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Bonds and how they work
Bonds are basically IOUs. Governments and firms routinely issue bonds in order to borrow money. So, for example, the UK Treasury may issue a bond that guarantees to pay the holder £1 million in ten years’ time when someone is willing to pay the Treasury money today in order to own the bond (it’s a valuable asset). In effect, the bond buyer is giving a loan to the government. When the bond matures, that is, it’s time to pay up, the government is obliged to pay the bondholder the face value of the bond (in this case, £1 million).
Potential bondholders are probably only willing to pay some amount less than £1 million in order to secure themselves a return but also to compensate them for the risk. When bonds are initially sold, an auction is used to maximise revenue for the seller (in this case, the Treasury).
Clearly the government wants to sell the bond for as much as possible: the higher the price it achieves, the lower the interest rate it’s paying to borrow money. For example, if the Treasury can sell the bond for a cool million today, it’s not paying any ‘interest’ on its loan. If, however, it can only sell it for £0.5 million, it’s paying over 7 per cent interest every year. The closer it gets to £1 million, the less interest it has to pay.
But this isn’t the end of the story, because a thriving secondary market exists for bonds. So a bondholder doesn’t have to wait until maturity in order to get paid. He can sell the bond today to someone else who’s willing to hold the bond for a little while longer. Bond prices on the
secondary market vary from day-to-day and from hour-to-hour, which means that the bond’s yield also varies. The yield of a bond is the implied rate of interest bondholders are paid if they hold the bond until maturity (based on the current bond price, not the price it initially sold for).
Bond prices and bond yields are inversely related. So if for some reason the bond price falls today, the bond’s yield increases, because the current bond price is lower but the face value is unchanged. Notice that this doesn’t impact the interest rate that the government pays the bondholder, which was ‘locked-in’ when the bond was initially sold. But it does typically affect the rate of interest the government has to pay if it issues new bonds today.
The central bank isn’t the same as the government. The central bank still expects to be paid by the government Treasury when the bonds it owns mature. The fact that the central bank owns some of the bonds doesn’t relieve the government of its liabilities. Indeed the only reason the central bank is trading on the bond market is to affect the supply of money and thereby change the interest rate.
Another way of thinking about open market operations is to consider the effect on the bond market directly, because the money and bond markets are two sides of the same coin.
Many different kinds of bonds exist, some issued by governments and others by firms. Some bonds are seen as quite risky, because the probability of default (not repaying) is relatively high, whereas other bonds are less risky, because their probability of default is low. Bonds also differ in terms of their maturities: some have short maturities (they must be repaid quickly) and others have longer maturities.
Open market operations focus on buying and selling short-dated government bonds, because doing so allows the central bank to influence the price of those bonds. The price of a bond determines its yield, so the central bank is able to affect the implied interest rate on those bonds.
Figure 10-4 makes this clearer. Initially the supply of short-dated government bonds is at S0. When the bond price is high (yield is low), not many people want to hold bonds, but when the bond price is low (yield is high), many people want to hold them. Equilibrium in the bond market occurs when the
quantity demanded is equal to the quantity supplied, which occurs at price p0.
© John Wiley & Sons
Figure 10-4: The bond market and open market operations.
If the central bank wants to engage in expansionary monetary policy, it increases the supply of money by buying bonds in the secondary market, which reduces the supply of bonds available to everyone else. Think of this as reducing the supply of bonds from S0 to S1. Note that this causes the price of bonds to rise, which means a fall in bond yields: in other words, a fall in the interest rate!
In a similar way, contractionary monetary policy reduces the supply of money by selling government bonds. In the secondary bond market this increases the supply of bonds and reduces their price, causing an increase in bond yields: in other words, an increase in the interest rate!
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