Government Bond

A government bond is a debt security issued by a national government to raise funds, promising to pay interest and to repay the principal at maturity. Government bonds are among the largest and most liquid securities in financial markets, and they serve as benchmarks for the pricing of other assets.

Characteristics

Government bonds have a maturity, a coupon, and a face value. Short-term instruments, with maturities of a year or less, are typically called bills and are issued at a discount. Longer-term instruments, called notes or bonds, pay periodic coupons.

The bonds may be denominated in the domestic currency or in a foreign currency. Domestic-currency bonds carry the risk of inflation and of exchange rate depreciation through their effect on the real return, while foreign-currency bonds carry the additional risk of exchange rate movements.

The bonds may be indexed to inflation, so that the payments adjust to changes in the price level. Indexed bonds provide protection against inflation and are used to extract information about market expectations of inflation.

Role in Markets

Government bonds serve as benchmarks for the pricing of other assets, since the yield on the government bond is the risk-free rate that is used to discount other cash flows. The yield curve, which plots yields against maturity, is used to infer expectations about future interest rates and about the economy.

Government bonds serve as collateral in financial transactions and as a store of value for investors. They are held by banks, pension funds, insurance companies, and central banks, and they are used to manage liquidity and to meet regulatory requirements.

The market for government bonds is central to the transmission of monetary policy, since the central bank operates in this market when it conducts open market operations. The purchases and sales of government bonds affect the liquidity of the banking system and the level of interest rates.

Issuance and Management

The issuance of government bonds is managed by the debt management office, which decides on the timing, the maturity, and the composition of the issuance. The objective is to raise the required funds at the lowest cost, subject to the need to manage risk.

The management of the debt involves decisions about the maturity structure. Short-term debt has lower interest cost but higher refinancing risk, since it must be rolled over frequently. Long-term debt has higher interest cost but lower refinancing risk.

The management of the debt also involves decisions about the currency composition, which affects the exposure to exchange rate movements, and about the use of indexed instruments, which affects the exposure to inflation.

Risks

Government bonds are subject to several risks. Interest rate risk is the risk that the price of the bond will fall when interest rates rise. Inflation risk is the risk that the real return will be eroded by inflation. Credit risk is the risk that the government will default, which is a concern for countries with weak fiscal positions.

The risks of government bonds are interrelated. A deterioration in the fiscal position can raise the credit risk, which raises the yield, which raises the cost of debt, which worsens the fiscal position. This feedback is central to the analysis of sovereign debt crises.

The Yield Curve

The yield curve is the relationship between the yields on government bonds and their maturities. It is one of the most closely watched indicators in financial markets, since it provides information about the expectations of the market and about the stance of monetary policy.

The shape of the curve reflects the expectations of future short-term interest rates and the term premium. Under the expectations hypothesis, the yield on a long-term bond is the average of the expected short-term rates over its life, plus a term premium.

The curve can take several shapes. A normal curve slopes upward, reflecting the term premium and the expectation of higher future rates. A flat curve indicates that the market expects rates to remain stable. An inverted curve, which slopes downward, indicates that the market expects rates to fall, and it has historically preceded recessions.

Debt Sustainability

The sustainability of government debt depends on the relationship between the interest rate on the debt and the growth rate of the economy. If the interest rate exceeds the growth rate, the debt ratio rises unless the primary balance is in surplus. If the growth rate exceeds the interest rate, the debt ratio can fall even with a primary deficit.

This relationship is central to the analysis of fiscal sustainability. It explains why countries with high growth can sustain higher debt ratios, and why an increase in interest rates can rapidly worsen the fiscal position.

The sustainability also depends on the maturity structure of the debt and on the currency composition. Short-term debt exposes the government to refinancing risk, while foreign-currency debt exposes it to exchange rate risk.

Sovereign Debt Crises

Sovereign debt crises occur when a government is unable or unwilling to meet its obligations. The crises are often triggered by a loss of confidence, which raises the cost of borrowing and can make the debt unsustainable.

The crises have common features, including a deterioration in the fiscal position, an increase in the cost of borrowing, and a loss of access to the market. The resolution typically involves a combination of adjustment, financing, and, in some cases, restructuring.

The design of the international framework for crisis resolution is a subject of debate. The framework includes the lending facilities of the international financial institutions, the use of collective action clauses, and the arrangements for the restructuring of sovereign debt.

Summary

Government bonds are central to financial markets and to the analysis of fiscal policy. The yield curve, the analysis of sustainability, and the experience of sovereign debt crises inform the understanding of the role of government debt in the economy.

See also

• Bond Duration
• Public Finance
• Monetary Economics