Knowledge Nugget: Government securities, T-bills, and bond yields explained for UPSC prelims

Key takeaways:

1. G-secs, or government securities or government bonds, are tradable instruments issued by the Central Government or the State Governments. It is used by the government to borrow money from the public.

2. The two key categories are treasury bills and dated securities. Treasury bills are short-term instruments which mature in 91 days, 182 days, or 364 days, and dated securities or government bonds are long-term instruments, which mature anywhere between 5 years and 40 years.

3. In 2010, the RBI introduced a new short-term instrument, known as Cash Management Bills (CMBs) with the aim to manage the temporary cash flow mismatches. CMBs, having the same generic character of T-Bills, are issued for maturities less than 91 days.

4. Treasury bills, or T bills are zero coupon securities and pay no interest. They are issued at a discount and redeemed at the face value at maturity. Let’s understand this through an example:

A 91 day Treasury bill of ₹100 (face value) may be issued at say ₹ 98.20, that is, at a discount of say, ₹1.80 and would be redeemed at the face value of ₹100. The return to the investors is the difference between the maturity value or the face value (that is ₹100) and the issue price (that is ₹ 98.20).

5. According to the RBI, “In India, the Central Government issues both, treasury bills and bonds or dated securities while the State Governments issue only bonds or dated securities, which are called the State Development Loans (SDLs). G-Secs carry practically no risk of default and, hence, are called risk-free gilt-edged instruments.”

6. The RBI is the sole authority for the G-Secs which issues it through auctions. The auctions are conducted on an electronic platform called the E-Kuber, the Core Banking Solution (CBS) platform of RBI. Commercial banks, Urban Co-operative Banks (UCBs), Insurance companies, and others who are members of E-Kuber can place their bids in the auction through this electronic platform.

Bond yield and its relationship with the bond price

1. The effective interest on the government bonds is called yield. But the rate of return is not fixed — it changes with the price of the bond. But to understand that, one must first understand how bonds are structured. Every bond has a face value and a coupon payment. There is also the price of the bond, which may or may not be equal to the face value of the bond.

Bond yield curves

2. Suppose the face value of a 10-year G-sec is Rs 100, and its coupon payment is Rs 5. Buyers of this bond will give the government Rs 100 (the face value); in return, the government will pay them Rs 5 (the coupon payment) every year for the next 10 years, and will pay back their Rs 100 at the end of the tenure. In this case, the bond’s yield, or effective rate of interest, is 5%. The yield is the investor’s reward for parting with Rs 100 today, but for staying without it for 10 years.

3. Imagine a situation in which there is just one bond, and two buyers (or people willing to lend to the government). In such a scenario, the selling price of the bond may go from Rs 100 to Rs 105 or Rs 110 because of competitive bidding by the two buyers. Importantly, even if the bond is sold at Rs 110, the coupon payment of Rs 5 will not change. Thus, as the price of the bond increases from Rs 100 to Rs 110, the yield falls to 4.5%.

4. Bond yields are in line with the prevailing interest rate in the economy. With reference to the above example, if the prevailing interest rate is 4% and the government announces a bond with a yield of 5% (that is, a face value of Rs 100 and a coupon of Rs 5) then a lot of people will rush to buy such a bond to earn a higher interest rate.

5. This increased demand will start pushing up bond prices, even as the yields fall. This will carry on until the time the bond price reaches Rs 125 — at that point, a Rs-5 coupon payment would be equivalent to a yield of 4%, the same as in the rest of the economy.

6. According to the RBI, “If market interest rate levels rise, the price of a bond falls. Conversely, if interest rates or market yields decline, the price of the bond rises. In other words, the yield of a bond is inversely related to its price.”

7. A yield curve is a graphical representation of yields for bonds (with an equal credit rating) over different time horizons. Typically, the term is used for government bonds — which come with the same sovereign guarantee.

8. If bond investors expect the economy to grow normally, then they would expect to be rewarded more (that is, get more yield) when they lend for a longer period. This gives rise to a normal — upward sloping — yield curve.

9. The steepness of this yield curve is determined by how fast an economy is expected to grow. The faster it is expected to grow the more the yield for longer tenures. When the economy is expected to grow only marginally, the yield curve is “flat”.

10. Yield inversion happens when the yield on a longer tenure bond becomes less than the yield for a shorter tenure bond. It portends a recession. An inverted yield curve shows that investors expect the future growth to fall sharply; in other words, the demand for money would be much lower than what it is today and hence the yields are also lower.

BEYOND THE NUGGET: Open Market Operations (OMOs)

1. The RBI uses Open market operations (OMOs) in order to adjust the rupee liquidity conditions in the market on a durable basis. When the Reserve Bank feels that there is excess liquidity in the market, it resorts to the sale of government securities, thereby sucking out the rupee liquidity.

2.  Similarly, when the liquidity conditions are tight, the central bank buys securities from the market, thereby releasing liquidity into the market. It’s used as a tool to rein in inflation and money supply in the system.

3. However, when liquidity is sucked out, it can lead to a spike in bond yields as the RBI will release more government securities into the market and bond buyers demand more interest rate on these securities.

Post Read Question

Consider the following statements: (UPSC CSE 2018)

1. The Reserve Bank of India manages and services Government of India Securities but not any State Government Securities.

2. Treasury bills are issued by the Government of India and there are no treasury bills issued by the State Governments.

3. Treasury bills offer are issued at a discount from the par value.

Which of the statements given above is/are correct?

(a) 1 and 2 only

(b) 3 only

(c) 2 and 3 only

(d) 1, 2 and 3

(Sources: Explained: Bonds, yields, and inversions, Explained: What are government securities, why the sudden push?, Explained: What are G-Sec yields, and how and why do they go up and down?)

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