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Government Bond Market in 2001
CPI - Indexed Bonds
Nonindexed Bonds
US dollar - Indexed BondsThe domestic Government bond market in 2001 The government bond market in 2001 experienced a rapid price increase and a sharp yields decrease in all sectors. This was in contrast to previous years, which were characterized by a rapid yield decrease on nonindexed bonds and a yield increase on CPI-indexed bonds. The yield decrease in 2001 can be explained by the nominal and real interest rates decline, the low inflationary expectations and the share markets crisis that swayed many investors to increase the Government bonds' share in their portfolio. The following figure shows the nominal interest rate, as derived from Bank of Israel monetary auctions, and the real interest rate, i.e., the nominal rate less inflation expectations. The nominal interest rate declined gradually throughout the year while the real interest rate increased by 2.1% from September to November as a result of the inflationary expectations decline at that time. It should also be mentioned that in late December 2001, the Bank of Israel cut its interest rate by 2% and led to a dramatic increase in the Government bond's prices. Nominal and Real Interest Rates in Bank of Israel Auctions, 2001 (Percent)  
CPI - Indexed Bonds Fixed-rate bonds-Yield on CPI-indexed bonds decreased dramatically during 2001, in contrast to previous years. While at the beginning of the year, the yields on long- and medium-term CPI-indexed bonds were 5.4 percent and 6.2 percent (respectively), at the end of the year they were 4 percent and 3.6 percent (respectively). The yield decrease reflects the renewed interest in CPI-indexed bonds as a result of increasing uncertainty and rising concern about inflation coupled with nominal interest rate cuts by the Bank of Israel throughout the year. The most notable yield decrease occurred in late December 2001 as a result of a 2 percentage-point rate cut by the Bank of Israel. Yield on Fifteen-Year Galil Bonds, 1999-2001 (Percent)  Yield on Five-Year Galil Bonds, 1999-2001 (Percent)  The following figure shows the CPI-indexed bond yield curve at the end of 2000 and at the beginning of 2001. While the yield curve at the end of 2000 was descending over time to maturity, the curve at the end of 2001 was a "normal," rising-slope curve. The CPI-indexed yield curve reflects expectations for changes in the interest rate. A horizontal or decreasing yield curve reflects expectations for a cut in interest rate that compensates the liquidity loss. The positive slope yield curve in 2001 was a result of the short time yield decrease caused by the reduction of short-term inflation expectations and a cut in nominal interest rates. Yield on Indexed Bonds, 2000-2001 (Percent)  Nonindexed Bonds Fixed-rate bonds - Yields on Shahar nonindexed fixed-rate bonds declined throughout almost all of 2001. Due to a 4.4 percent depreciation in the NIS from May to September, investors temporarily preferred indexed bonds over nonindexed bonds and the latter experienced a temporary yield increase. In sum, during 2001 Shahar nonindexed bond yields decreased by 1.3 percent to 2.4 percent, falling to levels of 5.5 percent to 6.5 percent at medium and long terms to maturity, respectively. This was a continuation of the decline in nonindexed bond yields in 2000. In 2001, in accordance with its policy of extending the term to maturity of government debt, the Ministry of Finance issued a ten-year Shahar nonindexed bond for the first time. Unlike the two previous years, in which the Shahar yield curve was flat, the curve had a "normal" positive slope at the end of 2001. A positive slope reflects the risk premium that medium- and long-term investors demand. In times when interest rates are expected to fall, the profit built into the interest-rate decrease (for the holder of a fixed-rate bond) offsets most of the risk and one would expect the slope in the yield curve to descend and even to become negative (whenever a substantial decline is expected). Yields on Shahar Bonds, 2000-2001 (Percent)  The following figure presents a time series of yields of Shahar bonds in various terms to maturity. It is evident that in the first five months of 2001 the yields hardly fluctuated over term to maturity. However, from June 2001 to year's end the yield on short-term Shahar bonds has been much different from yields in medium and long terms. This was due to changing preferences during the last seven months of 2001. Yields on Nonindexed Bonds, 1999-2000 (Percent)  Floating-rate bonds - Nonindexed floating-rate bonds (Gilon and New Gilon) behaved much like their fixed-rate counterparts. The trends in Gilon yields corresponded to those of Shahar. The various kinds of Gilon bonds pay interest periodically at rates that vary from term to term (Gilon-every half-year, New Gilon-every quarter) commensurate with the average yield on three-month to one-year Treasury bills. This yield is actually the underlying asset of the Gilon bond, and the yield spread at which the Gilon is traded is measured relative to it. A positive spread occurs when the yield on the bond is higher than the yield on its underlying asset; a negative spread occurs in the opposite case, i.e., when the yield on the bond is lower than that of its underlying asset. Since the interest on floating-rate bonds is adjusted periodically, when interest rates are going down investors prefer fixed-rate bonds, which are expected to generate larger capital gains under those circumstances. Accordingly, one would expect the Gilon spread to widen at such a time. Conversely, when an increase in interest is expected, investors prefer floating-rate bonds as a hedge against an upturn in interest. When this occurs, one would expect the Gilon spread to contract. Presumably, too, as imperfections in the Israeli capital market are eliminated and the market's nonindexed financial tools become more diverse, one may expect the yield spread of Gilon and Treasury bills to narrow to a minimum. In this context, yields fell sharply in December 2001 due to a rate decrease and an upturn in investors' expectations of a future rate increase, resulting in rising demand for Gilon and New-Gilon bonds. US dollar - Indexed Bonds Yields on dollar-indexed bonds declined significantly in 2001. However, contrary to CPI-indexed bonds, the principal reason was an exogenous one-the decrease in the LIBOR rate (which serves as an underlying asset for setting the Gilboa interest rate twice a year). During 2001, the LIBOR rate decreased from 5.5 percent to 2.0 percent at the end of the year. The spread, i.e., the difference between the yield on the bond and the 6 month LIBOR rate, was negative in 2001 for two main reasons:
Yield on Four-Year Gilboa Bonds, 6 months LIBOR, and the Spread Between Them, 2001 (Percent) 
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