How do bond yields fall and rise?

The Indian stock market can be considered a financial tree that keeps giving the fruits of various investments. Some prefer to invest in simple financial instruments such as Mutual Funds, while some look towards high-risk, high-reward instruments such as Equity. For more seasoned investors, investing in the financial market moves a step ahead with Bonds.

If you are an active stock market trader or new to the investing world, you can consider bonds as a new profit-making option. However, as many factors can influence the fall and rise in bond yields, it is vital to understand bonds and their affecting factors as a prerequisite.

What are Bonds?

IPOs help a company raise funds to cover its operational activities. But, what if it needs more funds in the future?

An ideal way for companies or the government to succeed in raising capital is by issuing Bonds. They are debt instruments, which implies that they work on the principle of loans, where a company issues bonds to borrow money from the lender, also called the bondholder. The lender is promised a regular predetermined interest by the company on the principal amount. In bond terms, this interest rate is called a coupon.

Coupon vs Yield: What’s the difference?

Similar to an interest rate on a Fixed Deposit, bonds, too, come with a fixed interest rate known as a Coupon rate which is declared on the face value of the bonds that remains constant until maturity.

The formula for coupon rate is Interest / the bond’s face value.

However, just like IPO shares, once the bonds are issued, they enter the secondary market and are left at the hands of the demand and supply forces to determine their current price. Bonds yields are the return you get on the bonds.

For example, if you purchase a 10-year bond of Rs 10,000 with a coupon rate of 5%, the bond will pay you interest of Rs 500 every year. However, the yield depends entirely on the price of the bond you purchase from the secondary market (inverse relationship). For the same example above, if the bond price in the secondary market falls to Rs 6,000. Your yield at the same coupon rate of 5% will be 8.33%.

How do bond yields fall and rise?

Similar to everything else in the secondary market, bond yields also depend on the supply and demand equilibrium. Bonds yield has an inverse relationship with bond prices. For example, if you have a bond with a 5-year maturity, a 5% coupon rate, and a face value of Rs 10,000. Each year the bond will pay you interest of Rs 500. Now, if the interest rates in the market rise above 5%, investors will not buy your bonds but buy the new ones that come with an interest rate higher than 5%. As a result, you will have to lower the price of your bond to increase its yield. When you lower the price, the coupon rate increases because of the lower face value, thus increasing the bond’s yield.

This is how bond yields fall and rise based on the prevailing interest rates in the market.

Correlation between bond price movement and the stock market

Bonds prices and stock prices have an inverse relationship with each other. If a company is doing well financially, the demand is high, the cash flow is good along with the economy, the company’s stock can provide good returns to the investor. Hence, the investor will buy stocks over bonds. However, if the economy is slow and people are left with less disposable income, the company’s sales may suffer, prompting the stock price to fall. In this case, investors may buy bonds for regular interest rather than invest in volatile stocks.

As a result, the only way to attract investors at a time when stock prices are rising is to lower the bond prices and increase competitiveness.

What are the implications of rising bond yields in India?

Rising bond yields put immense pressure on the prevailing interest rates, forcing the lending rates to go higher. The RBI tries to regulate the bond yields and aims to keep them lower to reduce the borrowing costs for the government and limit the rise in the lending rates. Hence, the implications of rising bond yields in India may increase the rate of borrowing for the government and the citizens.

Understanding the factors that affect the bond yields' fall and rise is vital in the process of being a bond investor. You can look towards bonds as an ideal way to diversify your portfolio and hedge against volatile stocks to keep your portfolio healthy. To know more, you can consult the financial experts at IIFL.