The government securities market in the pre-reforms period was characterized by administered (and often artificially low) rates of interest the participants were captive investors due to high SLR requirements there was an absence of a liquid and transparent secondary market for G-sec resulting in the lack of a smooth and robust yield curve for pricing of the instruments.
The volume of debt expanded considerably,particularly short-term debt, due to automatic accommodation to the central government by the reserve bank of the India, through the mechanism of ad hoc Treasury Bills with a captive investor base and interest below the market rate,the secondary market for government bonds remained dormant.Non market related yields on government securities affected the yield structure of financial assets in the system and led to higher lending rate.
The yield structure of the government securities.
A loan Carries a yield as a compensation for the loss of liquidity which ready money can provide.In an integrated market under equilibrium situation therefore,the yield on a loan should be a direct function of its liquidity and an index series of relative liquidity of different maturities should be nothing but the ratios of the reciprocal of such yield.
The market price of a loan need not be at par nor should the coupon rate have any definite relationship with its remaining terms to maturity the coupon was decided up on at the time.
The concept of yield curve
In the market,there is nothing like the rate of interest, nor for that matter, is there anything like the long- term or the short term rate of interest.Each rate of interest is at least two-dimensional.It is related on the one hand to the type of asset or loan for which it is being quoted and on the other to its term to maturity.Thus at any point of time the whole system of interest rate in the market can be represented in the form of a set of vector of interest rates in such a way that each vector pertains to one particular asset and consist of rates quoted for that asset for different maturities.
One such vector of interest rate is called a term structure of interest rates-it is a set of interest rates that pertain, at any point of time t, to a given type of assets such that the rate differentials within this set are solely due to the differences in the term to maturity.In the case of public debt,we have a term structure of yield rates-where yield refers to the yield to redemption inclusive of capital gain/loss.The theory of term structure of interest rates in such a term structure as also the rate differentials contained theirn.It does not explain,however,the rate differentials between different types of assets of a given maturity.
Shape of the Yield Curves
While the interest rate measure the price the borrower is agreed to pay for a loan, the yield or rate of return on the loan, from the lender’s point of view, may be quite different since it depends on the total rate of return on the transaction yield takes into account number of factors example change in market value of the security, default rate, deferring of payment etc.
The relationship between the rates of return or yield on financial instruments and their maturity is labeled the term structure of interest rates.The term structure of rates may be represented visually by drawing a yield curve for all securities of equivalent grade or quality.The yield curve consider only the relationship between the maturity or term of a loan and its yield at one moment in time, with all other factor held constant.
Yield Curves change their shape over time in response to change in the public’s interest- rate expectation, fluctuations in the demand for liquidity in the economy, and other factors.
Sensitivity of the Yield Curve
This bring us to the question of the sensitivity of the yield curve to debt management operation and policies,the yield curve could be expected to be sensitive to such exogenous changes if
a)the market was a completely segmented one, or if
b)there were maturity habits in the market.
In the absence of a complete integration of the market, the authorities should be able to “twist the yield structure and thereby effect the relative liquidity of different maturities.The extent of such “twisting” ability of the authorities is a function of many factors including the constitution of the market,the expectation that the debt management policies generate in the market,the scale of operations and the sensitivity of the liquidity premiums to the level of the yield curve and so on.
Uses of the yield curve
1)Forecasting interest rates-First, if the expectation hypothesis is correct the yield curve gives the investor a clue concerning the future course of interest rates.If the curve has an upward slope,the investor may be well advised to look for opportunities to move away from bonds and other long term securities.A downward sloping yield curve, suggest the likelihood of near term decline in interest rates and a rally in bond prices.
2)Uses for financial intermediaries-The slope of the yield curve is critical for financial intermediaries,especially commercial banks,saving and loan associations,and saving banks.A rising yield curve is generally favorable for the these institution because they borrow most of their funds by selling short-term deposits and lend a major portion of those funds long term.
The more steeply the yield curve slopes upward, the wider the spread between borrowing and lending rates and the greater the potential profit for a financial intermediary.
3)Indicating tradeoffs between maturity and yield-Still another use of the yield curve is to indicate trade-off between maturity and yield confronting the investor.
With an upward-sloping yield curve an investor may be able to increase a bond portfolio’s expected Annual yield by extending the portfolio’s average maturity.The investor must weigh the gain in yield from extending the maturity of his or her portfolio against added price,liquidity,and marketability risk.
4)Riding the yield curve-Finally ,some active security investor, especially dealers in government securities.have learned ti “ride” the yield curve for profit. If the curve is positively sloped,with slope steep enough to offset transaction costs from buying and selling securities,the investor may gain by timely .