EFB201 Lecture 6 – Government Debt Markets Reading – Viney chapter 10 Tutorial Questions – Viney chapter 10 Essay Questions 1-8. Outline Background Treasury Bonds Treasury Notes State Government Securities Overseas Government Securities. Background
EFB201 Lecture 6 –
Government Debt Markets
Viney chapter 10
Tutorial Questions –
Viney chapter 10 Essay Questions 1-8
State Government Securities
Overseas Government Securities
All governments need to fund their capital expenditures
and recurrent (day-to-day) operations.
They issue debt securities to raise these funds.
A fiscal policy deficit in Australia is typically funded by
the issue of Treasury bonds, which are medium- to
long-term coupon securities.
Day-to-day operations are mainly funded by the issue
of Treasury notes, which are short-term discount
Under monetary policy the central bank adjusts the
liquidity level in the financial system to influence
short-term interest rates.
The payments system facilitates the flow of funds
through the financial system and the economy.
The government must manage its financial position,
including the timing of its cash flows and the financing
of capital expenditures.
The matching principle sees the government match
short-term liquidity requirements with the issue of
short-term debt securities and long-term capital
expenditures and other commitments with the issue
of long-term debt securities.
Liquidity short-falls occur when there is a mismatch
between timing of government intra-year expenditures
and the receipt of revenue.
A capital expenditure short-fall occurs under a budget deficit.
A budget deficit occurs when a government’s expenditure
exceeds its revenue in any particular period.
The Commonwealth government’s financial position has
changed considerably over the last few decades:
Budget deficits occurred in the financial years from
1991–92 to 1995–96 due to an economic recession
requiring increased government spending to support
Budget surpluses occurred from 1996–97 until 2007–08
following the government’s implementation of the
ideology of a smaller government and privatisation of
government institutions, such as Telstra. The global
financial crisis saw the budget move back into deficit in
Prior to the global financial crisis, the government policy
of budget surpluses and government debt reduction
introduced an unusual problem into financial markets:
the potential for a limited supply of government securities.
The government overcame this problem by introducing the
following policy to maintain a debt issuance program:
1. Long-dated Treasury bonds would now be issued at
least every second year to ensure there are sufficient
securities issued to support the 10-year bond futures
2. On alternative years a mid-term Treasury bond
would be issued to cover the short end of the Treasury
bond yield curve.
A limited supply of government securities creates a
problem as market participants use them for a wide
variety of reasons:
1. Liquidity management – the active secondary market
in government securities makes them very attractive to
2. Portfolio investments – government securities pay a
rate of return so investors may hold them as part of a
3. Risk management – government securities are
regarded as risk-free so if included in a portfolio will
lower the overall portfolio risk.
4. Payments system requirements – they can be used to
ensure financial institutions can meet their obligations in
their exchange settlement accounts.
5. Prudential supervision – the high liquidity of
government securities allows financial institutions to
use them to manage their liquidity risk. In additional they
have a zero risk weighting in the capital adequacy
These reasons ensure there will continue to exist a deep
and liquid Treasury bond market in Australia.
The government needs to manage its day-to-day liquidity
The government’s main source of funds is taxation
receipts. However, timing of these receipts is not
perfectly matched to the timing of certain fixed
expenditures of government.
For example, the government makes regular
fortnightly payments to pension and benefit recipients.
At other times it will have sudden and unexpected
demands for liquidity, such as making cash payments
to victims of a natural disaster.
Issues of Treasury notes, short-term interest rate
securities, are used to ensure daily liquidity requirements
can be met.
Treasury bonds are the interest coupon securities issued
by the Commonwealth government.
Currently the main type of treasury bonds issued are
bonds which pay a periodic fixed-interest coupon and
the principal is repaid at maturity.
Treasury notes are the short-term interest rate
government security that is issued.
The Australian Office of Financial Management (AOFM)
is responsible for managing the government’s debt
The holder of a Treasury bond receives a fixed coupon
payment, normally every six months, and at the maturity
date the face value and the last coupon.
The risk faced by the bond holder is that if market yields
on similar maturity bonds increase, the price, or value,
of the bond will fall.
Since 1984 Treasury bonds have been inscribed stock,
not bearer bonds. When inscribed stock is issued the
investor who buys one of these bonds will receive a
receipt instead of a physical bond and their ownership
is recognised electronically with a registry.
There is no ownership record of bearer bonds. Holders
of bearer bonds simply detach the printed coupon from
the bond and present it for payment.
The advantages of issuing inscribed stock are:
1. It is less costly to maintain an electronic register of
bond holders than to print and distribute physical bonds.
2. Ownership of bearer bonds is not registered anywhere,
allowing nondisclosure for tax purposes. Similarly, bearer
bonds may facilitate money laundering.
3. Inscribed stock cannot be stolen, destroyed or misplaced.
This is because the ownership right to coupon payments
and face value is registered at an inscribed stock registry.
When inscribed stock is sold in the secondary market,
the ownership of the bond is transferred in the registry.
Australian Treasury bonds are issued through a
The Federal Treasurer decides on the timing of each
tender, and the maturities, coupons and quantities of
bonds to be marketed.
Under the tender process:
Bids are submitted electronically by registered bidders
through the AOFM tender system; the minimum bid
must have a face value of $1 million, and thereafter be
in multiples of $1 million
2. The bonds have a fixed interest rate but bids are
made in terms of yield to maturity up to three decimal
3. Bids are accepted in ascending order, that is the
lowest bid yield (so highest price) is accepted first.
There are a diverse group of investors in government
A proportion of each issue can be allotted to the
Reserve Bank at the weighted average issue yield.
The Reserve Bank uses its portfolio of government
securities to alter overall maturity composition of bonds
on issue and affect the amount of liquidity in the
2. Banks are large holders of government securities in
order to manage their operational liquidity and
3. Insurance offices, other financial institutions and
public authorities also hold government securities as
part of their liquidity management strategies.
Treasury bonds can be traded on-exchange or
over-the-counter transactions. On-exchange transactions
are conducted through a broker on the ASX. However,
the volume of on-exchange trades is very low compared
to over-the-counter trades.
Investors undertake transactions in the secondary
market to meet the following requirements:
Funding requirements: Financial institutions borrow
large amounts of funds to provide loan facilities to
customers. When all these funds have not been lent out
government securities are an attractive investment vehicle
for the short-term excess funds.
2. Liquidity requirements: Corporations buy and sell
government securities to manage their day-to-day
3. Reserve requirements: Some countries require banks
to hold a proportion of their assets as government
securities. Australian financial institutions are not subject
to these requirements but hold government securities in
order to manage their liquidity to the satisfaction of the
4. Interest rate expectations: If market participants
expect interest rates to fall they may increase their
holdings of long-term fixed-interest government
securities to take advantage of potential future
5. Managing the maturity profile of a bond portfolio:
Some fund managers, such as superannuation funds,
maintain a particular average maturity of bonds in their
portfolio. So they will buy and sell bonds to maintain this
Treasury Bond Pricing
When Treasury bonds are traded in either the primary
market or the secondary market they are quoted in terms
of their redemption yield or yield to maturity.
As the coupon cannot change, the price of existing bonds
will change if the current market rates change. Therefore,
the rate of the fixed coupon will generally be different
from the actual yield to maturity.
The bond’s price (P) will be the present value (PV) of the future cash flows, coupons (PVc) and face value (PVf):
P = PVc+PVf
The main type of short-term security issued by the
Australian Commonwealth government to manage its
ongoing liquidity position are Treasury notes (T-notes):
The government, through the AOFM, may issue from
time to time T-notes with differing terms to maturity.
The term of T-note issues coincide with the main revenue
receipt dates of the government during the year.
T-notes, as with Treasury bonds, may be issued by
tender in the primary market.
The tender arrangements are similar to those for
A bank is to bid at tender for $1 million of 182-day T-notes
at a yield of 5.50% per annum. If successful the bank will
pay the following price for the tender:
$973,307 = $1,000,000/(1+0.055×182/365)
The bank purchases the T-note and decides to sell it when
it has only 74 days until it matures. T-notes are currently
trading at a yield of 4.95%pa.
The bank will obtain the following price for the T-note:
$990,064 = $100,000/(1+0.0495×74/365)
Some advantages of having a central borrowing authority:
1. Economies of scale occur as instead of numerous state
authorities and instrumentalities raising funds separately,
a single issue can be made through the central borrowing
2. The timing of the issues can be controlled so they occur
at the most opportune time.
3. Potential for competition between different debt issuers
in the same state is overcome.
4. The development of a secondary market is encouraged
by the existence of large issues of instruments with
identical features, as opposed to numerous small issues
of instruments with non-identical features.
The central borrowing authority can choose to use public
or private, underwritten or non-underwritten placements.
Private placements are becoming more preferred as they
do not involve the use of a prospectus so are quicker and
less costly than public placements.
Typically, each central borrowing authority appoints tender
and dealer panels that are responsible for the placement
of a new issue and for making a market in secondary
Paper issued by central borrowing authorities will have an
investment-grade credit rating that is generally sufficiently
attractive to institutional investors, and so the issues are not underwritten.
Medium- to long-term securities are often referred to as
Overseas Government Debt Issues
From an investors’ perspective, overseas government
bonds may provide may provide differences in
risk/return profiles compared to domestic bonds
Government debt securities of different countries
will have various credit ratings
In addition, they may provide diversification benefits
to domestic investors
US government securities are seen as particularly
attractive in times of financial crises