Economy / Stock Market / Bond Yield
Bond Yield
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.
