Macroeconomic and Financial Management Institute (MEFMI)

Strategies for Increasing Liquidity of Government Bonds and the Government Bonds Market in Tanzania

by

Liku Irene Kamba (Bank of Tanzania)

For MEFMI Fellowship Accreditation

June 2015

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TABLE OF CONTENTS

ABSTRACT ................................................................................................................... 3 

CHAPTER ONE .......................................................................................................... 5 

1.0  Introduction ................................................................................................... 5 

1.2  Statement of the Problem ............................................................................. 6 

1.3  Objectives of the Study ................................................................................. 6 

1.3.1  General objective ................................................................................... 6 

1.3.2  Specific objectives .................................................................................. 7 

1.4  Research Questions ....................................................................................... 7 

1.5  Scope of the Study ......................................................................................... 7 

1.6  Data collection: Procedure and Administration ......................................... 8 

1.7  Data Analysis Plan ........................................................................................ 8 

1.8  Expected Results ............................................................................................ 8 

CHAPTER TWO ......................................................................................................... 9 

2.1  Understanding the concept of liquidity ....................................................... 9 

2.2  Measuring Liquidity ................................................................................... 10 

2.3  Research Methodology ................................................................................ 16 

CHAPTER THREE ................................................................................................... 18 

3.1  General Observations ................................................................................. 18 

3.1.1  The Government Bond Market in Tanzania ......................................... 18 

3.2  Results of the Volume-based measures of bond liquidity ........................ 23 

CHAPTER FOUR ...................................................................................................... 26 

4.0  Strategies to increase bond market liquidity ............................................ 26 

4.1  Experience from Uganda ............................................................................ 26 

4.2  Experience from Kenya .............................................................................. 27 

4.3  Strategies to increase liquidity of government bonds in Tanzania ......... 30 

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ABSTRACT 

The government bond market in the EAC has been one of the major sources of

government funding and has played a major role in funding long term development

projects in the region. This market took shape as a result of reforms implemented in the

1990s and some that are still ongoing.

There have been deliberate efforts taken by governments in the region to boost

development of the government bond markets. The question with all these initiatives

remains; has the government bond market been strengthened? And have all these efforts

improved the performance of the government bonds in the region with particular

emphasis placed on the liquidity of these securities?

The paper offers insight into the performance of the Government bond market in

Tanzania, the factors that have made government bonds illiquid and the efforts taken

by government to correct this. Among the factors highlighted to be affecting liquidity

of government bonds in Tanzania is the structure of the government bond market itself

in terms of the nature of the market players, instrument design, mechanism of issuance,

and the legal and regulatory frameworks in place, particularly, the collateral

management framework, statutory requirements, taxation policy and capital account

controls.

Using the volume-based measures of liquidity, government bonds in Tanzania are seen

to be illiquid when compared to those issued in Uganda and Kenya. And in order to

revamp the performance of government bonds in Tanzania through increased liquidity,

the paper looks at strategies applied by the two countries that worked favorably and

proceeds to propose strategies that would work in the Tanzanian environment such as:

introduction of benchmark bond programs; reduction of issuance frequency; introduce

market determined coupons; review of collateral management framework; full

liberalization of the capital account and enhancement of market infrastructure to

support Delivery Versus Payment (DVP) arrangement in both primary and secondary

market.

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CHAPTER ONE

1.0 Introduction

Development financing is a challenge facing most emerging markets, limiting their

ability to meet the set development targets. Much as East Africa is experiencing

financial sector development, however the depth and breadth of financial market

instruments, especially long term instruments, are yet to reach satisfactory levels.

While 1990s saw a wave of capital markets reforms, a lot of emphasis was on the stock

market with very minimal effort put on the bond market. This saw substantial

development of stock markets with new stock exchanges being established, regulatory

systems strengthened and trading systems rejuvenated. However, in most cases this has

not attracted a significant number of listings.

Government bonds in the EAC have offered an alternative avenue for mobilizing

finance for bridging the government deficit and for projects such as infrastructure

development. The government bond market in the region is characterized by

fragmented issues, undiversified investor base, few trades in the secondary market,

absence of regional market intermediaries, and varying tax regimes; all of which have

in one way or another been attributed/contributed to the current nascent status of this

market.

The Government bonds in the region have played a special role as collateral and

benchmarks for pricing other securities and as a safe haven because of limited credit

risk and the fact that the outstanding amounts often are quite large. In recent years some

EAC countries, particularly Kenya and Uganda, have concentrated their public debt on

fewer maturities but larger issues of each maturity with a view to promote the liquidity.

The development of bond markets is seen to play a crucial role in promoting

partnerships in the development process between the government and the private sector.

Successful development of the bond market though requires a developed money

market, favorable macroeconomic policies, significant market participation,

appropriate trading system and sound legal and regulatory framework. Experience also

shows that development of the government bond market is crucial in paving way for

development of the corporate bond market. In the development process of the bond

market, it is expected that at the initial stage a lot of effort is given to strengthen and

develop the short end of the market including transparency in securities operations and

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instrument design. After, focus moves to upgrading the trading facilities and the

settlement process and the market regulation. In the region, most countries are seen to

restructure their debt in favor of the long end of the yield curve to reduce refinancing

risk resulting from concentration of debt in the short end of the yield curve.

There have been deliberate efforts taken by governments in the region to boost

development of the government bond markets. The question with all these initiatives

remains; has the government bond market been strengthened? A market that is

characterized by high liquidity, efficiency and with minimal transaction costs and

volatility is desirable in the growth process. These are indicators that the market will

play a significant role in financing development.

Have all these efforts improved the performance of the government bonds in the region

with particular emphasis placed on the liquidity of these securities?

1.2 Statement of the Problem

The government bond market in the EAC has been one of the major sources of

government funding and has played a major role in funding long term development

projects in the region. This market took shape as a result of reforms implemented in the

1990s and some that are still ongoing. Among the ongoing reforms in this market, the

most prominent has been the introduction of the benchmark bond programme in Kenya

and Uganda in 2005 and 2007 respectively. This is where bonds with key maturities are

re-opened with a view to increase outstanding amounts for that bond.

Despite the measures taken by the respective countries, bond market liquidity in the

region seems to still be relatively low. This has had adverse effects on the performance

of the Government bond market in terms of low demand, increased cost of borrowing,

investor preference for the short end of the yield curve, and few trades in the secondary

market among others.

1.3 Objectives of the Study

1.3.1 General objective

The general objective of the study is to document the status of the Government bond

market in Tanzania.

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1.3.2 Specific objectives

1. To offer insight into the performance of the Government bond market in Tanzania,

factors that have made government bonds illiquid and existing efforts taken by

Tanzania to correct this.

2. To offer strategies to increase Government bond market liquidity in Tanzania and

in similar economies.

1.4 Research Questions

The following are the guiding research questions:

1. What is the current status of the government bond market in Tanzania?

2. Why is bond market liquidity important in the development of the government

bond market?

3. What is the best approach in measuring liquidity of the bond market?

4. What strategies are suitable in increasing liquidity of the Tanzanian government

bond market?

1.5 Scope of the Study

The study covers the Tanzanian government bond market during the period 2009 to

2014 to get insight into the performance trend of the bond market, while focusing on

liquidity of the government bonds.

The main focus of the study is the government bond market, because the secondary

market for corporate bonds is inactive in comparison to the government bond market.

According to Choudhry (2010), any investigation into market liquidity should focus

first on government bonds since with corporate bonds a number of other issues such as

credit risk which is unrelated to liquidity may influence the results. This is consistent

with Kamara (1994) who concluded that government bonds are fundamentally identical

and credit-risk-free and thus could help focus on liquidity issues.

In the context of the proposed research problem, the study looks into the performance

of the bond market both primary and secondary on a monthly basis for a five year period

from 2009 to 2014. This offers an understanding into the Tanzanian bond market in

terms of the nature of investors, maturity profile, yield curve and ultimately highlight

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areas for improvement and a clear insight into the government bond market liquidity in

similar economies.

1.6 Data collection: Procedure and Administration

The research uses both secondary and primary data. Primary data was collected in the

form of a survey that was carried out using structured questionnaires that were

administered to the Dar es Salaam Stock Exchange (DSE) and capital markets authority.

Secondary data included primary auction performance (amount offered, tendered and

issued), yields, investor categories, outstanding amount and market turnover.

To ensure practicability and applicability of the proposed strategies, in-depth

discussions were held with relevant officials at Dar es Salaam Stock Exchange (DSE)

and the Capital Markets and Securities Authority (CMSA)

1.7 Data Analysis Plan

Information gathered through discussions was subjected to content analysis. Data

generated mostly from documented sources (secondary data) has been illustrated and

interpreted.

1.8 Expected Results

1. To offer the status of bond market liquidity in the EAC region.

2. To propose strategies to increase bond market liquidity in the EAC region.

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CHAPTER TWO

LITERATURE REVIEW

2.1 Understanding the concept of liquidity

Liquidity of any market is a good measure of the proper functioning of that market as

it measures the degree of easiness with which a product can be traded. Levine (1996)

argues that liquid markets make investment less risky and more attractive because they

allow investors to acquire an asset and sell it quickly and cheaply if they need access to

their investments or want to alter their portfolios.

2.1.1 Liquidity Defined

Liquidity is the ability of a market to absorb a large number of transactions without

dramatically affecting price. The absence of liquidity for an asset implies difficulty in

converting it into cash, and generally reduces incentives to hold the asset, unless a

premium is offered. According to Mensah (2004b), the concept of liquidity is

multidimensional. Market participants perceive a financial asset as liquid, if they can

quickly sell large amounts of the asset without adversely affecting its price. Liquid

financial assets are thus characterized by having small transaction costs; easy trading

and timely settlement; and large trades having only limited impact on the market price.

2.1.2 Characteristics of Liquidity

Mensah (2004b) highlights five characteristics that liquid markets tend to exhibit

Namely:

i) Tightness:

Tightness of the spreads refers to low transaction costs, such as the difference between

buy and sell prices, like the bid-ask spread1 in quote driven markets, as well as implicit

costs.

1 This is the difference between the current bid and current ask of a given security.

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ii) Immediacy

Immediacy represents the speed with which orders can be executed and, in this context

also, settled, and thus reflects, among other things, the efficiency of the trading clearing

and settlement systems.

iii) Depth

Depth refers to the existence of abundant orders, either actual or easily uncovered of

potential buyers and sellers, both above and below the price at which a security now

trades.

iv) Breadth

Breadth means that orders are both numerous and large in volume with minimal impact

on prices. This could further entail a large pool of investors interested in a particular

security in one time.

v) Resiliency

Resiliency is a characteristic of markets in which new orders flow quickly to correct

order imbalances, which tend to move prices away from what is warranted by

fundamentals. According to Kyle (1985), market resiliency is the speed with which

pricing errors caused by uninformative order-flow shocks are corrected or neutralized

in the market. The less resilient a security is, the greater is the risk faced by an investor

trading on the assumption that price is the best available signal of true value (Jiwei

Dong 2007).

To obtain a full appreciation of a market, all dimensions of liquidity, tightness,

immediacy, depth, breadth and resiliency should be considered.

2.2 Measuring Liquidity

While the paper looks into ways of measuring bond market liquidity, it is important to

note that the concept of liquidity is also used to discuss other types of liquidity.

According to Sarr and Lybek (2002), a distinction can be made between asset liquidity;

an asset’s market liquidity; a financial market’s liquidity and the liquidity of a financial

institution. An asset is liquid if it can easily be converted into legal tender, which per

definition is fully liquid. Some financial claims are perfectly liquid as long as the credit

institution is liquid since they can be converted without cost or delay into money during

normal circumstances. The concept of an asset’s market liquidity is broader and related

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to the ease with which in the absence of new information altering an asset’s

fundamental price, large volumes of the asset can be disposed of quickly at a reasonable

price. Market liquidity depends on the substitutability among the various assets traded

in a particular market and how liquid each of these assets are. Institutional liquidity, on

the other hand refers to how easily financial institutions can engage in financial

transactions with a view to quickly cover mismatches between their assets and liabilities

which may be measured by liquid asset ratios among others and to settle their

obligations. In this case, the more liquid the assets in its portfolio are and the less liquid

the liabilities are, the greater the flexibility in managing asset-liability mismatches and

its ability to meet settlement obligations.

Sarr and Lybek et al, classify liquidity measures into four categories: (i) transaction

cost measures that capture costs of trading financial assets and trading frictions in

secondary markets; (ii) volume-based measures that distinguish liquid markets by the

volume of transactions compared to the price variability, primarily to measure breadth

and depth; (iii) equilibrium price-based measures that try to capture orderly movements

towards equilibrium prices to mainly measure resiliency; and (iv) market-impact

measures that attempt to differentiate between price movements due to the degree of

liquidity from other factors such as general market conditions or arrival of new

information to measure both elements of resiliency and speed of price discovery. No

single measure, explicitly measures tightness, immediacy, depth, breadth and

resiliency.

2.2.1 Transaction Cost measures

A distinction can be made between explicit transaction costs relating to expenses such

as order processing costs and taxes associated with trades and implicit transaction costs.

In this case, bid-ask spreads may capture nearly all of these costs, making them the

most commonly used measure of transaction costs.

In dealer markets, the bid-ask spreads may reflect order-processing costs; asymmetric

information costs; inventory-carrying costs and oligopolistic market structure costs2.

Immediacy is made possible by the existence of dealers who stand ready to buy and sell

2 Each one of these costs is affected by numerous factors. They range from the trading mechanisms and disclosure of traded prices and quantities, which may affect both the level of information as well as the extent of asymmetric information in the market, inventory costs associated with labor and capital costs; to the clearing and settlement systems which affect order-processing costs and risks.

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specific quantities of a financial instrument at the quoted bid and ask prices. High

transaction costs reduce the demand for trades and therefore the number of potentially

active participants in a market. High transaction costs reduce the demand for trades and

therefore the number of potentially active participants in a market; and could lead to

more fragmented markets as most trades take place within the market makers’ spreads

and not the equilibrium price. On the other hand, lower transaction costs, which are in

most cases associated with more liquid markets, allow for more diversification and

result in more transactions. These aspects will allow a high degree of market

information to be disseminated via the price mechanism. Prices will adjust quicker

resulting in a more efficient resource allocation. This results in transactions that are

more likely to take place around the equilibrium price of an asset leading to a more

unified and deep market.

The reduction in the number of market participants due to high transaction costs greatly

affects breadth and resiliency in terms of reduced number of participants and by

preventing orders from flowing in promptly to correct order imbalances that tend to

move prices away from their fundamental level.

The bid-ask spread can be measured as the absolute difference between bid and ask

prices or as a percentage spread. The percentage spread allows taking into account the

fact that a given spread would be less costly the higher the prices and it is easier to

compare across markets. Dealers’ uncertainty about the equilibrium price also leads to

adjustments in their bid and ask prices.

i. S = (PA – PB) where PA is the ask price and PB the bid

price or

ii. S = (PA – PB) / ((S = (PA + PB)/2)

The bid-ask spread of the market is calculated using the highest bid and lowest ask

prices in the market for a reference period or in practice the most recent quotation.

However, if there are several bid and ask prices available from different dealers and

particularly if they are not obligated to trade at the quoted prices, consideration should

be given to ignoring the most extreme outliers. In this case, the market spread should

be distinguished from individual dealers’ spreads.

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The bid-ask spread is sometimes calculated using weighted averages of actually

executed trades over a period of time in cases where trades have not taken place at

quoted prices. In this case, the spread is referred to as a realized spread.

In addition to the spread itself, the trade size at which a dealer is committed to trade at

quoted prices is also a useful indicator. All things being equal, the larger the trades that

can be conducted at a quoted spread, the more depth and breadth the market has. If

investors have large positions and dealers are reluctant to quote prices for larger trades,

then this is evidence of limited liquidity from the investor standpoint.

2.2.2 Price-Based Measures

According to Bernstein (1987), measures of liquidity when no information is hitting a

stock must be more relevant than measures of liquidity when new information leads to

new equilibrium values. Thus unrefined measures of liquidity may be nothing more

than a weighted average reflecting the frequency with which new information hits one

stock as compared with another. This being the case, there’s a need for an underlying

structural model to identify the equilibrium price. But given the difficulty in

determining whether new information is indeed affecting the price of an instrument,

Hasbrouck and Schwartz (1988), proposed the market efficiency coefficient to

distinguish short-term from long-term price changes.

The Market-Efficiency Coefficient (MEC) focusses on the fact that price movements

are more continuous in liquid markets, even if the information is affecting equilibrium

prices. Thus for a given permanent price change, the transitory changes to that price

should be minimal in resilient markets.

MEC = Var (Rt) / (T * Var (rt))

Var (Rt) = variance of the logarithm of long-period returns. Var (rt) = variance of the logarithm of short-period returns. T = number of short periods in each longer period.

The ratio tends to be closer but slightly below one in more resilient markets since a

minimum of short term volatility should be expected. Meanwhile prices of assets with

low market resiliency may exhibit greater volatility between periods which their

equilibrium price is changing. Factors that give rise to excessive short-period volatility

result in an MEC substantially below one. These factors include price rounding, spreads

and inaccurate price discovery. The MEC calculated over a long period covering a

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significant discrete price change may be an appropriate measure of resiliency. However,

this might not be true for all types of markets. Some argue that markets that are quote-

driven generally provide more price discovery than markets that are order and call-

driven.

2.2.3 Market-Impact Measures

The market –adjusted liquidity uses the residual of a regression of the asset’s return on

the return of the market (thus purging it from its systematic risk) to determine the

intrinsic liquidity of the asset. The smaller the residual of a regression of the asset’s

return, the smaller is the impact of trading volume on variability of the assets’ price and

therefore, the asset is more liquid. In this case, the lower the coefficient, the more

breadth the market has.

In practice however, the spread between a benchmark government bond and a

government security with roughly the same duration, but traded less is often used as a

proxy for the liquidity premium. In the case of corporate bonds, the spread between the

corporate bond and the benchmark government security reflects both the difference in

credit risk and a liquidity premium.

2.2.4 Application of Liquidity Measures to Bond Markets

The secondary market for government securities is often perceived as being the most

liquid of the various bond markets. Government securities are often used as collateral

and benchmarks for pricing other securities, with limited credit risk and often times

offered in quite large volumes. In recent years, some countries have concentrated their

public debt on fewer government bond issues but in large volumes with a view to

promote the liquidity. In some cases, some issuers when creating benchmarks guarantee

to buy back their bonds at a discount, thus ensuring the securities remain liquid. This

practice has been evident mostly for retail oriented programs for small purchases and

collective investment schemes, where the government in a move to get these investors

more interested in the bond market, would have special provisions for buyback.

Turnover ratios vary significantly among countries. The ratios are to some extent

affected by prudential regulation that may limit the amount of securities truly being

available for trading; the extent to which the central bank uses government securities to

conduct open market operations and operationalization of the intraday liquidity facility

(whether in the form of repurchase agreement or pledging) among others. In countries

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where dealers are required to report to the stock exchange or where securities are

dematerialized and the central depository collects information on final ownership,

statistics on market turnover are usually available. In other countries such information

is difficult to attain since dealers usually consider such information confidential.

2.2.5 Factors Affecting Asset and Market Liquidity

The measures of liquidity are affected by a number of factors that makes comparison

across countries and markets in the same country difficult. Although some of these

factors may have a predominant role in some of the markets, they do have ramification

on other markets as well. Box 1 briefly illustrates the factors.

Box 1. Factors Affecting Asset and Market Liquidity Macro Structure: Affecting the number and types of market participants as well as their expectations.

1. Vulnerabilities: Internal vulnerabilities: fiscal imbalances, public debt policies, financial sector vulnerabilities External vulnerabilities: current account imbalances and capital controls

2. Monetary Policy: Operational targets of the central bank. Design of monetary instruments: averaging of required reserves, standing facilities, lender of last resort. Central bank’s day to day management of liquidity in the banking system: coordination with government, frequency of interventions etc. Banking system’s ability to recycle liquidity within the banking system: structure of the banking system, credit risk etc.

3. Legislative framework: Bankruptcy legislation, cross border transactions etc.

Institutional Micro Structure 1. Product design: credit risk, maturity, substitutability and use of derivatives. 2. Market participants:

Issuers: types of issuers, their issuing policies, legislative requirements to issuers, share of issue actually available for trading. Buyers: types of potential participants (capital controls), their heterogeneity, prudential regulation affecting behavior (e.g. liquidity requirements creating a captive market for government securities, hedging requirements and practices (e.g. value at risk (VAR) models.

3. Trading systems: a. Periodic trading at discrete intervals (call trading) or continuous trading during a specified

period. b. Dealer markets and market makers (quote driven) or agency and auction markets (order matching

or order driven). c. Electronic trading or floor trading. Trading system: licensing of dealers and brokers, capital requirements, cross listings. Trading rules: tick-size, limit orders, bloc trading, short selling, stop loss orders, stop-buy orders; stop-loss rules; rules for margin transactions and circuit breakers. Trading transparency: availability of pre-trade and post trade information to dealers and other market players.

4. Clearing and settlement of transactions: Payment systems: risks (legal risks, finality, payment-versus-payment (PVP), costs and convenience. Clearing and settlement of financial instruments: risks (finality (T+3 or less), delivery versus payment (DVP).

5. Regulatory and accounting framework Different financial instruments: their use as collateral (repo, pledging), Accounting framework: historical cost or fair value accounting (mark to market may affect willingness to trade). Taxation: withholding taxes, capital gains taxation, special transaction taxes.

Sarr A. & Lybek T, 2002

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2.3 Research Methodology

The study applies volume-based measures to assess liquidity of Tanzania’s government

bonds and the government bond market as a whole. Noting the nascent nature of the

government bond market in Tanzania, characterized by absence of market

intermediaries quoting two way (bid-ask) and low volumes of secondary market trades;

getting information on volumes traded is simplified by the reporting requirement that

mandates all trades go through the stock exchange, thus making the data available,

unlike data on transaction costs, particularly, the bid-ask spread that is not available.

The study will instead capture the actual charges relating to government bond trades in

the secondary market. These charges often times make up the bid-ask spread.

2.3.1 Volume-Based Measures

Volume-based measures are most useful in measuring breadth (the existence of both

numerous and large orders in volume with minimal transaction price impact). Markets

that are deep tend to foster breadth since large orders can be divided into several smaller

orders to minimize the impact on transaction prices.

Large numbers of trades are a valuable source of information for dealers, such that

information from order flows portray the accuracy of their quoted prices. In this case,

changes in these quoted prices trigger balancing order flows which then counter price

movements that are not warranted by fundamentals (resiliency). This process allows

dealers to have a continuous information source as to whether price changes are

permanent or transitory. When markets lack breadth and depth, the continuous

information source provided by frequent trades may result in price uncertainty about

equilibrium prices. This can be prevented if market makers can identify potential buyers

and sellers such as institutional investors with large portfolios in the market.

Uncertainty about equilibrium prices does not only arise from lack of breadth and depth

or higher transaction costs in a given market; but by market participants who may infer

equilibrium prices from the market of close substitutes3. In this case, the existence of a

deep and broad market for a close substitute may compensate for thinness, since market

makers are free to hedge position imbalances without waiting for balancing orders.

3 Garbade (1982) notes that many investors view Treasury bills, bank CDs and commercial paper as close substitutes.

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Trading volume is traditionally used to measure the existence of numerous market

participants and transactions. The trading volume can be related to the outstanding

volume of the asset considered; in which case, the turnover rate gives an indication of

the number of times the outstanding volume of the asset changes hands as highlighted

in the following equation.

V = ∑ P1 × Qi where V is the dollar volume traded

P1 and Qi are prices and quantities of the i trade during a specified

period.

Tn = V/ (S × P) where Tn is the turnover rate

V is the dollar volume traded S is the outstanding stock of the asset P is the average price of the i trades

While it is relatively easy to estimate turnover rates in exchange traded securities markets, it is more difficult to choose an appropriate basis against which to measure turnover rates in a typical Over the Counter market. When data is available, the absolute trading volume, the number of transactions and the average trade size may be better measures of the existence of numerous and large trades (market breadth). For the Tanzania Government Bond market, the Volume outstanding and the values of trades over a certain period can be obtained. These are captured in the CDS

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CHAPTER THREE

STUDY FINDINGS AND ANALYSIS

3.1 General Observations

3.1.1 The Government Bond Market in Tanzania

The Government bond market in Tanzania has evolved significantly in recent years

following financial sector reforms undertaken for the past two decades. Nevertheless,

the markets are still at a nascent stage.

Treasury bonds are issued fortnightly (one bond per auction) to finance government’s

budget deficit and for market development and are in tenures of 2, 5, 7, 10 and 15 years

with matching fixed coupons of 7.82%, 9.18%, 10.08%, 11.44% and 13.50%. The

frequency of issuance is one of the reasons for low activity in the secondary market

because investors can easily acquire the bonds in the primary market.

Treasury bonds are listed at Dar es Salaam Stock Exchange (DSE) and cannot be

rediscounted at Bank of Tanzania as a way to encourage secondary market trading of

these securities. This however hasn’t had the anticipated impact because of the buy and

hold strategy of most investors especially pension funds who hold over 45% of

government bonds. In addition to that, the brokers haven’t been active in creating

trades, instead, the commercial banks (who are the main players in the secondary

market) have been initiating trades and forced to pay brokers for the transactions that

they played no role in.

Tanzania publishes a quarterly government bond issuance calendar and announces the

auction one week before the auction. Auctions are conducted on Wednesdays,

alternating between Treasury bills and Treasury bonds. The auctions are conducted

online, where bids are submitted by Central Depository Participants (CDPs) through a

web based portal. CDPs must have CDS accounts in their own name, and on behalf of

their clients. Pension funds that are among the major players in the market have been

granted “special client” status and can participate directly in the auctions. All auction

processes are automated.

The allocation methodology for government bonds is the multiple price system where

prices are quoted to four decimal places for Treasury bonds. The Settlement cycle for

government bonds is T+1 in the primary market (on DvP), while in the secondary

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market it is T+3 (with no DvP). The lack of DvP arrangement in the secondary market

limits secondary trading because of the counterparty risks and settlement risks

associated with it. DvP arrangement is key when further developing the secondary

market of government securities.

The existing Horizontal Repo in is not actually a true repo but a pledge-based

collateralized lending guided by credit lines and limits. This form of Repo is not the

best basis for the development of the secondary market of government bonds because

it does not offer the advantages that a true repo offers; such as efficient risk mitigation,

and the synergy between all categories of the government securities market.

Until May 2014, capital controls limited the participation of foreigners in the

government securities market. This was changed after Tanzania amended the foreign

exchange regulations on listed securities by partially liberalizing the capital account,

allowing East African residents access to the Government securities market under the

following conditions (speed bumps):

a. The total amount of Government securities acquired does not exceed forty

percent of a particular issue;

b. The amount acquired by the EAC residents from a single country does not

exceed two thirds of the forty percent; and

c. The Government securities acquired by the EAC residents are not transferred to

a Tanzanian resident within twelve months from the date acquired.

Despite liberalizing to EAC residents, the country is yet to witness participation of the

envisaged investors from the region as a result of the conditions attached.

3.1.2 Treasury bonds performance

The performance of the Treasury bonds market has improved over time as illustrated in

chart 3.1. Demand for the bonds has increased across the maturity spectrum in tandem

with the amount offered by the Bank, although investor preference was more inclined

to the 2 year bond. The amount sold has consistently been less than the amount offered

in the period under review, as a result of intervention to remove outlier bids and align

the yield curve. This has resulted in gaps in government budget funding and pricing

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challenges brought about by market uncertainty on what the government funding needs

are.

Chart 3.1: Treasury bonds performance

Source: Bank of Tanzania

Commercial banks’ holdings of government bonds have gone up from 44.7 percent in

2009 to 51.6 percent in 2014. On the other hand, pension funds’ holdings have gone

down from 47.3 percent in 2009 to 39 percent in 2014 (see chart 3.2). The recent low

participation of pension funds has resulted in dominance of commercial banks in the

government bonds auctions, lowered competition and increased yields that have

culminate to high cost of borrowing to the government and inability to borrow as

planned.

Chart 3.2: Government bonds holdings

Source: Bank of Tanzania

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7‐yr

10‐yr

2‐yr

5‐yr

7‐yr

10‐yr

2‐yr

5‐yr

7‐yr

10‐yr

2‐yr

5‐yr

7‐yr

10‐yr

2‐yr

5‐yr

7‐yr

10‐yr

15‐yr

2008/09 2009/10 2010/11 2011/12 2012/13 2013/14

Amount Offered Amount Tendered Amount Sold

21

In 2014 alone, the participation of commercial banks across all maturities has gone up

as a result of increased activity in the secondary market where commercial banks

dominate with over 88 percent of all the recorded transactions compared to 46.7%

recorded in 2009. Yield to maturity for the 2, 5, 7, 10 and 15 year bonds4 stood at

14.83%, 16.00%, 15.97%, 16.50% and 17.91% respectively as at 30th December 2014

(chart 3.0).

Chart 3.3: Government bond yields 2009-2014

Source: Bank of Tanzania Chart 3.4: Government Securities Yield Curve (31st December 2014)

Source: Bank of Tanzania

4 The 15-year Treasury bond was launched in November 2013

22

3.1.3 Financial markets infrastructure

Tanzania has two central depositories (CDS). One hosted by Bank of Tanzania, dealing

with Government Securities; another one at DSE, dealing with corporate bonds, equity

and government bonds. As part of E.A.C Monetary Union initiatives, the country is in

the process of linking the two CDS’ and provide a platform for a National Central

Depository System, that will ultimately pave the way for a regional depository.

BOT CDS is connected to the RTGS - Tanzania Interbank Settlement System (TISS)

and provides a platform for secondary market transactions, standing facilities (Intraday

and Lombard) and horizontal repo on real time. Currently the BOT CDS enables

settlement of securities in the primary market through TISS but only allows for transfer

of ownership of securities without supporting the settlement part of the transactions in

the secondary market. This being the case, settlement in the primary market is on DvP

while in the secondary market it is still done using electronic fund transfers (EFTs)

hence no DVP. The DSE CDS is in the final stages of being linked with TISS to enable

DvP.

To ensure smooth running of BOT CDS, Central Depository Participants (CDPs) were

introduced to manage the operations of the depository. The CDPs who are solely

commercial banks and brokers, have no market making or underwriting roles but have

played an important role to facilitate trades in the secondary market by finding buyers

and sellers of the bonds for their clients and posting indicative two-way quotes for the

market.

3.1.4 Market participants

There are currently 34 commercial banks; 17 non-bank financial institutions, 7 brokers,

7 government owned pension funds and 21 insurance companies. Most market

participants have been holding government bonds to maturity. Recent trend has six

commercial banks actively trading government bonds in the secondary market and more

players are anticipated particularly EAC residents after the partial liberalization of the

capital account in May 2014. The absence of other market players such as fund

managers has limited activity in the secondary market for government bonds. The slow

implementation of the pension sector reforms have also limited the growth of

government bonds secondary market in Tanzania. Pension funds unlike commercial

banks are well placed to hold long term government bonds because of the nature of

23

their liabilities. Their absence or low participation in the primary auctions, have reduced

competition, resulting in deep discounts that have created pricing challenges in the

secondary market.

3.1.5 Taxation and other charges

10% withholding tax is applied to the discount on Treasury bills, and is charged

on maturity

10 % withholding tax is applied to the coupon on the 2-year government bond

and not the discount.

The 5, 7, 10 and 15 year government bond maturities are exempt from

withholding tax.

3.1.6 Statutory requirements

There are statutory requirements that require pension funds to hold 20% to 70% of their

total assets in government securities and Insurance companies to hold at least 70% of

their total assets in government securities. In order to comply with the requirements,

pension funds and insurance sector have been purchasing government securities in the

primary auctions, with the buy and hold objective.

3.1.7 Collateral Framework

The collateral framework as applied by the Bank of Tanzania limits eligible securities

for BOT standing facilities and Repo to government securities with maturities of not

more than 91 days. The Law however, accommodates government securities with

maturities of not more than 182 days. By not accepting longer maturities as collateral,

commercial banks cannot access the standing facilities when in need of short term

liquidity from the central bank.

3.2 Results of the Volume-based measures of bond liquidity

The study used the Government bond Turnover ratio and the Secondary trading volume

to outstanding amount ratio as the volume based measures for bond liquidity. In this

case, the computation for the turnover ratio could not be applied to all the three

countries, noting that Uganda and Kenya do not maintain data on secondary market

prices. Tanzania started maintaining the data in 2013. Considering this, the ratio has

been computed for 2013 and 2014 as depicted in Table 3.1 with results of 2.3 percent

24

and 3.73 percent respectively. The ratios being below the 50 percent acceptable range;

portrays illiquidity in the Tanzanian government bond market and brings about the need

to build up strategies to increase secondary market trading and henceforth increase

liquidity of the respective bonds.

Table 3.1: Turnover ratio for government bonds in Tanzania

   2013 2014

Velocity (V = ∑ P1 × Qi)             6,301,745,254,380.00           11,618,784,081,260.00 

Average Price (P)   

85.18   

81.92 

outstanding amount (S)             3,218,485,140,000.00             3,812,089,677,000.00 

Turnover rate  (V/ (S × P))  2.30% 3.72%

The comparison for the ratio on secondary trading of government bonds against the

outstanding volume clearly shows the poor performance of the Tanzanian bond market

against Kenya and Uganda. Tanzania has maintained a ratio of less than 5 percent, while

Kenya and Uganda have maintained on average, ratios of 63 percent and 55 percent

from 2009 respectively as depicted in Chart 3.5.

Chart 3.5: Secondary trading of Government bonds as a percent of outstanding bonds

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2009 2010 2011 2012 2013 2014

Tanzania Kenya Uganda

25

Transaction costs in the government bond market, greatly affect the bid-ask spread for

the bonds in the secondary market. Charges relating to government bonds trades in the

secondary market are very low in Kenya and Uganda and have been capped at 3.5 basis

points and 5 basis points respectively. Tanzania on the other hand, maintains high

charges capped at 9.6 basis points for amounts exceeding TZS 40 million and 6.3 basis

points for amounts below or equal to TZS 40 million. These charges have not impeded

secondary market trading of government bonds but the procedure of trading through

brokers (exchange trading) has created delays and lowered settlement efficiency with

the T+3 settlement cycle.

26

CHAPTER FOUR

4.0 Strategies to increase bond market liquidity

Kenya and Uganda have been quite successful in creating a more active and liquid

government bond market. This chapter looks at efforts taken by these countries in

revamping their government bond markets and proposes strategies to increase liquidity

of government bonds and the bond market as a whole in Tanzania.

4.1 Experience from Uganda

The government bond market in Uganda has evolved significantly since its inception

in 2002 with the issuance of 2-year, 3-year, 5-year and 10-year maturities. The issuance

of bonds during this time was for monetary policy purpose until 2012 when the

government decided to issue bonds to solely finance the fiscal deficit. The bond market

was narrow and shallow in terms of the number of instruments issued and the number

of investors respectively; with poor infrastructure, low capacity of market players, and

low literacy levels of the public. In order to address these challenges Bank of Uganda

introduced the Primary Dealership (PD) system, introduced benchmark bonds,

modernized market infrastructure and embarked on capacity building programmes for

its market players among others.

The Primary Dealership System: Uganda launched the Primary Dealership system in

2005 with six well capitalized primary dealers. The PDs do not underwrite auctions but

are expected to meaningfully participate in the government securities auctions. They

are also required to mark to market thus forcing them to trade in the secondary market.

The PDs are required to provide two-way quotes for on-the-run securities. The quotes

provided, which in some cases are indicative, are used to create a yield curve for the

secondary market that is used as a reference when pricing securities in the secondary

market. As an incentive, BOU granted the PDs exclusive access to Repos. BOU also

introduced the PD ranking system as an incentive to enhance PD performance. The

system looks into the dealers’ participation in the primary auctions and secondary

market activities. The winner of this award is announced every month. The PD system

is given credit to the increased trades in the secondary market.

27

Introduction of benchmark bonds: Benchmark bonds were introduced in July 2014

in a bid to issue more liquid government bonds. The maturities currently issued as

benchmarks are 2-years, 5-years, 7-years, 10-years and 15-years. The coupon rates

attached to the benchmark bonds are market determined, something that has helped to

pull the prices close to par. The benchmark bonds are reopened to build up the volume

and to increase the number of investors holding the bonds. In 2014, the benchmark

bonds accounted for 15 percent of the outstanding government bonds.

Modernizing market infrastructure: Bank of Uganda introduced Primary Dealer

Shared Gateway to boost retail and Diaspora participation. Their participation has

nearly doubled since the introduction of this feature. BOU is in the process of linking

its CDS with that of Uganda Stock Exchange (USE) to enable real time price discovery.

The linkage will enable DVP in both the primary and secondary market. Plans are

underway to link the CDS’ to other depositories in the region.

Capacity building initiatives: BOU has addressed capacity needs through various

customized training and workshops for the market players. In a bid to simplify pricing

of government securities and to build more competitive capital markets through pricing

and trade transparency, market liquidity, and auction efficiency, BOU developed a price

matrix that raises awareness of the relationship between the primary and secondary

markets and offers guidance on benchmark pricing and yield curve valuation. This has

reduced disparity in pricing between primary auction and secondary market yields,

improved market transparency and increased secondary market liquidity.

4.2 Experience from Kenya

Development of Kenya’s bond market has been a dynamic process built on some basic

elements that can be borrowed by other African Markets. At the macro level, Kenya

established and strengthened institutions leading to credibility in implementing sound

fiscal and monetary policies, improved the legal and regulatory environment,

liberalized its financial system and improved payments and settlement arrangements.

These were the main pillars for other reforms that were undertaken.

A sound legal and regulatory regime: Initially, the country had a legal framework

that did not properly anchor some debt market activities in the law. The lack of a legal

basis hindered implementation in the market giving rise to avoidable risks and

uncertainties. To address this, the Kenyan Government enacted laws to provide the

28

basic framework for how the bonds markets would operate in the country in particular,

how public debt would be procured and managed. The Internal Loans Act, Cap 420

(repealed) and now the Public Finance Management Act of 2012 provided the legal

framework for the Minister for Finance to borrow on behalf of the Government from

the domestic market through issuance of Treasury bills and Treasury bonds, with the

Central Bank of Kenya appointed the fiscal agent. The law now provides for the

establishment of a public debt management office, a sinking fund and provides for bond

exchanges and buy-back operations which were not previously catered for.

Market involvement and participation through stakeholder initiatives such as the

Market Leaders Forum (MLF): The MLF was established in 2001 as a consultative

stakeholders’ forum meant to promote Government Securities to investors and to advise

the Central Bank and Government (Ministry of Finance) on various developments in

the financial markets that have direct bearing on the performance of the new bond

issues. Membership of the forum is drawn from Commercial Banks, Fund Managers,

National Treasury, Diaspora Representative, Insurance Companies and Investment

Banks. The Monetary Policy Committee sits in to harmonize with its policy stance.

The success of the Kenyan market can be credited to the fruitful deliberations and

decisions made by this forum over the last decade. The MLF provided a good feedback

channel for the Government allowing it to better understand the needs of the market.

A clear debt management strategy: The key driver for this strategy was a desire to

reduce refinancing risk, particularly in the domestic debt portfolio and develop the

domestic debt market further. The Medium Term Debt Strategy (MTDS) has been very

important in supporting the goal of lengthening the maturities on Government

Securities. The strategy has helped align domestic borrowing towards issuing more

medium to long term Treasury Bonds than Treasury Bills. The result of this is the ratio

of Treasury bills to bonds at 27:73 in 2014. The average life of all securities stands at

5 years in 2014 with the average life of bonds at 7.1 years.

Wider Investor Base: Liberalization of the pensions and insurance sectors resulted in

greater demand for medium and long term bonds. This is because the new laws included

investment guidelines that established limits on a variety of investments by these

institutions. Of significance was a requirement that pension funds and insurance

companies invest up to 70% of their assets in Government Securities. This requirement

29

helped open the debt markets to a new category of investors that, traditionally, is keen

on medium to long term investment.

In an effort to increase participation from the retail sector, the Central Bank reduced

minimum amounts required to invest in Treasury bills and bonds from Ksh.1,000,000

for both to Ksh.100,000 and Ksh.50,000 respectively. The purpose of this initiative was

to encourage retail investors to increase their levels of savings by providing wider

investment options and also the larger objective of promoting financial inclusion. This

strategy has been a success with over 17,000 new Central Depository for Securities

(CDS) accounts being opened since 2009.

Introduction of Benchmark Bonds: In an effort to develop a liquid secondary market

for government securities and a reliable yield curve, the Bank identified specific

maturities of 2, 5, 10, 15, 20, 25 and 30 years to serve as its benchmark issues. Bonds

issued in these tenors have been re-opened to increase their sizes and to avoid clustering

of maturities. Volume of benchmark bonds outstanding constitutes 60 percent of the

volume of traded bonds and approximately 70-80 percent of the bond portfolio. This

was critical towards addressing the Bond Market fragmentation problem and creating

liquidity necessary for developing a firm and reliable yield curve.

Infrastructure Development (Automated Secondary Trading System): With the

adoption of the Automated Trading System (ATS) in November 2009, trading of

Government Bonds increased exponentially. ATS linkage between the Nairobi

Securities Exchange (NSE) and CBK facilitated simultaneous exchange of securities

and cash settlement using the Kenya Payments and Settlement System (KEPSS)

infrastructure. Transactions are dealt on delivery versus payment mode (DvP), ensuring

efficiency of trading transactions, timely price discovery and security. This has resulted

in improved market confidence in securities trading and increased demand for securities

in primary auctions. Trade turnover in Government Bonds at the NSE has risen over

fourfold from Ksh.107.85bn in 2009 to Ksh.466.07bn in 2010 and Ksh.453bn in 2013.

The Bank is also in the process of automating the auction process through the

introduction of Internet banking to allow investors to access their holding statements

and transact online. This will also allow retail investors to open investor accounts and

bid for Government Securities through their mobile phones in an initiative called

30

Treasury Mobile Direct. These two initiatives are intended to increase efficiency in the

auction process and open up the market to more retail participants.

Ease of Access: Both corporate and retail investors are allowed easy access to the

auctions and the Central Bank as Fiscal Agent does not charge any fees to the

investors. This makes investment in Government Securities an attractive option in

addition to its high returns compared to the lower returns to savings and time deposits

in commercial banks.

System Integrity: Behind the success of Kenya’s Government Bond Market is the

integrity of issuance process, transparency by all involved regulatory and oversight

bodies.

4.3 Strategies to increase liquidity of government bonds in Tanzania

The following strategies are proposed to increase liquidity of government bonds in

Tanzania.

1. Introduce benchmark bonds with sufficient volumes and wide range of investors.

To enable this, re-opening of these bonds is recommended in order to build the

volume and increase the number of investors holding the bond. Currently every

bond auction creates a new bond and this has led to a fragmented market with small

outstanding issues and hundreds of ISIN codes. In this case, despite having similar

maturities of bond, investors don’t actually own the same bond nor is the price

equivalent. Liquidity and pricing transparency is thus less. Based on current

practice, 25 International Securities Identification Number (ISIN) codes are opened

and mature every year, with 200 codes outstanding.

For the re-opening to be effective the following is suggested:

To auction the same bonds in multiple auctions.

The price mechanism should be identical to the existing secondary market.

Apply the same ISIN code when reopening a bond in different auctions. This

will increase the number of investors holding the security, its fungibility,

thereby increasing liquidity. fungibility in the government bond market is

key to the development of securities lending and repurchase agreements.

31

This is because an investor will not be willing to re-lend a security because

the risk of not being able to replace it is high.

The main concern for re-opening is overly concentrating maturities (bunching)

thus increasing the refinancing risk. To prevent this, it is crucial to consider the

debt profile and the market absorption capacity.

2. To reduce frequency of issuance of government bonds from fortnightly to once a

month to stimulate secondary market trading.

3. Taking note of the lessons learnt from Uganda and to provide a truer duration and

primary market price closer to par, market determined coupons are recommended.

4. To review BOT’s collateral management framework to accommodate all

government securities. This however should be done with caution to ensure that

different maturities are given haircuts matching their risk profile.

5. BOT should not only rediscount Treasury bills but also Treasury bonds until when

the secondary market is vibrant enough. This will offer an alternative to investors

who fail to sell their securities in the secondary market.

6. To review the legal and regulatory framework and allow both exchange trading and

over the counter trading of government bonds. This will reduce the transaction costs

incurred when dealing with brokers.

7. To connect DSE depository with RTGS to enable DVP and to reduce the settlement

cycle to T+1 in the secondary market. This will reduce counterparty and settlement

risk and encourage trading in the secondary market.

8. To fully liberalize the capital account by allowing foreign investors to invest in

government securities without segregating between EAC residents and other

investors. This will widen the investor base, increase competition and enable the

government to borrow cheaply from the market.

9. To review the tax regime and remove withholding tax on government securities.

This will create uniformity in pricing and ultimately stir up secondary market trades.

32

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