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Financing Governments: Safe Investments

Government needs to fund its operational and capital expenditures, as does business. The main source of revenue for the government is taxation receipts; however, as times, expenditures exceed receipts and the government has a budget deficit. When the Government’s annual budget is in deficit, the government borrows from the public through the sale of medium-to-longer-term Treasury bonds

Within a financial year, the government will experience a mismatch of its cash flows, and will need to raise short-term funds to smooth out is cash flows over time. To fund those months, and to assist in smoothing the intra-year influences of the budget on the liquidity within the economy, the government sells and redeems short-term securities known as Treasury notes (T-notes).

The sale and redemption of Government securities is also used by the Reserve bank to achieve is monetary policy and financial system liquidity objectives.

The bonds sold by the government can be categorised on the basis of their terms to maturity and on the basis of whether they are discount or coupon securities. The only coupon instrument currently sold by the government are Treasury bonds. The straight Treasury bond, which is sold through a tender process, has a fixed coupon which is paid six-monthly. The owner of the bond redeems the bond at a face value on maturity. The main buyers of bonds are financial institutions. There is a very active secondary market in bonds through which investors may change the levels and/or maturity profile of their bond portfolios. The price of a fixed interest bond is the present value of the income stream (coupon payments) plus the present value of the bond’s face value, based on the current yield on this type of security in the market.

Another innovation in the Treasury bond market is the introduction of indexed bonds. The purpose of these bonds is to provide a guaranteed inflation-adjusted (real) rate of return to the bond holder. That outcome is achieved through either the inflation indexation of the interest paid, or the indexation of the capital value of the bond.

The short-term instruments sold by the government are called ‘T-note’. They are sold, at tender, with a maturity of 5, 13 or 26 weeks. T-notes are discount instruments; that is, they are sold at a discount to their face value, and are redeemed on maturity at full face value. The price of a T-note is calculated using the discount securities formula. In the money markets, there is a deep and liquid secondary market in T-notes, which support the active primary market. The Reserve Bank provides a rediscount facility at a penalty rate in order to facilitate the banks’ exchange settlement account obligations.

The state governments and their instrumentalities also raise funds through the sale of securities. Each state has established a single centralised borrowing authority for the marketing and sale of their securities. The instruments sold by the authorities fall into two categories: coupon instruments, which are similar to Treasury bonds, and discount instruments, which have similar attributes to those of commercial P-notes.