Bond & Bond yield meaning
A bond is a financial instrument through which a company or Government borrows money from the investors at a fixed rate of interest.
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 the 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 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 also called coupon rate. The interest is calculated on the face value of the bond which is fixed. Therefore, the interest payment is also fixed. (10 % of Rs.100)
10 years is the maturity period of the bond.
Bond yield meaning
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 %
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.
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 repay).
But, we can have negatively sloping and flat yield curve also in some circumstances.
- 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 expectation of higher economic growth or inflation. (When the difference between the yields on short-term bonds and long-term bonds increase, the yield curve becomes steeper. As we have gathered, 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
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