In recent months, the average yield for government securities in India is going up. This trend deepened after the budget 2022.
If you would like to grasp the topic, start from the scratch. Concepts like government bond, yield, bond price etc are to be understood well.
Following points will help to understand yield better.
- What is a government bod?
A government bond is a debt instrument issued by the government to borrow money from the market. They are issued in bulk to financial institutions. For example, in this year’s budget (2022), there is a fiscal deficit of Rs 1661196 crores and out of this, nearly Rs 1158719 crore will be mobilised by the government through selling of bonds.
- How are the bonds issued? What is coupon yield?
When the government auctions the bonds there will be a fixed rate of interest (e.g., 6%) called coupon. This also can be termed as coupon yield (there are different types of yields).
- Yield of a newly issued bond-calculation
Imagine that the investor bought a ten-year government bond at a price of Rs 100 at a coupon rate of 6%.
Here we can estimate the yield
Yield is (6/100) x 100 = 6%
It’s over about the newly issued bonds.
- Yield of an already issued bond and yield to maturity.
Now we are coming to see the most popularly referred yield that is applicable when people are selling the initially purchased bonds in the secondary market.
- Determination of bond price
Remember, nobody is going to keep the bond he bought till the end of the maturity period say 10 years. He is going to sell the bond at a higher price or when he needs funds.
- At what price he can sell the bond? He already spends Rs 100. The price depends on lot of factors. The most important one is the current market rate of interest.
- Suppose that the current market rate of interest goes up to say 8%. This means that from the bond, the investor gets just 6% whereas other investments like bank deposits have an interest rate of 8%.
- In this context, nobody will be ready to purchase the bond at Rs 100, rather he should reduce the price based on market estimations. He may be selling the bond at a price of Rs 90. Here, the bond is discounted by Rs 10. This is because the overall interest rate in the economy has gone up.
- Now, what is the yield of this 10-year government security when its is sold in the secondary market?
Yield is (6/90) x 100 = 6.6%
Understandably the yield has gone up.
It is this increasing bond yield trend that we witnessed after the budget 2022.
- Relation between market interest rate and bond price
- Now we get into a conclusion, when the market interest rate or the overall interest rate in the economy goes up, the yield for bonds goes up. Or in other words, there is inverse relationship between bond price and bond yield.
There is a rising trend of interest rate in the economy caused by multiple factors including higher inflation and lower availability of funds.
- What are the factors that caused higher yields in government securities recently?
- Lower price for bonds due to higher interest rate trends.
- Higher supply (ambitious borrowing target by the government) of bonds: Higher volume of bonds in the market due to the higher borrowing target by the government. higher the supply, the government will be compelled to offer higher interest to sell the bonds.
- Lower demand for bonds: Foreign investors are quitting the bond market because the US is going to increase their interest rate.
The rising interest rate trend and lower prices have increased yield of government securities.
Now, when the yield is increasing what it shows about the economy?
One leading indicator is that it shows the market reads the government’s borrowing as very high.
Similarly, it shows that there is stressed fund availability in the economy.