Bond Yields are Rising
WHAT’S HAPPENING?
India’s bond yields are rising at the fastest pace since the 2008 global financial crisis, As investors bake in the likelihood of stubborn inflation and higher-than-budgeted federal borrowing, outcomes that could prompt the central bank to raise policy rates more quickly than initially anticipated.
The yield on benchmark 10-year government bonds has shot up by 149 basis points to 7.50% in the last one year. Since the start of the year, long-term yields have risen by over 100 bps, and short-term yields by over 150 bps. Bond yields have been rising across the world amid higher inflation and plans for policy normalisation.
WHAT IS G-SEC?
G-secs, or government securities or government bonds, are instruments that governments use to borrow money. Governments routinely keep running into deficits — that is, they spend more than they earn via taxes. That is why they need to borrow from the people. But G-secs are different from everyday lending between two private individuals or entities.
For one, G-secs carry the lowest risk of all investments. After all, the chances of the government not paying back your money are almost zero. It is thus the safest investment one can make. The other ways in which G-Secs are different are in the manner in which they are structured, and how their effective interest rates (also called yields) are calculated.
HOW YIELDS ARE CALCULATED?
G-sec yields change over time; often several times during a single day. Every G-sec has a face value, a coupon payment and price. The price of the bond may or may not be equal to the face value of the bond. Here’s an example: Suppose the government floats a 10-year G sec with a face value of Rs 100 and a coupon payment of Rs 5.
If one were to buy this single G-sec from the government, it would mean that one will give Rs 100 to the government today and the government will promises- To return the sum of Rs 100 at the end of tenure (10 years), and Pay Rs 5 each year until the end of this tenure. At this point, the face value of this G sec is equal to its price, and its yield (or the effective interest rate) is 5%.
Imagine a scenario in which the government floats just one G-sec, and two people want to buy it. Competitive bidding will ensue, and the price of the bond may rise from Rs 100 (its face value) to Rs 105. Now imagine another lender in the picture, which pushes the price further up to Rs 110. But here is the crucial thing: the coupon payment on the G-sec is still Rs 5.
So, if you bought the bond at Rs 100, then the yield is 5% but if the price of the bond goes up to Rs 105 then the yield will fall; It will become 4.76% because the second person will be getting Rs 5 over an investment of Rs 105. Further, if bidding leads to the price going to Rs 110, then the third person will find that the yield has fallen further to 4.54%; Because the third person would have invested Rs 110 for the same return of Rs 5.
WHAT DO YIELDS SHOW?
As such, they are a good way to figure out the broader trend of interest rates in the economy. It is known that when it comes to lending, interest rates rise with the rise in risk profile. As such, if G-sec yields start going up, it means lending to the government is becoming riskier.
If you read that the G-sec yields are going up, it suggests that the bond prices are falling. But the prices are falling because fewer people want to lend to the government. And that in turn happens when people are worried about the government’s finances (or its ability to pay back). The government’s finances may be in trouble because the economy is faltering and it is unlikely that the government will meet its expenses.
Q. Which of the following is a long term source of finance?
A) Commercial Paper (CP)
B) External Commercial Borrowings (ECB)
C) Factoring
D) Line of Credit (LOC)