BONDS AND YIELDS - WHAT IS THEIR RELATIONSHIP?

By Ruma Dubey

The real panic is actually in the Indian bond markets. Yields have crossed 9% and these are yields which we saw on bonds of Greece and Italy when they were at a risk of default. So is India also turning to junk; at least that is what the rising yields are currently indicating? The mayhem in the stock markets is a residue of the bond market and money market panic.

For most of us understanding this bond market and its yields is often like a Rubik’s cube – you quite know it but do not really get it. So to understand this current situation better, a quick understanding of this bond market dynamics.

What is the co-relation between bonds and yields?

They both, the price of the bond, which is the face value of the bond is inversely proportionate to the yields. Imagine the price and yield sitting on a see-saw. When price goes up, yield will come down and when price goes down, yield will come down. This is probably the most simplistic way of understanding this concept.

What about interest rates and bond markets?

Interest rates and yields move in the same direction, so that naturally means interest rate and bond price move in opposite direction.

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How to calculate bond yields?

It is simple math – coupon rate/face value of bond.

Suppose you have a Rs.1000 face value bond and coupon rate of 7%, then the yield is 70/1000 = 7%.

How to co-relate interest rate, yields and bond prices?

An increasing bond price means yields will be going down. And when will bond prices rise? When there is demand. And when will the demand for bonds rise? Demand for bonds rise when people seek safer havens – that is usually how this works. And demand drops when other markets are safer. But then how does one explain the scenario today or in Spain then? Today, Indian stock markets are pounded down to pulp and there are no safe havens around. But this is a scenario where there is panic all around and thus even the bonds stop being safe havens. Ditto for Spain scenario. Yet, only in the US, despite all the other markets sinking, demand for US Treasury Bonds remained high – this is because despite the economy being in shambles there was faith that ultimately the dollar will bounce back and yields will improve. At the end of it, even bonds at some point of time, reflect more of sentiments.  

How do yields give an indication of the stock markets?

If yields go up, it means there is trouble on the horizon and this always indicates a negative market condition.  Yield and risk go hand-in-hand. Higher the yield, higher is the risk – so you get paid as per the risk in the market.

How does this affect you as a trader and as an investor?

Bonds are traded in the market unlike a fixed deposit, which is why yields and interest rates need to be taken into account. When bonds are traded in an open market, yield will be the profit which you make on the purchase of bond. Thus when bond prices rise, yields will fall and that will make purchasing the bond in the open market much attractive as the face value would have got adjusted upwards to adjust the lower yield.

For eg: Suppose you have purchased a bond A with a coupon rate of 6% and face value of Rs.1000 for 10 years. Your yield is 6%. Interest rates fall by 1% and bond B is issued at 5% coupon rate with face value of Rs.1000. So bond B gives you a yield of 5%. So in the open market, you get bond A with a coupon rate of 6% and another bond B with 5% coupon rate. Naturally, you will buy bond A. Thus demand rises, yield falls to adjust to 5%. So when you purchase bond A, which now gives a yield of 5% though coupon rate remains the same at 6%, the face value of the bond will adjust upwards to Rs.1200.

Now lets take a scenario where interest rates and yields are going up. Bond A is issued at a coupon rate of 6% with a face value of Rs.1000 and yield is 6%. Rates are hiked to 7% thus yield also moves to 7%. The face value now has to adjust downwards to accommodate the higher yield , working out at Rs.857.

So if you are a trader, in a rising yield scenario, it makes no sense to buy the bonds now as you fear prices will only go down further. Thus you find more traders dumping bonds as there is fear of your entire capital getting wiped out – your Rs.1000 principal amount is now quoted lower at Rs.857 and you are suffering a loss of Rs.143 per bond and when going ahead, there is fear of this loss only widening. This explains why traders dump bonds in a rising yields market.

But if you are a long term investor, who wants to stay put in the bond for its 10-year maturity period, you are as such assured of your principal remaining intact – you are sure to get back your Rs.1000 per bond. So if today, the face value of the bond is Rs.857 and you expect that in 10 years, interest rates would be much lower than what they are today, surely it makes sense then to buy the bonds.  That apart, you are Rs.143 less for a 7% coupon rate bond when you could see interest rates at 5-6% in the next few years.  Thus if you have faith that economy will bounce back in the next 8- 10 years and rates will come down from the current levels, only then can you invest in the bonds today.