Question

A government wishes to borrow £1 million. It issues a one-year bond at a price of £950,000 at a fixed rate of interest of 5%. Suppose in investors become concerned about a possible default, causing the bond price to fall to £930,000.

1. Calculate the bond yield before and after the fall in the bond price.
2. How will this affect the interest rates that companies and households pay on their debts?
3. What can governments do to prevent a debt default?

Answer 1

Bond Price = 950,000

Coupon rate = 5 % ie 47,500

Time = 1 Year

Bond yield Before fall in bond price = Coupon payment / BOnd price * 100

= 47500 / 950000 * 100

= 5%

Bond yield after fall in bond price = Coupon payment / BOnd current price * 100

= 47500 / 930000 * 100

=5.12 %

When the Investors believe that the government will defalult on its debt , the market paritcipants will sell off the government bonds resulting in fall in value of bonds in the secondary market. And as bond price has inverse relationship with bond yield, therefore the yield will rise. This will have direct impact on household and business borrowing in the credit market and excess volatility. The Interest rate will rise in the market leading to fall in consumer spending and business investment. This cause economic growth to slow down.

To prevent Debt default the government can reduce its excess expenditure or maintaing a balance fiscal budget. The government can work on generating more revenue so that interest and principal debt payment can be made to investors. The government can build investors confidence by providing stability in market and with prudent reforms and sound fiscal policy.