Focus: GS-III Indian Economy, Economic Development
Why in news?
- There is a growing expectation in the domestic market that the Reserve Bank of India will be cutting the repo Rate after the U.S. Federal Reserve reduced interest rates on 3rd March 2020, to fight the economic slowdown due to the spread of COVID-19.
- Bond yields softened on 4th of March amid these rate cut hopes, with the yield on the 10-year government bond dropping 12 bps to close the day at 6.23%.
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.