Bond Yield, quite a confusing term, especially if you haven’t studied monetary economics. But, understanding bond yields can be a necessity if you’re an investor as bond yields surely have the power to determine the market trends. Even if you aren’t an investor, understanding bond yield is still important as they dictate the rates and interests of general fixed deposits and loans. In a nutshell, bond yield’s influence can be wide-ranging. The fluctuating bond yields can provide a quantum jump for the capital markets and can be the biggest reason for their collapse. And this can be observed in the current times, where soaring bond yields, especially the U.S Treasury yields, are jeopardizing the stock markets around the world.
Bonds: What are bonds?
Bonds can be defined as a fixed-income instrument or fixed-income security that represents a loan taken by a borrower from a creditor (referred to as an investor). For example- If an individual or a company wants to raise capital for starting a new business, he can raise money from another individual or entity by issuing a bond, which includes the promise to pay the money back after a certain time and the regular interest payments to the bondholder. In general, the bondholder is the creditor and the entity is the debtor.
Bonds are generally issued by large corporations and governments to raise capital for their operations. Corporations issue bonds to raise capital for their expansion, new projects, and even to carry out their day-to-day operations. The case is similar for the governments, as they issue bonds to fund their infrastructure and welfare projects. These bonds have varying tenures like the 10-year bond, 5-year bond, 1-year bond, etc.
Bonds issued by corporations are referred to as Corporate Bonds and government-issued bonds are called Government Bonds or G-Secs (Government Securities).
Government securities are referred to as-
- G-Secs in India
- Treasury Bills in the United States
- Gilts in the United Kingdom
Many of these bonds can be traded in the primary and secondary capital markets, while some of them are traded privately between the issuing entity and the investor.
Bond yield is the return that an investor gets on a bond. Bond yield is nothing but the interest that the bond issuer pays the investor. The effective rate of return on a bond could be 2%, 3%, 5%, etc. So, the issuing entity or the government pays the investor a fixed rate of return at fixed intervals.
Let’s assume that the value of a 5-year Treasury Bill is $100 and its yield is 5% per annum. So, a person who bought the bond for $100 at the rate of 5% gets $5 per year. This $5 is called the Coupon Payment.
Bond Yield: Is it really this simple?
Well, not at all.
The value of bond yield is not a constant term, it fluctuates constantly depending on various factors like the condition of the economy, the trend of stock markets, etc. How? Let’s understand it with examples-
Suppose the economy of a country isn’t doing good and the GDP is declining continuously, hence, the stock markets would be adversely affected by this. In such a situation, the investors would surely pull their money out of the equity and invest in safer instruments like gold and bonds. Due to this, the demand for Government bonds would increase, and as the demand increases, so does the prices.
Since the price of the bond increases, a bond that was brought for $100, would now be valued at $120. So, a person, who brought it for $100, could sell it for $120 in the capital market. The buyer buys this bond for $120, but would he get the 5% yield that the initial investor got? No. Because the Coupon Payment associated with that bond, which was $5, remains constant. (Coupon Payment remains constant). A $5 coupon payment on a $120 bond, what’s the bond yield, the bond yield would be 4.167%.
Now, the opposite case, when the economy of a country is flourishing, as so is the stock market. Obviously, the investors would desire high returns, and in order to get that, they’ll pull their money out of bonds and invest in stocks. Due to this, the demand for bonds would go down and so would their prices. The price of a bond, which was $100 initially, would go down to, let’s say $80. But again, the coupon payment remains constant. Hence, an investor buys the same bond for $80 and gets a $5 coupon payment on it, what’s the yield? 6.25%.
Summing it up, the bond prices are inversely proportional to the bond yields.
Major factors influencing bond yields
The monetary policy of the central bank of a country greatly influences the bond yields.
Let’s understand it with respect to India. If the RBI reduces the repo rates, the interest rates at which loan is extended by banks to the customers would also go down. This means that loans would be cheaply available in India (Central Banks generally reduce the repo rates to give a boost to the economy and enhance the overall demand).
But however, this would have an adverse effect on the interest rates of fixed deposits. Because as the interest rates on borrowing fall, so does the interest rates paid to the depositors. So, as the interest rates on saving accounts fall, people generally tend to take their money out of them and invest in other safer instruments like bonds, which are giving considerable yields. And as the demand for the bond rises, so does its price and the yield falls.
And the condition is opposite when RBI decides to increase the repo rates.
Stock Markets and the economy
As the economy grows, the stock markets soar experiencing new highs. In such a situation, the investors tend to invest more in equities than in debt segments for higher returns. Due to which the overall demand for bonds reduces and hence its prices fall.
Inflation also plays a major factor in determining the bond yields. Rising inflation often leads to negative real interest rates. Let’s understand the term with an example, suppose our $100 bond gives a 2% yield per annum, but however, inflation is rising at a rate of 3% per annum, this is the case of negative real interest rates. Let’s make it more clear, if a month’s grocery cost you $100 this year, it’ll cost you $103 next year, rise in price – $3. But, your fixed-income security is giving you just $2 per annum. Hence, the real interest rates are in the negative zone.
So, in order to keep pace with the inflation, the bond issuers would now issue bonds with higher yields. So, the companies might issue new bonds with 4% yields. And the bondholder having the $100 bond with 2% yields will surely not get a buyer if he seeks one in the secondary markets, so he must sell it with a discount at the price, say $800. And as the price of this bond decreases, its yield rises.
Affect on Stock Markets
But it gets quite complex sometimes. When the Central Banks infuse extensive capital in the market by its monetary policy tools like bond purchases and reducing the repo rates, inflation tends to rise.
A steady rise in inflation is considered good for the economy, but however, the inflation could see a quantum jump due to these expansive policies of the central banks. And this rise in inflation isn’t healthy at all! So, the Central Banks, in order to control inflation, introduces a contractionary monetary policy in which it tends to increase the interest rates and limit the capital infusion.
The stock markets don’t really welcome the contractionary policy of the central banks, and hence, a slight, or sometimes a major fall can be seen in stock markets. Hence, the affinity for the bonds increases.
What’s causing the recent yield surge?
In response to the recent economic depression caused by the pandemic, central banks around the world are providing excess stimulus in the economies causing the stock markets to create all-time highs. With this new rise in equity, the affinity for equity has risen and fixed-income securities like bonds have gone down. And due to the fall in demand, the prices of bonds are falling and yields increasing.
How rising bond yield would hurt the corporates and the stock markets?
The corporates and government would surely not welcome the rising bond yields. Why? Because as the bond yield rises, the companies and the government, who would issue newer bonds will have to pay higher interest to the bondholders, which would eventually increase their cost of capital.
The higher cost of capital would highly affect the company’s cost of production and reduce their profits, which would be disastrous for their stock valuations. As the bloodbath in the global stock markets was evident due to the rising U.S Treasury yields.
What’s RBI doing?
It’s obvious that the RBI would not like higher yields. RBI states that the borrowing practices could continue smoothly only when the yield is less than 6%. So, in order to regulate the yields, RBI has started a bond purchasing program in the open markets. By this, RBI is creating additional demand for the bonds and trying to rationalize the yields.
We can conclude that this asset purchasing program is RBI’s ‘Brahmastra’ which could save the economy from high yields.
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