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  • What can you learn by tracking bond yield movements?

    Publish date: 11th July, 2018

    India's 10-year benchmark bond yield sprinted to 7.99 per cent, it is the highest in three years, on June 7, 2018 after the Reserve Bank upped the benchmark rate by 25 basis points. The bond yield was last seen at the same level in May 2015.

    So for a fixed-income investor who invests in bonds to get regular interest payments, this increase in yield can be described as painful.

    Why, exactly?

    To most people, the language of bonds is tricky to grasp initially. The first, and most important concept you need to understand when discussing bonds is that bond prices and bond yields have an inverse correlation. When the bond market has a bad day, the newspapers and TV channels tell that bond yields rose. And then when bond market rally back, they report that yields fell.

    So how does it work?

    Let’s make it easier for you. Consider a company issued a bond (X) in 2017 with coupon of 10 per cent. Now a year later, interest rates have risen, and the same company issues a new bond (Y), but with a coupon of 12 per cent. Now why would an investor purchase bond X with 10 per cent yield when bond Y with 12% yield is available? Since the coupon is fixed, the price of bond X must fall to attract investors. Now, what would have caused the interest rate to rise?

    Bond yield, inflation and interest rates

    Inflation and interest rates have a direct relationship with bond’s yield. A rise in expected inflation would increase the market interest rates which would in turn increase the bond yields. Here’s how? Inflation reduces the purchasing power of each interest payment a bond makes. Thus, the investors worry about their bond yield keeping up with the rising cost of inflation. As a result, the price of bonds drops because of the fall in its demand.

    Related: How interest rates affect equity markets

    High bond yields make equities look expensive, thus impacting the equities market as well. Thus, the bond prices can fall. Similarly, macroeconomic factors like recession, bank rates set by central governments and unemployment etc. have an impact on bond yields.

    Related: 4 macro-economic factors that can affect corporate profits in FY18-19

    Why should you care?

    Now you may be thinking, “I’m not a bond investor. Why should I care what bond yields are doing?” That’s a fair question. The reason you should care is because bond yields are a good indicator of how strong the stock market is. Looking at the bond yield movements, one can make sense about market’s predictions regarding the future of economic health. One can also analyse bond yields to predict the direction of equities and prices of almost everything.

    Stock market and bond yields

    The influence of bond yields on stock market depends on different economic conditions. It also acts differently for government as well as corporate bonds. For example, in the case of corporate bonds, if a company is making regular coupon payments means it has a decent cash flow and that their inventory is moving (not sitting idle). Moving inventory is an indication of a consistent revenue which leads to regular coupon payments. This signals that it can become debt-free as per the payment schedule. This in turn can lead to rising stock prices.
    Furthermore, stock prices and bond prices move in opposite direction when the economy is healthy or shows signs of expansion. Economic growth brings with itself market optimism i.e. higher valuation of stocks. But it also brings with itself a rising inflation expectation. This causes the interest rates to rise which requires the company to pay higher interest rates if it has to borrow. Therefore, the newer bonds are more in demand as they have higher interest rates. This causes the bond prices to go up and bond yields to go down.
    This is another topic for discussion. We will explain this in depth in our next piece. You can keep a track of it here. Until then, you may want to read: