In any economy, there is often a mismatch of financial resources. Often, those who have surplus funds do not know what to do with it, while there are many who know what to do with the money but do not have any funds to spare.
This mismatch creates the reason why some people lend and others borrow. For instance, a lot of households and individuals save money while most businesses and governments borrow money.
Whenever money changes hands, it is done with the stipulation of an interest rate that the borrower will pay to the lender. So, if person A parts with their money and gives it to person B for a period of say, 10 years, then A would expect to be paid back not just the initial amount but also something more to compensate for not having that money for the next 10 years.
Advertisem*nt
Best of Explained
- What Lok Sabha election results could tell about consumption divide in India
- Behind Opposition postal ballot concern, Election Commission rule change in 2019
- What explains Franz Kafka’s cultural relevance a century after his death?
Click here for more
Obviously, this rate of interest will be higher if A is parting with their money for a longer period. So, under normal circ*mstances, A would expect to earn a higher rate of interest when he/ she lends money for 10 years as against say, 5 years; similarly, the rate of interest might be quite low if A is lending for just one day.
Where do G-secs come in?
On Thursday (June 30), the government said that it had decided to keep interest rates on small savings instruments unchanged for the July-September quarter, defying expectations of a hike in rates given the sharp rise in government security (G-sec) yields over the last three months.
G-secs, or government securities or government bonds, are instruments that governments use to borrow money. Governments routinely keep running into deficits — that is, they spend more than they earn via taxes. That is why they need to borrow from the people.
Explained | What is the GST Council, and what does it do?
But G-secs are different from everyday lending between two private individuals or entities.
Advertisem*nt
For one, G-secs carry the lowest risk of all investments. After all, the chances of the government not paying back your money are almost zero. It is thus the safest investment one can make.
The other ways in which G-Secs are different are in the manner in which they are structured, and how their effective interest rates (also called yields) are calculated.
How are G-sec yields calculated?
G-sec yields change over time; often several times during a single day. This happens because of the manner in which G-secs are structured.
Every G-sec has a face value, a coupon payment and price. The price of the bond may or may not be equal to the face value of the bond.
Advertisem*nt
Here’s an example: Suppose the government floats a 10-year G-sec with a face value of Rs 100 and a coupon payment of Rs 5.
Explained | Explained: What is ISRO’s ‘POEM’ platform?
If one were to buy this single G-sec from the government, it would mean that one will give Rs 100 to the government today and the government will promises to 1) return the sum of Rs 100 at the end of tenure (10 years), and 2) pay Rs 5 each year until the end of this tenure.
At this point, the face value of this G-sec is equal to its price, and its yield (or the effective interest rate) is 5%.
How do G-sec yields go up and down?
Imagine a scenario in which the government floats just one G-sec, and two people want to buy it. Competitive bidding will ensue, and the price of the bond may rise from Rs 100 (its face value) to Rs 105. Now imagine another lender in the picture, which pushes the price further up to Rs 110.
Advertisem*nt
But here is the crucial thing: the coupon payment on the G-sec is still Rs 5.
So, if you bought the bond at Rs 100, then the yield is 5% but if the price of the bond goes up to Rs 105 then the yield will fall; it will become 4.76% because the second person will be getting Rs 5 over an investment of Rs 105.
Further, if bidding leads to the price going to Rs 110, then the third person (who finally bought the bond at Rs 110) will find that the yield has fallen further to 4.54%; because the third person would have invested Rs 110 for the same return of Rs 5.
What do G-sec yields show?
As mentioned earlier, G-secs are the safest investments in any economy, and the G-sec yield is the lowest risk-free interest rate in any economy. As such, they are a good way to figure out the broader trend of interest rates in the economy.
Advertisem*nt
If G-sec yields (say for a 10-year bond) are going up, it would imply that lenders are demanding even more from private sector firms or individuals; that’s because anyone else is riskier when compared to the government.
It is also known that when it comes to lending, interest rates rise with the rise in risk profile. As such, if G-sec yields start going up, it means lending to the government is becoming riskier.
If you read that the G-sec yields are going up, it suggests that the bond prices are falling. But the prices are falling because fewer people want to lend to the government. And that in turn happens when people are worried about the government’s finances (or its ability to pay back).
The government’s finances may be in trouble because the economy is faltering and it is unlikely that the government will meet its expenses.
Advertisem*nt
By the reverse logic, if a government’s finances are sorted, more and more people want to lend money to such a G-sec. This in turn, leads to bond prices going up and yields coming down.
