• Issuer sets clean price of destination (source) bond; Market bids
clean price of source (destination) bond
Bilateral
• Negotiated price
Two separate
auctions
• Held the same day
IMPLEMENTING LMOS
IMPLEMENTING LMOS
Legal framework
The law governing debt management should:
• include bond buybacks and exchanges among authorized transactions
• indicate all the objectives for which it could be used, ideally as a guideline, at the
discretion of the debt manager.
Institutional set-up
The debt management office should have the authority to decide:
• the securities to be retired from the market
• the appropriate mechanism to do so
• the pricing – typically the same committee as the one in charge of auctions
SETTING OBJECTIVES
Reduce refinancing risk
• Cost-risk trade off
• Mutual interest of the investor and issuer: reinvestment vs refinancing risk
Support benchmark issuance policy
• Gradual increase of the target size
• Support benchmark building – reach target size within a shorter period of time
• Facilitate secondary market trading
• Lower the cost of domestic funding
• Improve yield curve
• Attract foreign investors
SETTING OBJECTIVES
Improve cash management framework
• Buyback can be considered as an investment
• Refinancing of benchmark sizes is spread over a longer period of time
Portfolio consolidation
• Consolidate liquidity into fewer number of instruments
Reducing interest expenditures
Duration extension
INVESTOR PARTICIPATION
The critical factor in determining the success of an LMO is the extent to which investors
wish to participate.
Some considerations:
• Appetite from end-investors: are they buy-and hold?
• What is liquidity like in the existing (and the new bond)?
• What sort of price will the investors expect?
• Are the investors domestic or international?
• How will market makers channel investor demand into the LMO?
0
