One way the Federal Government can raise funds to finance developmental projects is by issuing debt instruments such as the treasury bills, notes or bonds.
Treasury bills are short term debt obligations that mature within a year, while treasury notes typically mature within 10 years or less. On the other hand, treasury bonds are more long term in nature with maturity date as high as 30 years.
The return on investment from owning these debt instruments is regarded as the treasury yield which is expressed in percentages. Hence, the treasury yield represents the interest rate at which the Nigerian government pays to borrow money.
One important thing to note is that treasury yields and its corresponding bond values move in opposite directions. That is, when there is high demand for a particular treasury bill, its price rises above its face value such that the yield starts to decline.
On the other hand, low demand pushes the price below its face value, thereby inducing an increase in the yield. In addition, the government is only obligated to pay back the face value of the bond plus the stated interest rate.
The yield spread
The yield spread is the difference between the yield on the short and long term debt obligations of the government and it also serves as an important indicator for investors in trying to gauge the future direction of the economy. This is because it illustrates how much more yield investors will require to invest in the long term bond.
When the spread is plotted on a graph, it translates into the yield curve. A rising yield spread calculated by the difference between the treasury note and the treasury bill suggests that the yield curve is steepening or normal. This means that the long term bond has a higher and rising yield in comparison to the short term bond.
Why is this so one may ask? This is because investors will expect a higher return for investing over a long period of time than over a short period of time.
At this point, investors are optimistic about the market economy and are foreseeing stronger economic growth in the coming quarters or the future.
Conversely, a declining yield spread signifies that the yield curve is flattening as the difference between the treasury bill and note starts to fall. At this point, the yields in the economy are usually low.
This typically reflects a period of weak economic growth as investors are careful about the economy.
Lastly, a scenario where the yield spread falls below zero suggests the presence of an inverted yield curve. Here, the yield on the short term debt is rising faster and higher than that of the long term bond. This is mostly common during periods of economic recessions.
It can be clearly seen that the direction of the yield curve can be used by investors and economists to gauge how the economy will fare in the future. An inverted yield curve could suggest an imminent recession, whereas a normal curve depicts the likelihood of continuous growth and expansion.
How the treasury yield affects the Nigerian economy
To understand how treasury yields affect the economy, it is necessary to understand that these debts are backed by the Nigerian government; hence they are the safest forms of investments.
Therefore, as treasury yields rise, there is the tendency for the interest rates on other bonds to rise because they are more risky than the government bond. This implies that, in order to remain competitive, the interest rates on other bonds and loans tend to rise as the treasury yield increases.
In the short term, the effect could hamper economic growth as other business loans starts to rise. This is due to the fact that the cost of borrowing as disincentive to companies from making investment and expanding production.
The yield spread in Nigeria
BusinessDay Research and Intelligence Unit (BRIU) compiled data on treasury yields on both the 2 year government bond and the 10 year government bond from January 18 to February 18, 2019.
The data on the 2 year bond yield averaged 15.56 percent, while the 10 year bond yield averaged 14.94 percent during the reference period. This shows that the 2 year government bond has been rising higher than the 10 year government bond.
From the graph, it can be seen the yields on the 2 year bond have largely been greater than that of the 10 year bond. Further observations show that the 2 year bond clearly surpassed the 10 year bond starting from the 13th of February.
Source: World Government Bonds
Computing the treasury spread, the difference between the 10 year and the 2 year government bond during the reference period, we find out that yield curve in Nigeria is inverted. This situation reflects that investors are demanding more yields for the short term bond than for the long term bond.
In order words, it can be said that investors in the Nigerian bond market are anticipating that the economy will do much worse in 2 years than in 10 years, hence, the less demand for the 2 year government bond.
Source: World Government Bonds
Note: Treasury spread is defined as the difference between the 10 year FGN Bond and the 2 year FGN bond
The next question is why are the yields on the 2 year bond greater than the 10 year bond? One way of explaining this is the presence of a huge public debt. When debts are constantly increasing and very high, investors begin to question the ability of the economy to repay back. According to the data compiled from Debt Management Office (DMO), Nigeria’s public debt has increased to $72.2 billion in September 2018 from $66.6 billion in September 2017 representing an 8.41 percent increase.
