Archived - Evaluation of the Bond Buyback Program
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The Department of Finance values the work of Professor MacKay in the preparation of this report and is moving to address the issues raised within the report.
We are pleased to note that Professor MacKay expressed the opinion that the Bond Buyback Program is well managed in that its practices generally compare well with the best practices of other sovereigns.
The issues presented below are summaries of recommendations contained in the document above and in the technical background paper submitted to the Department of Finance with this document. Specific management responses to issues raised are:
1. Bonds Eligible in Bond Buyback Operations: The criteria for eligibility for inclusion in the basket of targeted buyback bonds have changed during the life of the program. It is recommended that the government be sensitive to the various purposes that outstanding bonds may serve. This sensitivity for target selection will become increasingly important as the number of issues outstanding continues to decrease and so those eligible are fewer in number.
The evolution of criteria for eligibility of bonds has contributed to the success of the buyback program and has, in turn, supported the size of new issuance. This evolution of criteria has come about as program managers expanded the list of targeted bonds after dealers sold back their warehoused stocks of the bonds first targeted as part of the program. Program managers are conscious of the impact of buyback operations on the liquidity of less-liquid bond issues targeted by the program. In general, program managers will favour buying back the less liquid, higher coupon, bond when two bonds are trading at equal relative prices. As a means of ensuring liquidity in outstanding issues, program managers also introduced a $6 billion floor for old outstanding benchmark issues. Going forward, program managers will continue to actively consult with market participants to remain well informed of relevant sensitivities.
2. Market Risk Reduction: Market risk faced by bond market participants has decreased with the shortening of the time horizon between the end of the submission of tenders and revelation of results, and with the advent of the switch buyback program. It is recommended that the government continue to monitor the marketplace for other ways to mitigate the market risk faced by participants.
In support of well-functioning markets, program managers pay considerable attention to mitigating risk for dealers. In summer 2002, following market consultations, the length of time between auction and cash buyback operations was reduced in order to reduce market participant's risk. As announced in Debt Strategy 2003-04, program managers are committed to further reducing turnaround time.
3. Potential for Increased Transparency: The UK Debt Management Office's policy on bond market transparency requires greater transparency of their buyback operations than that of the Canadian government. Should the Canadian authorities consider a move toward increased transparency, careful scrutiny of the UK experience is warranted. This will be particularly true in the future as the UK program continues to evolve and its experience broadens.
Transparency in its operations is one of program management's main operating principles as it contributes to well-functioning markets. In terms of the buyback program, program managers have worked closely with market participants to ensure a high degree of transparency including pre-announcing buyback schedules, targeted bonds and amounts and also announcing the results of the buyback operations. Program managers decided against divulging the pricing model to ensure a competitive price discovery process at buyback, i.e. to prevent participants from trying to raise prices beyond what they have been in the period leading up to the buyback operation, thus allowing the government to maintain a low cost of buying back targeted issues. Despite the difference with the UK government on this issue, program managers closely monitor the experiences of other sovereigns in this area.
4. Reduction in Market Debt: Government of Canada market debt is a long way from being eliminated. As the market debt shrinks, issues regarding the continued well-functioning of the market will change as the scope of available outstanding issues and the size of those issues offers reduced flexibility to manage the market. It is recommended that the Australian public debt experience be monitored closely since its current experience may shed light on the future for the Canadian case.
As part of their governance procedures, program managers continuously monitor developments in borrowing programs of other similar sovereigns. Unlike some other sovereigns, we are neither eliminating our debt, as in the case of Australia, nor are we eliminating maturities, as was done in the US and UK. Program managers maintain a long-term strategy to ensure a well-functioning market for Government of Canada securities.
5. Consultation with Market Participants: It is recommended that the government continue its current practice of consultation with bond market participants on a regular basis. Considerable insight has been gained from the experience of those who work within the relevant markets on a daily basis.
Program managers will continue to work closely with market participants to address issues of market function and integrity. Market participants are consulted on the Government's debt strategy and adjustments to its domestic debt programs on a semi-annual basis. Through this approach, program managers seek to maintain a high standard of transparency, improve the attractiveness of the market for investors, and take into account market views in their operational and strategic decisions.
Other Issues Raised
6. Market participants believe liquidity in the off-the-run issues targeted by the program has declined.
The objective of the buyback program is to maintain and enhance the liquidity of benchmark bonds. Program managers are of the view that buyback operations have positively contributed to the overall liquidity in Government of Canada securities market, as the contribution of buyback operations to the liquidity of newly issued issues has offset the reduction in liquidity of off-the-run issues. Program managers intend to maintain a balance between liquidity of off-the-run issues and benchmark issues; therefore in summer 2002, a $6 million floor on off-the-run issues was introduced to ensure that sufficient liquidity is maintained in these issues.
7. The amount of quantitative data was insufficient in some areas to allow for greater analysis of the effects of the Bond Buyback Program.
Program managers are taking steps, as means become available, to improve data quality such as in the area of bid-ask spreads. As the data related to trading in the over-the-counter market is proprietary to the dealers, and dependent on the quality of their systems, there are limits to the availability of some types of information. Recent market developments, including the launch of Alternative Trading Systems (ATS) and associated initiatives with respect to transparency may facilitate the collection of improved data.
8. The question of the cost of the bond buyback program cannot be answered definitely because of the confidential nature of much of the data. The evidence that is available indicates that the program has been at least economically neutral to the government.
Information regarding the cost of buybacks relative to the Bank of Canada's estimates of fair value, relative to the current traded prices for Government of Canada securities and relative to the cost of the bonds that were issued to finance the bonds repurchased, are available. More specifically, a standard rich/cheap model is used to assess short-term price levels and to select bonds for repurchase. Program managers limit the buying back of bonds that trade too expensively, on a relative basis, vs. the recent trading range. All bonds repurchased are at a positive spread to the cost of new issuance, i.e. the program has provided a modest economic gain.
9. The Government should buyback higher coupon bonds even when they are not "cheap".
As part of their commitment to well-functioning markets, program managers do not wish to disrupt the market or move prices by buying back bonds at prices inconsistent with recent trading levels. By not buying "expensive" bonds, program management minimizes the "footprint" left in the market by buyback operations. As seen with the Australian experience, buying back on an absolute value basis generates poor buyback performances and distorts bond prices.