Falling Bond Yield

• 07 May 2021

Why in News

Recently, the Reserve Bank of India’s (RBI) decision to step up purchase of Government Securities (G-Sec) under the Government Securities Acquisition Programme (G-SAP) led to the yield on the benchmark 10-year bond falling below 6%.

• In India, the yield of 10-year G-Sec is considered the benchmark and shows the overall interest rate scenario.

Key Points

• Bond Yield:
  
  • Bond yield is the return an investor realizes on a bond. The mathematical formula for calculating yield is the annual coupon rate divided by the current market price of the bond
    
    • Bond: Is an instrument to borrow money. A bond could be issued by a country’s government or by a company to raise funds.
    • Coupon Rate: It is the rate of interest paid by bond issuers on the bond's face value.
• Effect of General Movement of Bond Yields:
  
  • Movements in yields depend on trends in interest rates, it can result in capital gains or losses for investors.
    
    • A rise in bond yields in the market will bring the price of the bond down.
    • A drop in bond yield would benefit the investor as the price of the bond will rise, generating capital gains.
• Reason for Decreasing Bond Yields:
  
  • Due to economic uncertainty caused by Covid-19.
  • In April 2021, the RBI launched G-SAP which has caused a decrease in G-sec yields which has continued since then.
• Impact:
  
  • Better Equity Markets:
    
    • A decline in yield is also better for the equity markets because money starts flowing out of debt investments to equity investments.
      • Equity market: It is a market in which shares of companies are issued and traded, either through exchanges or over-the-counter markets. Also known as the stock market.
    • That means as bond yields go down, the equity markets tend to outperform by a bigger margin and as bond yields go up equity markets tend to falter.
  • Reduced Cost of Capital:
    
    • When bond yields go up, the cost of capital goes up. That means that future cash flows get discounted at a higher rate.
      
      • Discounting is the process of determining the present value of a payment or a stream of payments that is to be received in the future.
    • This compresses the valuations of these stocks. That is one of the reasons that whenever the interest rates are cut by the RBI, it is positive for stocks.
  • Reduces Risk of Bankruptcy:
    
    • When bond yields go up, it is a signal that corporates will have to pay a higher interest cost on debt.
    • As debt servicing costs go higher, the risk of bankruptcy and default also increases and this typically makes mid-cap and highly leveraged companies vulnerable.
• RBI’s Stand:
  
  • The RBI has been aiming to keep yields lower as that reduces borrowing costs for the government while preventing any upward movement in lending rates in the market.
  • A rise in bond yields will put pressure on interest rates in the banking system which will lead to a hike in lending rates. The RBI wants to keep interest rates steady to kick-start investments.

Government Securities Acquisition Programme

• About:
  
  • The RBI, for the year 2021-22, has decided to put in place a secondary market G-SAP 1.0.
    
    • It is part of RBI’s Open Market Operations (OMOs).
  • Under the programme, the RBI will commit upfront to a specific amount of Open Market Purchases of G-Secs.
• Objective:
  
  • To avoid volatility in the G-sec market in view of its central role in the pricing of other financial market instruments across the term structure and issuers, both in the public and private sectors.
• Significance:
  
  • It will provide certainty to the bond market participants with regard to RBI’s commitment of support to the bond market in Financial Year (FY) 2021-2022.
  • It will help reduce the difference between the repo rate and the 10-year government bond yield.
    
    • That, in turn, will help to reduce the aggregate cost of borrowing for the Centre and states in FY 2021-22.
    • Repo rate is the rate at which RBI lends money to commercial banks.
  • It will enable a stable and orderly evolution of the yield curve amidst comfortable liquidity conditions.
    
    • Yield curve: It is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates.
      
      • The slope of the yield curve gives an idea of future interest rate changes and economic activity.

Source:IE