9. Prefecture & Municipal Bonds

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Edwina Underwood
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1 9. Prefecture & Municipal Bonds 80

2 9.1. Security Type Public Bonds: Issued by 15 Prefectures and 12 Big Cities designated by a cabinet order ( Seirei Shitei Toshi ) Private Bonds: Issued by 47 Prefectures, 12 big cities designated by a cabinet order ( Seirei Shitei Toshi ), and some other wards. Refer to for more details Maturity Type (1) Bullet Redemption at Maturity (2) Even Amortization Style After a specific unredeemable period, bonds with a prescribed serial number are redeemed on each coupon payment date. (As described before, every bearer form has a serial number.) Redemption pattern: 1 Redeeming 3% of the initial principal on each coupon date for 7 years after 3-year unredeemable period (Portion redeemed at maturity is 61%) Called 3year, 3% Teiji 2 Redeeming 7.143% of the initial principal on each coupon date for 7 years after 3-year unredeemable period (Portion redeemed at maturity is also 7.143%%) Called 3year, 7.143% Kinto 3 Redeeming 6.25% of the initial principal on each coupon date for 8 years after 2-year unredeemable period (Portion redeemed at maturity is also 6.25%) Called 2year, 6.25% Kinto 4 Redeeming a% of the initial principal after b-year unredeemable period Called byear, a% Teiji or Kinto 81

3 (3) Lottery Style After a specific unredeemable period, the serial numbers that will be redeemed on the next coupon payment are determined by lottery 1 ~ 2 months prior to the coupon date. It means that bonds with this maturity style, unlike the type (2), cannot fix the yield. Redemption pattern: 1 Redeeming 3% of the initial principal by lottery after 3-year unredeemable period Called 3-year / 3% Lottery 2 Redeeming 7.143% of the initial principal by lottery after 3-year unredeemable period Called 3-year / 7.143% Lottery 3 Redeeming 6.25% of the initial principal by lottery after 2-year unredeemable period Called 2-year / 6.25% Lottery 4 Redeeming a% of the initial principal by lottery after b-year unredeemable period Called b-year / a% Lottery Until 1992, most of public Municipal Bonds were issued in 10-year maturity / 3-year unredeemable / 3% Lottery Style. This is to even out the redemption burden on issuers but investors can not determine the final yield until the redemption were actually made. To improve the liquidity enough to satisfy growing secondary demands, issues of bullet redemption at maturity began around Actually, by March 1992, all the 15 Prefectures and 12 Seirei Shitei Toshi had switched their maturity style of public bonds to a bullet redemption. Public Municipal Bullet Redemption at Maturity Private Municipal 6 biggest cities Bullet Redemption at Maturity Others Bullet Redemption at Maturity, Teiji, Kinto, Lottery 82

4 [Market Terminology] Difference between Even Amortization and odd final ( Teiji ) and Even Amortization ( Kinto ) 1 3-year / 3% Teiji 100% 3% Grace Period 3% Outstanding 61% 0 After the 3-year unredeemable period, redeem 3% of the initial principal on each of 13 coupon dates (3% * 13 = 39%), and 61% on maturity date. 3yr Life It is called Teiji. 10yr 2 2-year / 6.25% Kinto 100% 6.25% Grace Period 6.25% Outstanding 0 2yr Life After the 2-year unredeemable period, redeem 6.25% of the initial principal on each of 15 coupon dates (6.25% * 15 = 93.75%), and same 6.25% on maturity date. It is called Kinto. 6.25% 10yr If the final redemption percentage at maturity is same as Even Amortization ratio, it s called Teiji and if not, it s called Kinto. 83

5 9.3. Tiering The 1st Grade: Tokyo Metropolis The 2nd Grade: Yokohama City Nagoya City Kyoto City Osaka City Kobe City Called 6 Big Cities The 3rd Grade: Other Prefectures and other Seirei Shitei Toshi (Called Local issues) The 4th Grade: Ward Bonds There used to be only 3 grades until around 1994 as 6 Big Cities were regarded as the same in terms of credit quality. Since 1994, Tokyo started to outperform the rest of 6 Big Cities, and spread determination was based on Tokyo. (However, we do not call the 2nd Grade as 5 Big Cities.) The spread between Tokyo Metropolis and Local issues trades within the range of 4 ~ 15 b.p. (8 ~ 10 b.p. on average). There is little secondary trading of the 4th Grade issues but might be defined as Local issues + 5 ~ 15 b.p.. In 1998, with many press reports that local governments are in financial crisis, financial ratios of local governments became main determinants of Municipal Bond pricing. 84

6 9.4. Even Amortization Style (Teiji or Kinto) Bonds Yields Pattern A: First of all, an average life must be calculated. Then, a simple yield and a compound yield can be calculated by using an average life as a remaining life of the bond. (Average Life Yield) Average Life (X) = Number of Years to Maturity (L1) - Redemption Rate Rate of Remaining Principal * (L1 Number of Years to Next Redemption (L2) ) * (L1 L ) [Example] Calculate a unit price and an average life yield of a bond with 5.5% coupon, 03/30/2003 maturity, 3-year unredeemable, 3% Teiji, 02/02/1998 Settlement, L + 40 b.p. X = % 91% * ( ) * ( ) = (years) 365 Assuming year LIBOR as 1.377%, an average life yield (L + 40) is 1.777%. A unit price is and a simple yield is 2.222%. Pattern B: Swap cash flows at each redemption and calculate a yield from that result. Pattern C: Decompose cash flows into a portion of bullet redemption at maturity and a portion of Even Amortization. 3-year, 3% Teiji can be decomposed into: 3-year, 7.143% Kinto 42% Bullet Redemption at Maturity 58% 2-year, 3% Teiji can be decomposed into: 2-year, 6.25% Kinto 48% Bullet Redemption at Maturity 52% 85

7 [Example] 10 billion of 3-year, 3% Teiji, 5/20/2007 maturity, 2.4% coupon Original cash flow Settlement 01/20/1998 Maturity Coupon Grace Year Sinking Ratio 05/20/ yr 3.00% cpn Payment Life Outstanding Redemption 05/20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ This can be decomposed into: billion of bullet redemption at maturity, 5/20/2007 maturity, 2.4% coupon billion of 3-year, 7.143% Kinto, 5/20/2007 maturity, 2.4% coupon 86

8 Cash Flow of 2 Settlement 01/20/1998 Maturity Coupon Grace Year Sinking Ratio 05/20/ yr 7.143% cpn Payment Life Outstanding Redemption 05/20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/ Pattern C has some problems. First of all, not many investors can handle the yield calculated by this method. In other words, not many investors have a system that can manage two different cash flows under the same bond name. Secondly, not many issuers can manage such cash flows. Thirdly, the markets for two different bonds generated by decomposition are still immature. Fourthly, investors who use JSDA s based indications will undervalue the portion of Bullet Redemption and overvalue the portion of Even Amortization. Pattern B also has some problems. Similar to Pattern C, there is no secondary market for the swapped bond. In actuality, one needs to recover the original cash flow by detaching a swap portion, but that will worsen the liquidity. For such reasons, most of actual transactions are made with the pricing by the Pattern A method. 70% of transactions are using A method while only 20% are using B and 10% are using C. If one says L + 40 b.p., it refers to LIBOR spread calculated by the A method. It should be noted that some investors compare LIBOR (s.a.) with Average Life Simple Yield. One must check if the client uses a simple yield or a compound yield as a reference. That will differentiate the final yield by 10 b.p. Pattern A is currently dominating the market. The LIBOR spread described here has no rationale but we are using it as a market practice. On the other hand, if one can trade with a client who calculates a price by the C method, there will be a good profit opportunity ~ 0.80 pricing difference used to be seen between the two methods in early The difference narrowed to 0.30 level towards late It is now around Pattern B and C will become the mainstream in the near future. 87

9 9.5. Lottery Style (Random) Bonds Yield In the Lottery Style Redemption, a prescribed portion of the initial principal is redeemed on each coupon date. The serial numbers that will be redeemed at the next coupon payment are determined by lottery 1 ~ 2 months prior to the coupon date. The result is publicly announced in the Nihon Keizai Shimbum (Nikkei). Unless one holds the entire amount of the outstanding of the issue, it is impossible to fix the final yield, as one cannot know what percentage of the issue will be redeemed. For this reason, investors try to avoid the Lottery Style issues. Compared to the Even Amortization Style, Lottery Style issues are, in general, cheap by 70 ~ 80 b.p. (at LIBOR basis calculated by A method). On the other hand, it means that one can gain more if actual redemption rate is 3%. If one purchases many different 3% Lottery Style issues for a specific amount (for example, 20% of the originally issued amount), it is highly probable that the actual redemption rate is around 3%. 70 b.p. spread will pay even if 6% were to be redeemed. Lottery Style bonds generally cannot be traded during the period of lottery (1 ~ 2months prior to each coupon date). If one tries to trade during that period, it will be traded only the amount excluding the amount that may be redeemed. For example, if one purchased 1 billion (with condition that the portion redeemed will be excluded) and 2.5 billion was actually redeemed, one must sell that redeemed portion back to the original seller. (Any transaction is possible under the agreement between a buyer and a seller.) The elected serial numbers are announced only in the Nikkei, and the notice to the buyer will not be made until about a week after the actual redemption. Therefore, the buyer needs to watch the Nikkei carefully to know whether their bond is redeemed or not. The yield is determined as follows: [Example] #5-2 Private Aichi Prefecture Bond Coupon 4.2% Maturity Date 10/15/2003 Coupon Date April & October 15 Unredeemable Period Until 10/15/1996 Original Issue Amount 30 billion Maturity Style 3% Lottery ( 900 million at every coupon payment) As of now (January 2000), the remaining principal is 2.46 billion with 6 redemption already made. If this bond is traded at over-par: 88

10 Holding Amount Redemption Rate Spread Normal Worst Case As of Jan % of Outstanding = 24.6 billion 3% 3% L % of Outstanding = 12.3 billion 3% % L % of Outstanding = 2.46 billion 3% 11.45% L Regularly Scheduled issues with the same remaining life L + 25 Case 1 Very simple. This is a Lottery Style bond but, as one holds 100% of the outstanding, one can fix the final yield as one can do for regularly scheduled redemption. The spread in this case should be the spread for Even Amortization plus a bit here would be less than 10 b.p. Case 2 Getting complicated. Redemption rate should be 3% on average but, in the worst case, it might be %. On the other hand, as the probability of getting % is very low, the spread calculated assuming the % redemption rate is likely to give one a large gain. Therefore, the actual spread will be determined somewhere between the spread calculated for 3% redemption and the spread calculated for % redemption. Case 3 In the worst case, all the bond one holds might mature as early as April 2001 though the original maturity is October 15, Therefore, in this case, the spreads for the worst case are calculated assuming that this bond matures in April One should repeat the same calculation as Case 2 to determine the actual spread. 89

11 9.6. History Spread Levels Tokyo Metropolitan (1 st Grade) / JGB Spread History Tokyo 5y Tokyo 10y Mar-97 Jun-97 Sep-97 Dec-97 Mar-98 Jun-98 Sep-98 Dec-98 Mar-99 Jun-99 Sep-99 Dec-99 Local Municipal (3 rd Grade) / JGB Spread History Local 5y Local 10y Mar-97 Jun-97 Sep-97 Dec-97 Mar-98 Jun-98 Sep-98 Dec-98 Mar-99 Jun-99 Sep-99 Dec-99 90

12 The graphs above are showing the spread history since 1997 of Tokyo Metropolis Bond and Local Municipal Bonds with remaining life 5 years and 10 years. As can be seen in those graphs, the spreads have shown a relatively stable movement except for the large sell-off in the Yamaichi debacle in 1997 and the Russian Shock in 1998.Excluding those large sell-offs, the average spread in the last 3 years has been JGB + 15 ~ 25 b.p. for Tokyo Metropolis Bond, and JGB + 25 ~ 35 b.p. for Local Municipal Bonds. During 1995 ~ 1997, the spread movement was more stable with around JGB + 15 b.p. for Tokyo and JGB + 20 b.p. for Local Municipals. The movement in late 1998 shown in those graphs is the biggest swing in the last 15 years. The comparison between 5-year maturity and 10-year maturity also tells an interesting story. 5-year spread has been rather stable while 10-year spread has been volatile and tighter than the 5-year spread. Non-JGBs market is dominated by the supply and demand of long-term investment instead of that of proprietary trading or day-to-day trading. For this reason, the current 10-year zone is influenced by the coupon level of new issues. As the current and under-par issues are always popular, over-par issues have a wider spread whereas under-par issues have a tighter spread. This makes the 10-year spread movement volatile as seen in the graph. On average, the 1 ~ 9-year zone will show the same kind of spread movement as the 5-year zone Public & Private Placement Both public issues and private issues are traded in the secondary market. As the issuance scheme is the only difference between the two, those have been traded interchangeably until late The situation changed, first when market participants became aware of credit risk after the Russian Crisis, and second when many news reports were released about early redemption of Municipal Bonds. Among private issues, what was actually redeemed early was those not traded in the market. Early redemption had nothing to do with the private issues traded in the market, but market participants were alarmed by the word private. This widened the spread between public issues and private issues for the first time. The spread once widened to 15 ~ 20 b.p. temporarily but currently stays at 2 ~ 4b.p. level. 91

13 9.7. Risks to Consider When Investing in Prefecture &Municipal Bonds Generally, the financial condition of Local Governments, which issue Prefecture & Municipal Bonds, are miserable. (Details of financial condition are stated in the next section.) Only Tokyo Metropolis, Chiba City, and Kawasaki City can finance their administrative needs on a stand-alone basis. Other Local Governments are financed by the Local Allocation Tax granted by the National Government. Some Local Governments financed as much as 80% of its financing needs by the Local Allocation Tax. It may look highly risky but what it really means is that the Local Government finances is up to the National Government. Let s think about the default risk of Municipal Bonds. The possibility of default of Municipal Bonds is minimal as those bonds are supported by multiple safety nets provided by the National Government. The most important one is the Finance Reconstruction System. This would be applied either 1 if the Net Income and Expenditure Balance goes below 5% for Prefectures & Municipals and 20% for cities, towns and villages, or 2 if the Adjusted Debt Expenditure Ratio exceeds 20%. One should pay more attention to the latter. The former case seldom occurs since the Net Income and Expenditure Balance can be improved by issuing the Finance Normalization Bond etc. On the other hand, since the Adjusted Debt Expenditure Ratio is calculated from the redemption of bonds issued in the past, it cannot be improved by doing something in the current finance period. Therefore, the Adjusted Debt Expenditure Ratio is the most critical point to measure the credit risk of Municipal Bonds. If this ratio exceeds 20% and Special Measures Law for Promoting Local Finance Reconstruction is applied, the Local Government concerned is placed under The National Government s control. This means that the finance of a Local Government will be supported by the National Government before it defaults. In other words, Local Governments designated, as Entity under Finance Reconstruction due to bad financial condition would not go bankrupt. We might safely say that an entity with bad financial condition has lower credit risk. From the discussion above, one might think that Municipal Bonds are similar with JGBs and GGBs with no credit risk. However, scrutinizing their financial condition might not justify such an optimistic argument. The finance program and liabilities of one Local Government is not necessarily fully monitored by the National Government, and some portion such as the socalled The 3rd Sector might be run by the Local Government itself. It depends on to what extent the National Government supports local finances, but one should assume that the portion not monitored by the National Government has some credit risk. 92

Fiscal Status of Kobe City. October 2017

Fiscal Status of Kobe City. October 2017 Fiscal Status of Kobe City October 2017 Contents 1. Overview P3 2. Fiscal Profile P7 3. Kobe City s Local Government Bonds P12 4. Appendix P17 1.Overview Overview of Kobe City Kobe City Area 557.02km2