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Studies 

 

PDEX: APPROPRIATE FOR IAS/PAS 19 VALUATION

Lyndon F. Fadri, FASP, ASA

 

(Last year, a major auditing firm prescribed the use of Zero-Coupon Bond rates published by Bloomberg even if the rates were incredibly high. According to the firm, the reason is that PDEX rates (commonly used by most actuaries) are not appropriate for use because government bonds are coupon-paying and therefore, do not conform to the IAS / PAS 19 provision that the rates should be reflective of the timing of cash flows of the retirement obligation, retirement benefits being commonly payable in lump sum.

 

This has prompted the Actuarial Society of the Philippines (ASP) through its Employee Benefit Committee to submit its position to the Interpretations Committee of the Accounting Standards Council.

The author submitted a position paper to the ASP Employee Benefits Committee which has the same substance as this one.)

 

I am of the position that the reference rates published by the Philippine Dealing Exchange Corporation (PDEX) are appropriate for use as discount rates for IAS / PAS 19 purposes. PDEX rates, used appropriately, can satisfy the IAS / PAS 19 provision that the currency and term of the government bond should be consistent with the currency and estimated term of the post-employment benefit obligations.

 

It should be noted that the standards prescribed the use of government bond rates where there is no deep corporate bond market. As I see it, it is not acceptable for IAS / PAS 19 to use rates that may not be reliable either because of the thin trading or a derivation of rates because there simply were no available figures for certain terms of maturity.  

 

Yes, I agree that PDEX rates may not exactly be reflective of the timing of cash flows of the retirement obligation. However, following the principle implied in requiring a deep market to qualify as reference for the discount rates, there is no deep market of zero-coupon bonds here in the Philippines, hence we should stick to the PDEX rates.

 

Granting that the yields of coupon-paying bonds are not acceptable, we can only approximate the equivalent yields of zero-bonds from the yields of coupon-paying bonds. The problem is there are many methods of approximation and there are various assumptions that could be employed. Thus, there are numerous different resulting rates even if the same approximation method is used. Some methods are enumerated below.     

 

One method is setting the zero-bond rate equal to the coupon-paying bond rate. This method is probably the most acceptable method here in the country, particularly for the bankers. In my interview with some of them, they say that the actual difference in the price of zero-bonds and coupon-paying bonds depend on liquidity requirements and interest rate outlooks. Changes in these factors can drive zero-bond rates either higher or lower than the coupon-paying bond rates. On the average though, the zero-bond rates should be close to coupon-paying bond rates.

 

Below are actual transactions published by PDEX that tend to support the premise that zero-bond yields are not consistently lower than coupon-paying bond yields and conversely:

 

  1. ZCB 07-01 (zero-bond) with remaining years to maturity of 1.67 years fetched 4.75% on 3/27/09. Just 2 days before on 3/25/09, FXTN 05-57 (coupon-paying bond) with remaining years to maturity of 0.78 years fetched 5.30%. (shorter maturity, coupon-paying - higher yield)
  2. ZCB 07-02 (zero-bond) with remaining years to maturity of 2.02 years fetched 5.00% on 3/10/09. Just 4 days before on 3/4/06, FXTN 03-17 (coupon-paying bond) with remaining years to maturity of 1.76 years fetched 5.10% (shorter maturity, coupon-paying - higher yield).
  3. ZCB 05-01 (zero-bond) with remaining years to maturity of 0.38 years fetched 5.25% on 3/27/09. Sixteen 16 days before on 3/11/09, FXTN 05-57 (coupon-paying bond) with remaining years to maturity of 0.69 years fetched 4.65%. (longer maturity, coupon-paying - lower  yield)
  4. FXTN 10-11 with remaining years to maturity of 0.44 years (effectively a zero-bond because no more coupons are payable) fetched 4.95% on 1/28/09. Just 8 days before on 1/20/09, FXTN 05-56 (coupon-paying bond) with remaining years to maturity of 0.53 years fetched 4.75%. (longer maturity, coupon-paying - lower  yield)

 

As mentioned above, there are many other valid methods of approximation. To enumerate some:

1. Bootstrapping Method. This is most likely the method employed by Bloomberg. Given a normal yield curve, this method will produce rates higher than the coupon-paying bond yields. In this method, the present value of coupons using the spot rates corresponding to the duration of the coupon is deducted from the price of the bond. Given the adjusted price and the maturity / par value of the bond, the rate is determined.

 

This method has the following weaknesses:  

    1. It produces rates that are unreliable for long durations. This is shown by the resulting incredibly high rates.
    2. Given a normal yield curve, it produces yields consistently higher than the coupon-paying yields. This is not consistent with actual market transactions.
    3. This method seems to be more applicable in countries where the coupons could be sold even before they become due. In the Philippines, there is no market for coupons that have not become due.

2. Average Bond Duration Method. Given a normal yield curve, this method will produce rates higher than the coupon-paying bond yields. Under this method, the average duration of the bond is determined. As an example, if the average duration of a 15-year coupon-paying bond with a yield 12% is determined to be 12 years, then the 12% rate is assigned to 12 years.

 

This method has the following weaknesses:

    1. There are many methods of estimating the average duration: simple average, Macaulay duration, Modified duration, etc.
    2. It can not produce rates for long durations and it becomes necessary to extrapolate. There again are infinite methods of extrapolation.
    3. Given a normal yield curve, it produces yields consistently higher than the coupon-paying yields. This is not consistent with actual market transactions.

3. Re-investment Method.  The underlying principle in this method is that the investor re-invests the coupons (in other words, used to buy another bond which will mature at the same time as the original bond). Some quarters say that this is the more appropriate method here in the Philippines as we have no market for bond coupons.

 

Given a normal yield curve, it produces yields consistently lower than the coupon-paying yields. This is not consistent with actual market transactions.

 

Below are sample approximated rates using the different methods.

 

Tenor

Zero = PDEX

Re-Investment

Bootstrapped

Average Duration

1

6.05%

6.05%

6.05%

6.22%

2

6.48%

6.47%

6.49%

6.45%

3

6.16%

6.15%

6.17%

6.66%

4

6.60%

6.57%

6.64%

6.78%

5

6.55%

6.54%

6.58%

6.96%

6

6.78%

6.73%

6.84%

7.21%

7

7.00%

6.92%

7.11%

7.33%

8

7.08%

6.99%

7.20%

7.45%

9

7.17%

7.07%

7.30%

8.12%

10

7.25%

7.14%

7.41%

8.78%

11

7.61%

7.41%

7.95%

9.44%

12

7.98%

7.67%

8.54%

10.10%

13

8.34%

7.92%

9.19%

10.77%

14

8.70%

8.17%

9.92%

11.10%

15

9.06%

8.41%

10.76%

11.29%

16

9.43%

8.64%

11.76%

11.46%

17

9.79%

8.87%

13.03%

 

18

10.15%

9.10%

14.78%

 

19

10.51%

9.32%

17.58%

 

20

10.88%

9.53%

24.80%

 

21

10.98%

9.63%

32.90%

 

22

11.08%

9.73%

 

 

23

11.18%

9.83%

 

 

24

11.28%

9.92%

 

 

25

11.38%

10.01%

 

 

 

In carrying out these methods, inputs and assumptions have to be made. There are effectively infinite assumptions and input variations, all of which will produce varying results.

 

In summary, PDEX rates should be accepted as a valid reference rates in setting the discount rate because there is no deep market of zero-coupon bonds. Granting that we really need to use zero-coupon bond rates, equating the zero-bond yield with the coupon-paying bond yield is a valid method. It is simple and applied without need for complicated calculations and further assumption. It should be noted that IAS / PAS 19 does not prescribe nor disqualify a particular method (again, most probably because discount rates should be based on actual market yields and not from derived or approximated rates).

 

Actually, given the infinite number of possible approximated zero-bond rates, insisting on using derived zero-coupon bond rates defeats the implied objective of accounting standards to enhance uniformity and comparability of financial statements.