A bond is a financial instrument through which a company or government borrows money from the investors at a fixed rate of interest.
Effectively, when you are buying a bond, you are lending money to the Government or the company.
To illustrate– a company wants to borrow Rs.100 for 10 years. It can issue a bond of Rs.100. These bonds will be bought by investors.
The company will have to pay an interest rate to the investors. (let’s say 10 % of Rs.100 or Rs.10 yearly).
The company will also have to repay Rs.100 to the holder of the bond at the end of 10 years.
Rs.100 is the face value of the bond.
This interest rate of 10 % is called the coupon rate. The interest is calculated on the face value of the bond which is fixed. Therefore, the interest payment on bonds is also fixed. (10 % of Rs.100)
10 years is the maturity period of the bond.
Bond yield meaning
Bond yield is the amount of return realised on a bond
As mentioned, bond yield is the amount of return realised on a bond.
Continuing with the above illustration, we know that the investor bought the bond for Rs.100. The interest rate is fixed at Rs.10. Therefore, bond yield or return = (10/100) * 100 = 10 %
But, it is not necessary that the buyer of the bond/ investor will hold the bond for the maturity period of 10 years. The bond can be bought and sold in the secondary bond market.
So let’s assume the investor sells his bond for Rs.90. (because the price of the bond has decreased)
It means that the new bondholder has bought the bond for Rs.90.
As we know, the interest rate is fixed at Rs.10. Therefore, bond yield or return = (10/90) * 100 = 11.1 %
We have seen that if the price of bond decreases (from Rs 100 to Rs.90), the bond yield increases (from 10 % to 11.1 %) and vice versa.
Hence, there is an inverse relationship between bond yield and bond price.
We read in the newspapers that the bond yields in India have increased. It implies that the bond prices have fallen.
Higher yields also mean higher risk. Investors want higher yield to compensate for the increased chance of default.
Update 28/01/2022: India’s 10-year yield hits 25-month high. India’s benchmark 10-year bond yield rose to 6.73%, up 7 basis points from its previous close and its highest level since Dec. 19, 2019. The bond yield has increased in anticipation of the increase in interest rates by the Fed. When fed increases its interest rates, bond yield in emerging countries increases as well to compensate for higher returns in the US.
[You may also read: Quantitative Easing and Taper Tantrum- Explained]
To sum up, we have calculated bond yield as per the coupon rate of the bond (Rs.10). There are other ways to calculate yield like yield to maturity (YTM), bond equivalent yield (BEY) and effective annual yield (EAY).
Yield curve
The bonds of different maturity periods sell at different yields.
If this relationship between yield and maturity is plotted graphically we get a yield curve.
Normally it is is positively slopping as bonds with longer maturity are sold at higher yields. For instance- 10-year bonds are sold at a higher yield than 5-year bonds . This is because investors demand a higher yield to be compensated for taking a higher risk by investing in longer-term bonds. (it takes longer to recover).
But, we can have a negatively sloping and flat yield curve also in some circumstances.
[As a side note, the difference between different bonds is known as yield spread. Eg- difference between 10-year Government bond and corporate bond is spread]
- Normal or positively sloping yield curve: It implies that people expect yields on longer-term bonds to continue to increase in the future. They hold-off purchasing longer-term bonds in expectations of higher yield in the future. Therefore, there is a greater demand for short-term bonds. The price of short-term bonds increases. and hence their yields become even lower. In sum, people expect yields on longer-term bonds to increase further. This happens in the expectation of higher economic growth or inflation. (When the difference between the yields on short-term bonds and long-term bonds increases, the yield curve becomes steeper. As we have gathered, a steepening yield curve means investors are optimistic about the economy)
- Inverted or negatively sloping yield curve: It implies that people expect yields on longer-term bonds will fall in the future. This happens in expectation of economic recession or lower inflation. Therefore, they buy more long-term bonds to lock-in the fixed rate of interest in expectation of a decrease in yield. There is a greater demand for long-term bonds and their yields decline further.
- Flat yield curve: It means that there is no gap in the yields on short-term and long-term bonds. It can happen in case of a transition from normal to inverted yield curve or vice-versa.
[Update 28/01/2022: Yield curve in the US has flattened to levels not seen since 2019-20.]
Expectations of sooner-than-expected rate increases have pushed short-term yields higher in recent days. Longer-term ones have fallen in part due to bets that a potentially more hawkish rate policy will successfully tamp down inflation. (Basically, investors expect lower inflation in the future as the Fed is increasing rates to control inflation. Hence, yield curve is flattening)
Source: //www.reuters.com/business/why-is-yield-curve-flattening-what-does-it-mean-2021-11-01/
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Why does the price of bond decreases from 100 to 90?
The price is determined by the forces of demand and supply. If the demand for a bond decreases, its price will decrease.
One of the reasons for the decrease in demand can be an increase in interest rates in the economy. We have gathered from the article that the interest on a bond is fixed. If the interest rate rises, the demand for that bond declines as it generates a low interest in comparison. Hence, its price decreases. It causes yield/ return to increase. (price and yield have an inverse relationship.)
Thank you so much…
How does a increase in interest rates in the economy generates a low interest in bonds? Does it has anything to do with purchasing power of investors which reduces with increase in interest rate, hence reduces demand for a perticular bond?
If interest rates in the economy increase, bonds become less attractive in comparison. A person would rather keep his money as fixed deposit than investing in bonds if there is no difference in interest rates.
I am not able to relate increase in bond yields with inflation. Does it has anything to do with purchasing power of investors, as it reduces with inflation?
The bond yield is nothing but the return on bonds. If investors expect inflation to rise in the future, the return of long-term bond should also increase to compensate for higher inflation. Therefore, the investors will not buy long-term bonds now at a lower yield (higher price) as they expect higher inflation and, hence higher bond yield (lower price) in the future.
Note: If all other factors are constant, the interest rate/ return on any investment increases with the inflation rate. Investors are concerned about the real interest rate. The real interest rate is the nominal interest rate minus inflation.
Very nice and lucid explanation. Thanks
Keep reading 🙂
How does the difference in yield affects the Monetary Policy of RBI?