Bond Prices and Bond Yield
Bonds are financial instruments issued by governments or corporates to raise money. Main components of a bond are its face value or price, yield on the bond and maturity date.
Bond prices and bond yield move in opposite direction. To understand this, consider a bond issued in 2020 with face value INR 1,000 at a coupon rate of 10% for a 10-year maturity period. The interest, paid annually for this bond would be Rs 100.
Now consider that in 2021 (one year after the bond was issued), interest offered by a similar instrument is 12%. For the holder of the first bond selling the bond in the market at 10% interest rate and face value Rs. 1000 would be difficult. Buyers would be willing to purchase the bond only if can effectively pay out a 12% interest. Since the nominal value of the interest payment will remain the same, that is, Rs. 100 (since it was decided on the face value of Rs. 1000), for this to fetch a 12% interest, the value of the bond would need to come down. In this example, the current holder of the bond would need to offer the bond at a discounted rate of Rs. 833.33 so that the interest payment of Rs. 100 amounts to 12% rate of interest, which is what is currently prevailing in the market. For more clarity, see the table below:
There are multiple other factors, apart from the prevailing interest rate that affect bond prices and bond yields. Some of these are given below:
When inflation is high, the real return on investment goes down. As a result, the investors or buyer will ask for a greater yield to cover for inflation. Since prices and yield move in opposite direction, price of the bond will go down.
For example, if a bond pays a 7.25% yield and the current inflation is 5%, the bond’s real rate of return is 2.25%. However, if the inflation increases to 6%, the real rate of return falls to 1.25%. In this case the new buyer of the bond will only purchase the bond, if its effective or real return covers for the rise in inflation. Thus, for the bond to provide the real rate of return that it was originally providing, price of the bond would need to fall. Hence, when inflation increases, bond yields go up and bond prices come down.
When the economy is gearing itself to grow, that is government is investing in new infrastructure projects and incentivizing corporates to expand, there would be greater demand on the part of government and corporates to raise money and finance various projects. In such a case, yield on the bond offered would be higher, in order to attract investment. Thus, when economy is growing, with controlled inflation, bond yields go up.
However, as the economy overheats, inflation might go up. When the economy reaches this stage, as discussed before, the real return on investment will begin to fall for the holders of the bond and for them to sell it again in secondary market, they would need to reduce the price of the bond.
Changes in Stock Market
Stock and Bonds are considered as competitors as they are both competing to get the investor’s money. Thus, if one is performing better than the other, it would become more attractive for the investor and thus, would have a higher demand. When the stock market is performing better, demand for bonds will go down. If the current owner of the bond would want to sell it in the secondary market, they would need to lower the bond prices. As seen earlier, a drop in bond prices, implies an increase in bond yield. To understand this intuitively, let’s take our previous example – say the current holder of Rs. 1000 @ 10% bonds wants to sell his holding in the secondary market. Since there are few bond takers, to attract them, the current holder would have to lower the price. Say the current holder is now willing to sell the bond at a discounted rate of Rs. 850. At 850, the bond will continue to fetch an annual return of Rs. 100. This is because this return was decided at the face value of the bond and not the current value. Now the bond valued at Rs. 850, pays off Rs. 100 as interest, thus bring the yield to 11.8%. Hence, when stock market performs better, bond prices go down and bond yields go up.
Credit rating of a bond signifies how safe it is to invest in a bond and what are the changes of it defaulting. There are various independent credit rating agencies that rate a bond, like Standard & Poor’s, Moody’s, and Fitch. Bonds that are considered as high risk, offer higher yields at lower prices in order to attract investors. However, as the credit rating of a bond goes up, its demand would rise leading to an increase in its current value and thus an effective lowering of its yield.