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A Primer on Treasury Bonds – Part II: Economics of Treasury Bond yields

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In my previous column, ‘A Primer on Treasury Bonds’. Daily FT 24 March 2015 (read here), I discussed the key features of Bonds in the context of the Sri Lankan Treasury Bond market. I explained some of the main technical terms such as face value, maturity, interest rate, yield and price as well as the basic market information such as the primary and secondary markets. This technical and market information is essential to understand the operation of Bond markets. Today’s column builds on this basic technical knowledge and elaborates on the economic foundations of Treasury Bond yields.   What is the risk-free rate of interest in the economy? This may seem like an unusual question. After all, is there truly such a thing as a risk-free investment? In theory, risk-free means that one can expect to earn a return with complete certainty. In practice, while there is no investment that promises a complete risk-free return, we consider government securities as risk-free because the government is fully expected to honor the payment obligations associated with such securities. In other words, the government is not expected to default on the promised interest and principal payments. There are two underlying reasons for this expectation. If needed, the government can print money and increase taxes to pay for promised obligations on rupee-denominated Treasury Bills and Bonds. Surely there actions have limits and printing money or increasing taxes may lead to negative economic consequences, particularly in developing economies such as ours. But, in general, the markets accept the fact that government Bonds are free of default risk, unless circumstances suggest otherwise as in the case of Greece. Yields of government securities, therefore, are considered the risk-free benchmark interest rates in an economy. Depending on the maturity of government securities, it is possible to talk about both short-term and long-term risk-free rates of interest.   What is the short-term risk-free rate of interest? The yield on a short-term government security represents the short-term risk-free rate of interest in the economy. Treasury Bill yields are typically used for this purpose. Since there are three maturities of Treasury Bills in Sri Lanka, there are three short-term yields. However, it is common to use the one-year Treasury Bill yield as the short-term risk-free benchmark in most situations. In practice, secondary market yields provide a good proxy for the market yield on a government security at a given point of time. Table 1 shows the secondary market Treasury Bill yields as of 25 March 2015. The secondary market average one-year Treasury Bill yield was 7.03% per annum. Under normal economic and market conditions, what this means is that given the real economic growth and inflationary expectations in Sri Lanka, the market demands an annual return of about 7% for investing in one-year Bills. This is the current short-term risk-free rate of interest in Sri Lanka.  
            What determines the Treasury Bill yield? The Treasury Bill yield consists of two components. The first one is known as the real risk-free rate. This is essentially the inflation-adjusted Treasury Bill yield and represents the rate of interest in an economy when there is no inflation and risk. The real risk-free rate represents the real economic growth as measured by the real growth in the Gross Domestic Product (GDP). The second part of the Treasury Bill yield is the expected inflation rate, also known as the inflation premium or spread. In the real world, prices of goods and services generally increase over time, thus lowering the real value of the investment returns. Investors demand a compensation for this loss of purchasing power of money in the form of an extra return called the inflation premium. Although none of the inflation measures is perfect, the annual point-to-point change in the Colombo Consumers’ Price Index or CCPI provides an estimate of the most recent annual inflation which can be used as an estimate of the expected inflation for the next year. The annual inflation as of February 2015, the latest available, was approximately 1%. With the assumption that future inflation will be about 1%, currently Treasury Bills provide a real return of about 6%. Strictly interpreted, this indicates that the economy is expected to grow at 6%. Of course, different estimates of expected inflation will result in a different real risk-free rate. The point is to understand the fact that the real economic growth and inflation expectations are the primary determinants of the Treasury Bill yield. In addition, the yield is also influenced by the liquidity of the particular security and the general market liquidity conditions. A security has good liquidity if it has a good market in that it is traded more frequently in good quantities. Less liquid instruments tend to carry an additional premium called the liquidity premium to compensate the investor for risks associated with lack of liquidity.   What is the long-term risk-free rate of interest? The yield on a long-term government security represents the long-term risk-free rate of interest. Treasury Bonds with maturities of more than one year are used to estimate long-term risk-free rates. Depending on the maturity chosen from the available maturities (i.e. 2, 5, 6, 8, 10, 15, 20, 30 years), there exists different long-term risk-free rates each representing a particular maturity. As of 25 March 2015, the average secondary market yields on long-term government Bonds are shown on column 2 (yield) of the Table 2. Accordingly, for example, the 10-year risk-free rate of interest is about 9.7% whereas the 30-year risk-free rate is about 11.2%. The yields are increasing with maturity, and this pattern is typical in normal economic and market conditions.   What determines the Treasury Bond yield? In addition to the real real-free rate of interest and inflation, the long-term risk-free rate contains an additional premium called the maturity risk premium. This is also known as the term premium or the term spread. This is because long-term Bonds are more risky than short-term Bonds. In response to changes in interest rates in the economy, the prices of long-term Bonds tend to be more volatile than the prices of short-term Bonds. Hence, investors demand an additional compensation in the form a term premium for investing in long-term government Bonds. The term premium is estimated as the yield difference between the long-term and short-term government securities. Using the current Treasury Bill yield of 7% as the short-term rate, column 3 of Table 2 shows the term premia for different maturities. For example, the term premium embedded in the 10-year government Bond is about 2.7% and that in the 30-year Bond is about 4.2%. It should also be noted that, as with the case of short-term rates, the long-term rates are also influenced by the liquidity of the particular instrument as well as the general market liquidity. The liquidity premium is the compensation for the risk that the investor may not be able to sell the securities in the secondary market quickly and at a price near its true value. This liquidity premium is also embedded in the above term premia. Disentangling the liquidity premium from the term premium is a tedious task and not attempted here. It is suffice to say that in a market where instruments across all maturities are fairly frequently traded in good quantities, this liquidity premium tends to be very small. In Sri Lanka, however, the market for long-dated government securities has not been particularly liquid or deep and, as a result, liquidity risk should have an impact on such yields. To summarise, the real economic growth, inflation expectations, maturity and liquidity are the primary determinants of long-term government Bond yields.     What is the yield curve? The yield curve is a graph showing the relationship between yields and maturity of Bonds at a given point in time. It shows the interest rate structure of the economy as well as the future interest rate and inflation expectations. A competitive and liquid secondary market for government securities is very important to establish a reliable yield curve. Bonds chosen to construct the yield curve must represent Bonds that are comparable in all characteristics except maturity. Typically, the securities used for this purpose are the short and long-term Treasury securities, and the yield curve so constructed is called the Treasury yield curve. There are four key yield curve patterns – rising, declining, flat and humped. A rising or upward sloping yield curve is where yields on short-term issues are low and yields rise consistently with longer maturities. This is considered the normal yield curve and observed during times of normal economic growth. A rising curve indicates that the market expects rising future interest rates and inflation. A rise in interest rates results in lower Bond prices. A declining or inverted yield curve pattern occurs when yields on short-term issues are high and yields on longer maturity periods decline consistently. Such a pattern is indicative of market’s expectation of declining future interest rates. Typically, an inverted yield curve is observed before an economic downturn or a recession in which economic growth slows and inflation expectations decline. Since Bond price and yields are inversely related, a decline in interest rates will lead to higher Bond prices. This also means that the rate of interest at which funds can be invested in the future will be lower. A flat yield curve is a case where the yields on short-term and long-term maturities are fairly identical. This indicates the expectations of the market of no future change in interest rates. When yields on intermediate-term issues are above those on short-term issues, and the rates on long-term issues decline to levels below those for short-term issues and then level out, such a yield curve is known as a humped yield curve. In the past, there were periods in which the Sri Lankan yield curve took a humped pattern.   How does the yield curve look like in Sri Lanka? Now, we are in a position to understand the shape of the Treasury yield curve prevailing in the Sri Lankan Bond market at the present time. The yield curve constructed by using the short-term (Table 1) and long-term (Table 2) yields of government securities is shown in Figure 1. It is clearly a rising yield curve pattern. Yields increase consistently from 6.79% (3-month) to 7.51% (2-year), jump by 1.24% from 2 to 5-year maturity, and then rise consistently over the rest of the maturities indicating expectation of higher future interest rates.                           How do we assess the reasonableness of interest rates and yields? The above discussion shows that government Bond yields are determined by economic and market fundamentals. They include expectations for real economic growth, inflation, maturity and liquidity. Therefore, in setting interest rates and yields on a particular Bond, one needs to carefully examine these fundamentals. In practice, one of the most important type of analysis involves calculating historical benchmark spreads. At a minimum, these include determining historical average spread between a particular long-term government Bond yield such as the 30-year yield relative to the one-year Treasury Bill yield and the annual inflation. The average past spreads combined with the knowledge of the current economic and market conditions form the analytical basis to determine an appropriate interest rate and yield for a government Bond offering. A similar analysis can be used to assess the interest rate and yield determined at a particular auction as well. For example, the current Treasury Bill yield provides a good estimate of the underlying real risk-free rate and expected inflation. One could add the past average term spread of the 30-year Bond, calculated based on a more recent time period, to the current Treasury Bill yield to obtain a first-cut approximation of the 30-year Bond yield. Alternatively, one could add the expected real economic growth (or the past average real risk-free rate), expected inflation premium and the past average term spread of the 30-year Bond to estimate the 30-year Bond yield. Invariably, alternative methods will provide different yield estimates. But such an analysis provides useful insights and good estimates to understand the reasonableness of a particular government Bond yield.   Conclusion This article presented the analytical foundation for understanding Bond yields. Of course, there are many theoretical and practical nuances, exceptions and complications. Ultimately, what we observe in the markets must make some economic sense. In that context, the above discussion captures the essence of economic rationale and practice. I hope to discuss the economics of auction mechanisms, both competitive auctions and private placements, in the next article.   (Lalith Samarakoon [B.Sc. (Bus. Adm., Frist Class Honors), MBA, PhD (Finance), FCA, CFA] is a professor of finance and a financial economist. He has worked with USAID, World Bank, ADB, Central Bank, Public Debt, EPF, Ministry of Finance, SEC, CSE and other key banks and financial sector institutions for over 20 years in various advisory capacities in the areas of financial sector development, public debt management, and investment banking. He is an accomplished researcher on capital markets and international finance with current focus on economic and financial crises, appropriate monetary and fiscal policies, and monetary policy and asset bubbles. He has authored four books in Sinhala, English and Tamil published by the SEC which are widely used as standard texts on securities markets in Sri Lanka. Professor Samarakoon can be reached at lalithsamarakoon@yahoo.com. Follow @LSamarakoon.)

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