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 over-
subscribed at the expense of the government bond. Explore all possible scenarios. [Not
more than one-page]

Answer 1

When investing under uncertainty, expected utility maximizers will look firstly at three features of the bond to decide if the investment is worth the opportunity cost of the financial capital sacrificed.

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1) Price of a bond unit: Assuming fractional quantities can’t be purchased, this is the minimum expenditure. You can think of this as relevant because it’s the risk ceiling in absolute terms ceterus paribus – you may lose ALL of that money in the (perhaps unlikely but still possible) event of a major collapse in economic order, or even some smaller event which disrupts the specific bond issuer’s business plan to make that money grow.

2) Maturity period: Humans employ hyperbolic discounting in valuing future promises – the Value of a promise goes down disproportionately with increase in expected number of periods to realization. This is usually reasonable – the longer we have to sit tight with an asset that’s both risky (could drop to zero in Value in the blink of an eye) and illiquid (can’t pull out the money if we see a shock looming over the horizon) the more room there is for something to go wrong, which is psychologically taxing.

The above two are relevant aspects of the asset’s risk profile, which is incorporated as statistically-informed expectations into calculating the expected utlity.

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3) Coupon rate: Increase in this is what negates the disutility of increase in the previous two numbers – a greater risk must be justified by greater reward. This is what adds the utility in expected utility.

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Now we have a framework in which to analyze the problem.

The charts shows that COVID-19 numbers in India are still increasing at an increasing rate – this means there’s no visible sign of the numbers asymptoting, a sure indicator of possible collapse as there’s no statistical risk ceiling. This could well escalate into an even greater situation than it is now, in which case the social fabric which facilitates business is disrupted because people lose faith in the government’s ability to preserve order and essential supplies.

Of course, a turn of events (numbers) could change investor expectations in a jiffy – but until then the price of the bond and maturity cannot exceed a modest threshold, otherwise the risk just cannot be justified to enough bond purchasers. If the government can’t sell as many bonds to bring in as much cash as required to overturn the situation, failure becomes a self-fulfilling prophecy.

On the other hand, the coupon rate has to be at par with Ashanti’s – or at least with within a reasonable range, since the representative investor’s patriotic goodwill may only go so far.

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If these two conditions aren’t met (the other three of 2x2 cases), ASHANTI’s bond will be inevitably favored by investors.