Why RBI wants moderate bond yields?

Context:

The yield on the 10-year benchmark 5.85%, 2030 bond fell by 0.62% and closed at 5.978% (compared to 6.01% on the previous day).

The Reserve Bank of India (RBI) had stepped up purchase of government securities under the government securities acquisition programme (G-SAP) which led to the yield on the benchmark 10-year bond falling below 6%.

Relevance:

GS-III: Indian Economy (Growth and Development of Indian Economy, Mobilization of Resources)

Dimensions of the Article:

1. What are Bonds?
2. What is Bond Yield?
3. How have bond yields moved recently?
4. Why are bond yields softening?
5. What has been/will be the impact on markets and investors?
6. Why is the RBI keen on keeping yields in check?

What are Bonds?

• A bond is like an IOU. The issuer of a bond promises to pay back a fixed amount of money every year until the expiry of the term, at which point the issuer returns the principal amount to the buyer.
• When a government issues such a bond it is called a sovereign bond.
• Governments issue bonds as part of their borrowing programme.
• By purchasing a debt instrument like bond, an investor becomes a creditor to the corporation (or government).
• A bond is a financial security issued by a borrower to avail long term funds.
• Thus, a bond is like a loan: the holder of the bond is the lender (creditor), the issuer of the bond is the borrower (debtor). The primary advantage of being a creditor (by purchasing bonds) is that he has a higher claim on assets than shareholders do. That means, in the case of bankruptcy, a bondholder will get his money back before a shareholder.
• However, the bondholder does not have a share in the profits of a company.

What is Bond Yield?

• Bond yield is the return an investor realizes on a bond.
• The bond yield can be defined in different ways.
• Setting the bond yield equal to its coupon rate is the simplest definition.
• The current yield is a function of the bond’s price and its coupon or interest payment, which will be more accurate than the coupon yield if the price of the bond is different than its face value.

As bond prices go down – bond yields go up

• Now, seeing the increased bond yield, more and more buying of the bonds will ensue leading to increased demand of the bonds and we know that increased demand will command a higher price.
• So, an increased demand will propel the bond prices up thereby leading to a reduction in bond yield, which will further lead to reduction in demand.

How have bond yields moved recently?

• The yield on the 10-year benchmark 5.85%, 2030 bond fell by 0.62% and closed at 5.978%. It closed under 6% for the first time since early February 2021.
• In April 2021, the RBI launched G-SAP under which it said it would buy Rs 1 lakh crore worth of bonds in the April-June quarter and since then he 10-year bond has declined 15 basis points from 6.15% in one month.

How is this significant?

• Movements in yields, which depend on trends in interest rates, can result in capital gains or losses for investors. If an individual holds a bond carrying a yield of 6%, a rise in bond yields in the market will bring the price of the bond down. On the other hand, a drop in bond yield below 6% would benefit the investor as the price of the bond will rise, generating capital gains.

Why are bond yields softening?

• The fall in bond yields in India could also be due to a sharp decline in US Treasury yields or the economic uncertainty caused by Covid-19.
• But the most important driver of the bond market was RBI interventions. The announcement of a bond-buying programme – G-SAP — at the start of the month played a crucial role in turning the market sentiment.
• The RBI continued to send strong yield signals by cancelling and devolving government debt auctions. In the last month alone, the RBI cancelled more than Rs 30,000 worth of debt auctions.
• Although part of this amount was offset by availing the green-shoe option (option to accept bids for more than the notified amount of debt auction) in other securities, the decision to buy Rs 35,000 crore worth of bonds in May would help the market absorb a portion of the Rs 1.16 lakh crore market borrowings by the government during the month.

What has been/will be the impact on markets and investors?

• Experts say the structured purchase programme has calmed investors’ nerves and reduced the spread between the repo rate and the 10-year government bond yield.
• A decline in yield is also better for the equity markets because money starts flowing out of debt investments to equity investments. That means as bond yields go down, the equity markets tend to outperform by a bigger margin and as bond yields go up equity markets tend to falter.
• In the past 5 years since late 2012, the benchmark 10-year yields are down by almost (- 17%) and have been moving consistently downward, despite occasional hiccups. At the same time, the Nifty is up by nearly 82%.
• It says the yield on bonds is normally used as the risk-free rate when calculating the cost of capital. When bond yields go up, the cost of capital goes up.
• When bond yields go up, it is a signal that corporates will have to pay a higher interest cost on debt. As debt servicing costs go higher, the risk of bankruptcy and default also increases and this typically makes mid-cap and highly leveraged companies vulnerable.

Why is the RBI keen on keeping yields in check?

• The RBI has been aiming to keep yields lower as that reduces borrowing costs for the government while preventing any upward movement in lending rates in the market.
• The RBI wants to keep interest rates steady to kick-start investments. A rise in bond yields will put pressure on interest rates in the banking system which will lead to a hike in lending rates.
• If yields come down, the RBI will be able to bring down the cost of government borrowing for 2021-22, which is set at Rs 12.05 lakh crore.

-Source: The Hindu