Question

Assuming the government is selling a government bond to fight COVID-19, and at the same time, ASHANTI Goldfields Company is selling a corporate bond to increase its production. Under what conditions will the production-linked corporate bond be oversubscribed at the expense of the government bond. Explore all possible scenarios.

Answer 1

Whenever the government, or a private company requires money for its use, it has the option of issuing a bond, which is widely a debt instrument by which the government or the private company in this case, repays the same at a dividend or a rate of return.

In the current scenario, the government and Ashanti Goldfields are providing bonds to the general public to subscribe to. Since the government is a safe entity, the person purchasing the bond would be aware that the returns from the government issued bond would be substantially lower.

On the other hand, the reason why Ashanti Goldfields could be oversubscribed is because it may be sold at a discount to the end user with a dividend rate much higher than the government which usually charges a premium for its subscription due to the safety of the bond itself.

The following example will help in clarifying this even further.

Example: -

For example, we assume that in this case, the Government offers a bond for 100$ at a premium of 1$ which makes its price 101$ and the rate of interest is 5% per year on 100$ investment. On the contrary, a bond for Ashanti Goldfields is available at a discount of 2$ at 98$ and the rate of interest is 10% per year on the total investment.

In this case, considering that a person was to invest 100$ in total, then his investment value at the end of a year for government bond will be 105$ as per the interest rate and he would have to pay a total of 101$ for the same. The net return would be 4$ only. On the other hand, if the bond of Ashanti Goldfields is purchased, then the return would be 110$ and the invested value would be 98$ only. The net return in this case would be 12$.

Thus, we can conclude by saying that the additional revenue which a person would be able to generate as a result of investing in Ashanti is the reason why, it would be oversubscribed up and above government bonds. However, it is to be remembered that the government would not default on payments of interest or redemption of the bond itself would be easy. On the contrary, the risk factor in a private company is always very large.

Please feel free to ask your doubts in the comments section if any.