Ch.14 Q14.19

Hi

My question is about Ch.14, Q.14.19:

Q - Why might the government be particularly interested in the level and shape of the real yield cure compared with the gross redemption yield when issuing bonds?

A - The government will want to issue bonds as cheaply as possible. By looking at the real yield curve compared with the yield curve it may be able to identify the stocks that are the cheapest to issue.

Which stocks will be the cheapest - the ones where the inflation expectation is highest? i.e. the point where the two yield curves are the furthest apart?

Thanks!

 

I'm not sure if that's the only (or primary) reason that goes into deciding bond term. The govt will try to issue bonds whose payments matches the cash flows of investments (unless govt is planning to squander this on subsidies or consumption related expenditure - but these are usually met by tax revenues rather than bond issue).

Given the term structure of asset investments and the shape of the yield curve for bonds, rolling over bonds does not make financial sense. Even if shorter term bonds are cheaper now, given higher (or lower) inflation expectation, future rates will adjust accordingly.

Most of govt income is in real terms (taxes depend on sale of goods, wages and profits that rise approximately in line inflation), so I'm not sure why the nominal curve will even play a role here. Inflation risk premium will, but not inflation itself - but this is already factored into real rate, isn't it?.

 

Maybe it is because the government envisages in the future higher inflation and lower central bank interest rates, i.e. lower real yields. While gross redemption yield includes capital gains (on top of the coupon rate) which tends to grow since lower interest rates and higher inflation tends to push up the price of the issued bonds.