Explained: What are G-Sec yields, and how and why do they increase and decrease?

In any economy, there is often a mismatch of financial resources. Often those with excess funds don’t know what to do with them, while many people who know what to do with the money but have no funds to spare.

This mismatch creates the reason why some people lend and others borrow. For example, many 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 the lender. So if person A parted with his money and gave it to person B for a period of, say, 10 years, then A would expect to be refunded not only the original amount, but also something more for compensate for not having that money for the next 10 years.

Obviously, this interest rate will be higher if A parts with his money for a longer period. Thus, under normal circumstances, A would expect to earn a higher rate of interest when he lends money for 10 years versus, say, 5 years; similarly, the interest rate may be quite low if A only lends for one day.

Where do G-secs come from?

On Thursday (30 June), the government announced that it had decided to keep interest rates on small savings instruments unchanged for the July-September quarter, defying expectations of a rate hike given the sharp rise in government bond yields (G-sec) over the past three months.

G-secs, or government securities or government bonds, are instruments that governments use to borrow money. Governments regularly continue to run deficits, that is, they spend more than they earn through taxes. That is why they must borrow from the people.

But G-secs are different from daily loans between two individuals or entities.

For one thing, G-secs have the lowest risk of all investments. After all, the chances of the government not refunding your money are almost nil. It is therefore the safest investment one can make.

Other differences between G-Secs are in how they are structured and how their effective interest rates (also known as yields) are calculated.

How are G-sec yields calculated?

G-sec yields change over time; often several times during the same day. This happens because of the way G-secs are structured.

Each G-sec has a face value, a coupon payment and a price. The price of the bond may or may not equal the face value of the bond.

Here is an example: Suppose the government issues a 10-year G-sec with a face value of Rs 100 and a coupon payment of Rs 5.

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 promises to 1) return the sum of Rs 100 at the end of the mandate (10 years ) , and 2) pay Rs 5 each year until the end of this term.

At this point, the face value of this G-sec is equal to its price, and its yield (or effective interest rate) is 5%.

How do G-sec yields increase and decrease?

Imagine a scenario where the government launches a single G-sec and two people want to buy it. Tenders will ensue and the price of the bond could drop from Rs 100 (its face value) to Rs 105. Now imagine another lender in the picture pushing the price further up to Rs 110.

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 rises to Rs 105, then the yield will fall; it will become 4.76% as the second person will receive Rs 5 on an investment of Rs 105.

Additionally, if the auction leads to a price going to Rs 110, then the third person (who eventually bought the bond at Rs 110) will find that the yield has dropped further to 4.54%; as 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 return on G-secs is the lowest risk-free interest rate in any economy. As such, they are a good way to determine the general trend of interest rates in the economy.

If G-sec yields (say for a 10-year bond) rise, this would imply that lenders are demanding even more from private sector companies or individuals; it’s because anyone else is riskier than the government.

It is also known that in credit, interest rates increase with increasing risk profile. So if G-sec yields start to rise, it means lending to the government is getting riskier.

If you read that G-sec yields are rising, that suggests bond prices are falling. But prices are falling because fewer people want to lend to the government. And that happens when people worry about government finances (or their ability to repay).

Government finances may be in trouble because the economy is faltering and the government is unlikely to meet its expenses.

By the reverse logic, if a government’s finances are sorted out, more and more people want to lend money to such a G-sec. This in turn causes bond prices to rise and yields to fall.

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