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Bond yield is the return an investor can expect to earn by holding a debt security until it matures. Read more.
It is a common preference among risk-averse buyers to invest in the bond market to diversify their investments and balance the risk.
Bond yield is something that a lot of investors look at when they are researching potential bonds to buy. This article will help you better understand the definition of bond yield and its relation to bond price and the stock market.
Bond yield: What is it?
A bond yield is the money an investor gets back from buying a bond. The yield on a bond is not the price of the bond. In fact, they are inversely correlated.
There are several ways to find the yield on a bond, such as the coupon yield and the current yield. Among other things, yield to maturity (YTM) is another way to figure out a bond’s yield.
When someone buys a bond and keeps it until it matures, the yield to maturity shows them how much they are likely to earn. Meaning the bond is not traded on the secondary market by the investor. Instead, they wait until the bond matures before selling it.
As a result, the yield to maturity of a bond accounts for both the value at maturity and all anticipated future cash flows through maturity, including interest due. If you look at the present value of these future cash flows, they match the bond’s current price. This is called the YTM.
Below is a chart of the India 10 Years Government Bond yield of 7.193% (as of 18 April, 2024).
Example of bond yields
For example, if an investor invests in a bond with a face value of ₹10,000 and a yearly coupon rate of 8%, the bond will pay ₹800 in interest annually. If bond interest rates rise above 8%, the investor will have to sell the bond at a lower price.
The relationship between bond yield and bond price
Contrary to popular belief, there is a relationship between the bond yield and the bond price. An increase in bond price means a decrease in yield and vice-versa. Bonds with low prices and high values are usually preferred for investing.
But when you want to sell them, you might wait for their market value to increase. You might want higher bond rates instead if you are considering keeping the bond until it matures so that your total returns stay high.
How to calculate bond yield?
The easiest way to figure out the return on a bond is to divide the coupon payment by the bond’s face value. To put it in a formula:
Bond yield (coupon rate) = Annual coupon rate / Bond face value
For instance, a bond with an ₹2,000 face value would pay ₹400 in interest or coupons every year. This means that the coupon rate is 20%, or ₹400 divided by ₹2,000.
The connection between bond yields and the stock market
- Yields on bonds and the cost of capital
Companies need a certain rate of return to cover the opportunity cost of borrowing money. This rate is called the cost of capital (COP). It figures out how much people are willing to risk that their money won’t earn as much as they thought it would.
How much it costs for businesses and buyers to borrow money is largely based on bond rates. Government bond interest rates, which are usually higher than those on government assets, are what drive corporate bond yields.
- The yields on bonds and foreign funds
Let’s say that at a certain point in time, the yields on Indian bonds are higher than those on the international bond market. Investors from around the world will find Indian debt more appealing than global debt.
Additionally, if the debt market seems more appealing than the stock market, foreign institutional investors (FIIs) will move their money towards the stock market.
- Opportunity cost
A higher opportunity cost may make buying in stocks less appealing if bond yields rise high enough to beat the profits from stocks.
Conclusion
It is essential that you, as an investor, comprehend the various methods used to calculate bond yields. Also, it gives you a good idea of when to sell your bond if you don’t want to keep it until ten years have passed. Knowing what bond yield means can help you make better financial choices in general.
FAQs
In India, when bond yields rise, it indicates an increase in borrowing costs for the government and businesses, as they have to offer higher interest rates to attract investors. This can lead to a shift in investor preference from equities to bonds, potentially causing a dip in the stock market. For existing bondholders, the value of their bonds decreases, as bond prices and yields are inversely related. Higher yields may also reflect investor concerns about inflation or fiscal deficits.
Bond yield, specifically the Yield to Maturity (YTM), represents the annual return an investor can expect if they hold the bond until maturity, considering the current price, face value, and coupon payments. The interest rate, or coupon rate, is the fixed percentage of the bond’s face value that the issuer agrees to pay the bondholder annually. While the interest rate remains constant, the bond yield fluctuates with changes in the bond’s market price.
High bond yields in India can be both good and bad. They offer the potential for higher returns on investment compared to lower-yielding bonds, which can be attractive to investors seeking income. However, high yields often come with higher risks, including the risk of default, especially if the economy enters a recession. Investors need to balance the desire for higher returns against the increased risk associated with high-yield bonds.
Buying bonds when interest rates are high can be beneficial for long-term investors who anticipate a decrease in rates in the future. High-interest rates offer attractive coupon rates and the potential for capital gains if bond prices rise when rates fall. However, investors should be mindful of reinvestment risk and inflation risk, as these factors can affect the real return on bonds over time.
Bond yields in India fall due to various factors, such as a decrease in interest rates by the Reserve Bank of India (RBI), increased demand for bonds, or a positive outlook on the economy. Additionally, government interventions, such as open market operations or policy changes, can also lead to a decrease in yields. Lower yields often indicate a preference for safer investments and can be a sign of economic uncertainty.