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The yield on a long-term government security represents the long-term riskfree rate of interest. Treasury Bonds with maturities of more than
one year are used to estimate long-term risk-free rates. Depending on the
maturity chosen from the available maturities (i.e. 2, 5, 6, 8, 10, 15, 20, 30
years), there exists different long-term risk-free rates each representing a
particular maturity.
As of 25 March 2015, the average secondary market yields on long-term
government Bonds are shown on column 2 (yield) of the Table 2.
Accordingly, for example, the 10-year risk-free rate of interest is about 9.7%
whereas the 30-year risk-free rate is about 11.2%. The yields are increasing
with maturity, and this pattern is typical in normal economic and market
conditions.
What determines the Treasury Bond yield?
In addition to the real real-free rate of interest and inflation, the long-term
risk-free rate contains an additional premium called the maturity risk
premium. This is also known as the term premium or the term spread. This
is because long-term Bonds are more risky than short-term Bonds. In
response to changes in interest rates in the economy, the prices of longterm Bonds tend to be more volatile than the prices of short-term Bonds.
Hence, investors demand an additional compensation in the form a term
premium for investing in long-term government Bonds.
term rates are also influenced by the liquidity of the particular instrument
as well as the general market liquidity. The liquidity premium is the
compensation for the risk that the investor may not be able to sell the
securities in the secondary market quickly and at a price near its true value.
This liquidity premium is also embedded in the above term premia.
Disentangling the liquidity premium from the term premium is a tedious
task and not attempted here. It is suffice to say that in a market where
instruments across all maturities are fairly frequently traded in good
quantities, this liquidity premium tends to be very small. In Sri Lanka,
however, the market for long-dated government securities has not been
particularly liquid or deep and, as a result, liquidity risk should have an
impact on such yields.
To summarise, the real economic growth, inflation expectations, maturity
and liquidity are the primary determinants of long-term government Bond
yields.
issues are high and yields on longer maturity periods decline consistently.
Such a pattern is indicative of markets expectation of declining future
interest rates. Typically, an inverted yield curve is observed before an
economic downturn or a recession in which economic growth slows and
inflation expectations decline. Since Bond price and yields are inversely
related, a decline in interest rates will lead to higher Bond prices. This also
means that the rate of interest at which funds can be invested in the future
will be lower.
A flat yield curve is a case where the yields on short-term and long-term
maturities are fairly identical. This indicates the expectations of the market
of no future change in interest rates.
When yields on intermediate-term issues are above those on short-term
issues, and the rates on long-term issues decline to levels below those for
short-term issues and then level out, such a yield curve is known as a
humped yield curve. In the past, there were periods in which the Sri Lankan
yield curve took a humped pattern.
How does the yield curve look like in Sri Lanka?
Now, we are in a position to understand the shape of the Treasury yield
curve prevailing in the Sri Lankan Bond market at the present time. The
yield curve constructed by using the short-term (Table 1) and long-term
(Table 2) yields of government securities is shown in Figure 1. It is clearly a
rising yield curve pattern. Yields increase consistently from 6.79% (3month) to 7.51% (2-year), jump by 1.24% from 2 to 5-year maturity, and
then rise consistently over the rest of the maturities indicating expectation
of higher future interest rates.
appropriate monetary and fiscal policies, and monetary policy and asset
bubbles. He has authored four books in Sinhala, English and Tamil published
by the SEC which are widely used as standard texts on securities markets in
Sri Lanka. Professor Samarakoon can be reached at
lalithsamarakoon@yahoo.com. Follow @LSamarakoon.)
Posted by Thavam