Advisory Note: Changes to Issuance Approach for Inflation Indexed Bonds

Background

Inflation indexed bonds (IIBs) are an important funding instrument for the Crown. There are four IIBs outstanding, with maturities ranging from September 2025 to September 2040. Inflation adjusted coupon and principal amounts better align repayments with the variability in Crown revenues, which are correlated with the business cycle, thus reducing the risk of the Crown’s balance sheet. In addition, IIBs contribute to increased diversity in the New Zealand Government Bond investor base. 

At end-November 2021, there were NZ$19 billion of IIBs outstanding, representing 13% of the bond portfolio.

Globally, sovereigns have generally experienced lower turnover and liquidity in inflation linked relative to nominal securities. New Zealand is no different. During 2021, IIB tenders have often experienced low bid cover ratios, and a wide range of successful yields, highlighting issues with price transparency, liquidity and market saturation. Secondary market turnover was also relatively subdued. Consequently, in September, New Zealand Debt Management (NZDM) paused tendering for the remainder of 2021 while consulting with Registered Tender Counterparties (RTCs) and investors on ways to build greater vibrancy in the IIB market.

Changes to the issuance process

• Following feedback from market participants, NZDM will take a more flexible approach to IIB issuance volumes. NZDM’s updates alongside Economic and Fiscal Updates will include a range of expected IIB issuance for the current fiscal year, rather than a specific expected volume.
• Issuance will be more flexible and responsive to changes in demand. Specific details of upcoming IIB tenders will no longer be published in the monthly bond tender schedules. Instead, NZDM will regularly conduct a survey of market participants to gauge demand for IIBs. Following this, NZDM will announce when IIB tender issuance is to be offered, at the usual tender confirmation date for nominal bonds. The frequency at which NZDM will consider offering IIBs will be confirmed ahead of the resumption of IIB tenders, that will not occur before March 2022.

Changes to the tender mechanism for IIBs

• NZDM intend to change from a ‘multi-price’ to ‘single-price’ auction mechanism for IIBs from March 2022. This decision is based on analysis of auction theory and peer practices for tendering securities. This does not impact tenders for nominal bonds and T-Bills which will continue to use a multi-price mechanism with no change anticipated for these products in the future.
• In a single price auction, NZDM will offer a fixed amount of securities. The bidder then submits bids which detail the amount of securities targeted and the yield. At auction close, the process allocates securities to the bidder/s with the lowest yields until the final issuance amount is covered. All successful bidders then receive the same issue yield equal to the highest accepted yield.
• While there are advantages and disadvantages of each tender method, single price auctions may offer benefits for less-liquid markets like IIBs. As outlined above, all successful bidders are allocated at the same yield, thereby avoiding the ‘winners curse’ which refers to the winning bid exceeding an asset’s ‘intrinsic value’ due to information asymmetry or price uncertainty.
• In some cases where sovereigns have chosen to use a combination of tender types, such as Canada and the UK, both have chosen to use single-price for their inflation indexed products while retaining multiple-price for nominal bonds. Addressing lower liquidity and higher pricing uncertainty is highlighted as the rationale for using a single-price method.

These changes are aimed at addressing some of the concerns raised during the consultation process with investors and RTCs. NZDM remain committed to IIBs as part of the Crown’s term funding strategy and will assess the impact of the changes alongside potential further actions to support the market, as required.