Context: The yield on 10-year government bonds in the US, the benchmark for asset prices across the globe, rose to hit 5.02 per cent, its highest level since July 2007. The yield of the Indian 10-year benchmark Government Security (G-Sec) also hardened to 7.50%, tracking the rise in US Treasury yields, which are reacting to expectations of heavy bond supply due to a jump in the fiscal deficit, continuing price pressures.
Bond is debt instrument issued by governments and corporates to raise capital. The value at which the bond is issued is regarded as its face value and the value at which the bond is traded in the secondary market is referred to as its market value.
The return received by the investor on the capital invested on a particular bond. The yield of the bond depends on the market value of the bond.
- If the market value increases above the face value of bond (the price at which it is purchased in the primary market when it was issued), then the rate of returns on the purchase of the bond in secondary market decreases. This phenomenon is often known as softening of bond yields.
- On the other hand if the market value decreases below the face value of the bond, then the rate of returns on the purchase of bond in secondary market increases. This phenomenon is known as hardening of bond yields.
Demand for the bonds
|Market price of the bond decreases||Market price of the bond decreases|
|Bond Yield increases (Yield hardening)||Bond yield increases (Yield softening)|
|Reasons: Increased InflationSale of G-secs by the central bank under open market operationsIncreased borrowings by the government (Increased fiscal deficit)||Reasons: Deflationary trends in the economyPurchase of G-secs by the Central bank under open market operationsReduced borrowings by the government|
|Loss to the bond holder||No loss to the bond holder|
Impact of hardening of bond yield
- Loss to the banks: Since commercial banks in India hold significant size of g-secs owing to their SLR requirements and LAF purposes, increasing bond yield as a rise in yields leads to a fall in bond prices and therefore these losses have to be booked by the banks.
- Loss to the mutual funds: Mutual funds holding significant size of g-secs also face similar losses.
- Increased cost of borrowings:
- Higher yield on G-secs would mean that the government will have to offer higher interest rates on fresh borrowings.
- Corporates also need to increase interest rates on their bonds as result of increasing bond yields in the market. Since Indian banks follow interest rates of long term G-secs to fix their lending rates, hardening yields of g-secs may increase their lending rates as well.
- Impact on equity market: As bond yields rises, the opportunity cost of investing in equities goes up and therefore equities become less attractive.