Bond yield is a fundamental metric in the realm of finance, serving as a crucial indicator of an investment’s profitability and risk. Simply put, it represents the annual return an investor can expect to receive from holding a bond. This metric is essential for both investors and issuers alike, as it influences pricing decisions, investment strategies, and overall market sentiment. Understanding bond yield requires insight into various factors such as prevailing interest rates, bond characteristics, and economic conditions, making it a cornerstone in the evaluation and management of fixed-income securities.
What is Bond?
- A bond represents a loan from an investor to a borrower over a defined period. In exchange, the investor receives regular interest payments.
- The period from issuance to repayment is termed ‘term to maturity’. Bonds enable the issuer to raise funds for expansion projects, debt refinancing, welfare initiatives, and other activities.
What is Bond Yield?
- The bond yield represents the annual return anticipated by an investor throughout its term to maturity. It relies partly on coupon payments, which are periodic interest income received for holding bonds.
- Bondholders ultimately receive the bond’s face value upon maturity. Bonds may be purchased at par value, discount (below par value), or premium (above par value) in the secondary market.
- Thus, the market price of bonds impacts the bond yield. The bond yield is calculated using the formula:
Bond Yield = Coupon Amount / Price
- Price and yield share an inverse relationship.
- A bond’s price increase leads to a decrease in its yield, and vice versa.
- For instance, if interest rates decline, existing bonds become more valuable as they offer higher interest payments compared to new bonds.
- Consequently, their prices rise.
- However, this makes it costlier for new investors to buy these bonds, leading to a decrease in yield.
Demand for the bonds
| Increases | Decreases |
| Market price of the bond decreases | Market price of the bond increases |
| Bond Yield increases (Yield softening) | Bond yield decreases (Yield hardening) |
| Reasons: Increased Inflation – Sale of G-secs by the central bank under open market operations – Increased borrowings by the government (Increased fiscal deficit) | Reasons: – Deflationary trends in the economy – Purchase of G-secs by the Central bank under open market operations – Reduced borrowings by the government |
| Loss to the bond holder | No loss to the bond holder |
Impact of hardening of bond yield
- Loss to the banks: Commercial banks in India, due to their SLR requirements and LAF purposes, hold a significant amount of G-secs. An increase in bond yield results in a decrease in bond prices, leading to losses for banks.
- Loss to the mutual funds: Mutual funds, holding substantial G-secs, also incur similar losses due to rising bond yields.
- Increased cost of borrowings: Elevated yields on G-secs necessitate higher interest rates on fresh government borrowings. Corporates must also raise interest rates on their bonds in response to increasing bond yields. Indian banks, following the interest rates of long-term G-secs to set lending rates, may experience increased lending rates due to hardened G-sec yields.
- Impact on equity market: Rising bond yields elevate the opportunity cost of investing in equities, rendering equities less attractive to investors.
FAQs
Q: What is bond yield?
A: Bond yield is the return an investor receives on a bond investment, expressed as a percentage of the bond’s face value. It includes interest payments and any capital gains or losses if the bond is bought at a different price than its face value.
Q: How is bond yield calculated?
A: Bond yield can be calculated in different ways, depending on the type of yield. The most common method is the yield to maturity (YTM), which considers the bond’s current market price, face value, coupon rate, and time to maturity. Other measures include current yield, yield to call, and yield to worst.
Q: What factors affect bond yields?
A: Bond yields are influenced by various factors, including interest rates set by central banks, inflation expectations, credit risk associated with the issuer, supply and demand dynamics in the bond market, economic conditions, and changes in investors’ risk appetite.
Q: How do changes in interest rates affect bond yields?
A: Bond prices and yields have an inverse relationship: when interest rates rise, bond prices fall, leading to higher yields, and vice versa. This is because newly issued bonds offer higher coupon rates to attract investors in a higher interest rate environment, making existing bonds with lower coupon rates less attractive.
Q: What is the significance of yield curve in bond markets?
A: The yield curve plots the yields of bonds with different maturities, providing insights into the market’s expectations for future interest rates and economic conditions. A normal yield curve typically slopes upward, reflecting higher yields for longer-term bonds. Inverted or flat yield curves may signal economic downturns or recessions, affecting investors’ decisions and portfolio strategies.
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