Government bonds and bond yield

Government bonds and bond yield

Subject: Economy

Section: Fiscal Policy

Context:

The 10-year benchmark bond ended at 7.46%, after earlier reaching a high of

7.49%. The official said the government expects the RBI to conduct a switch operation, offering investors a chance to exchange their short-dated bonds for debt with a longer maturity, or to buy back government bonds within the next two weeks.

Concept:

Bonds are loans the one makes to a corporation or government. The interest payments remain largely unchanged over the life of the loan. Moreover, one receives the principal at the end of the loan tenure if the borrower doesn’t default.

Bond yield, on the other hand, is the return that an investor gets on that bond or on a particular government security.

Bond yield and bond prices:

A fall/rise in interest rates in an economy pushes up/pulls down bond prices. However, bond yields fall/rise in this situation.

This happens because if RBI, for example, decides to increase interest rates, the bond’s price (which is offering similar return as the current interest rates) would fall because its coupon payment is less attractive now on a relative basis. Therefore, investors would chase new bonds with better risk-free returns.

Causes of high bond yield:

• Higher government borrowing-Higher government borrowing through Issuance of securities, especially when inflation is high, will push up yields on bonds and result in a falling bond price.
• Inflation-
• Rise in repo rate- if RBI, for example, decides to increase interest rates, the bond’s price (which is offering similar return as the current interest rates) would fall because its coupon payment is less attractive now on a relative basis.
• Rise in Fed rate-capital outflows

Impact:

• Rising yields mean investors expect a rise interest rates and therefore, sell the bond papers they are holding thus, leading capital outflows and stock market crash due to outflow of funds from the equity market.

Measures:

Measures that would boost demand (leads to decline in bond supply or rise in price of bonds) for government bonds and keep yields in check:

• Increase the held to maturity (HTM) limit of banks substantially -The entire investment portfolio of the banks (including SLR securities and non-SLR securities) are  classified under three categories viz. ‘Held to Maturity’, ‘Available for Sale’ and ‘Held for Trading’. Held-to-maturity securities are debt security investments which the holder has the intention and ability to hold until a specific date of maturity. The investments classified under HTM need not be marked to market and will be carried at acquisition cost, as subsequent changes in market value are ignored because the return is predetermined.

Earlier RBI allowed the HTM investment to rise provided it remains within an overall limit of 19.5 percent of the deposit base. This 19.5 per cent limit has now been increased to 22 per cent. This extra limit of 2.5 per cent meant an extra demand of nearly Rs 3.56 trillion bonds.

• Open Market Operation-The central bank conducts special open market operations (OMO), under which it simultaneously buys and sells bonds worth Rs. In market parlance, this kind of OMO is called Operation Twist.
• Reverse the funds taken under long-term repo operations (LTROs), to ease their cost of funds. Thus, the banks may reduce their interest liability by returning funds taken at the repo rate prevailing at that time (5.15 per cent) and availing funds at the current repo rate of 4 per cent. Reversal of LTRO will reduce intertemporal consequences for Banks, and will improve appetite for banks to borrow and park in bonds.
• Increase Statutory Liquidity ratio- also increase demand for bonds as SLR includes investment in government bonds.
• An Appreciating rupee theoretically makes import cheaper, and therefore controls inflation. It is considered an indirect method of raising interest rates without touching policy rates potential of leading capital inflows.

Issue:

RBI policy to curtail bond yield is generally associated with excess liquidity in the system especially OMO (purchasing bonds in return of money)  thus, is in conflict with the ongoing monetary tightening session.