The market for Portuguese sovereign bonds

This paper studies the Portuguese auction market for sovereign bonds, the Portuguese Treasury’s ability to place bonds and the liquidity in the secondary bond market.

The paper analyzes a unique dataset from the Treasury and Debt Management Agency (Portuguese acronym IGCP-Instituto de Gestão do Crédito Público). The data used in the main analysis contain all the bids for 66 bond auctions conducted by the Portuguese Treasury from 2014 to 2019. 

The data is used to construct the demand curve for each auction and from it to obtain an elasticity of demand, i.e., the marginal increase in quantity demanded by investors for a marginal decrease in the price of the bond. In a perfectly competitive market, an asset’s price elasticity of demand is infinite, meaning that investors absorb any shock to supply at the equilibrium price. In contrast, in models of slow-moving capital, primary dealers’ (the banks that participate in the auction) limited risk-bearing capacity gives rise to a less-than-perfectly elastic demand. Because an auction significantly increases primary dealers’ bond holdings in the short run, their ability to absorb this shock likely depends on several factors including their own inventory and the ease with which they can manage the supply shock in the secondary market in a window of time around the auction. 

 The paper’s main hypothesis is that, if the elasticity of demand at the auction is high, then primary dealers expect to be able to sell acquired bonds quickly, and there should be no significant price movement around the auction. In contrast, with a low elasticity, there should be both a price drop prior to the auction and a slow price reversal after the auction. 

 The paper offers several findings: 

-- The auction cut-off point appears to be systematically chosen by the IGCP at an inflection point of the demand curve (see Figure). 

-- The average absolute value of the elasticity of demand calculated with unsubscribed bids is 332 (the marginal elasticity in the Figure). According to this estimate, an increase in quantity supplied at an auction by roughly 3% is accommodated with only a one basis point drop in the price on average, an indication of a fairly liquid market.

-- In the cross-section of all the auctions, the marginal elasticity has a strong negative correlation with the pre-auction volatility of the secondary market returns of the bond being auctioned. This negative correlation suggests that the two variables may be proxying for dealer risk-bearing capacity.

-- The Portuguese government secondary Treasury bond market displays a V-shaped price pattern around T-bond auctions. On average, the secondary-market price of the bond being issued drops by nine basis points in the three trading days prior to an auction and subsequently increases by six basis points, relative to a benchmark representing the performance of all Portuguese government bonds. These effects exist only when the marginal elasticity of demand is low, as predicted. 

-- In predictive bond return regressions, the marginal elasticity has a negative coefficient at every investment horizon and is statistically significant at all horizons up to 10 days, except for the two-day horizon.

The paper thus offers evidence that primary dealers’ risk bearing capacity impacts the Treasury’s ability to place bonds and the liquidity in the secondary market. Also, since primary dealers were a point of fragility during the U.S. financial sector crisis of 2007-2009, the paper suggests that looking at sovereign debt auctions may be a place to detect fragilities in the financial sector.

Click here to go to the paper by Rui Albuquerque, Jose Miguel Cardoso-Costa, and Jose Afonso Faias.