Inflation and rising Bond Yield

Inflation and rising Bond Yield

Subject: Economy

Section: Inflation

Context:

India’s benchmark 10-year government bond on Tuesday rose by another four basis points to hit a new high of 7.19 per cent amid worries over rising inflation and the RBI move to suck out liquidity from the system.

Concept :

Bond yield and inflation relation:

Bonds are units of debt issued by the companies/government and traded like shares. As companies/government issues bonds to raise money, they pay a fixed interest to the bondholders which is popularly known as the coupon rate. It is declared upfront and payable on the face value of the bond and remains fixed until maturity. As bonds are tradeable, they also give returns. These returns are called bond yields.

For example, if an investor buys a 10-year bond worth Rs10,000 with a coupon rate of 5%, he will get an interest of Rs 500 per year

But while trading, if the bond price falls to Rs 8,000, your yield will become 6.25% (Rs500/ Rs8000*100).

Thus, bond yields and prices move in opposite directions, when bond prices rise, yields fall, and vice versa.

• Treasury yields move higher as fixed-income products become less desirable: This causes decrease in demand vis-a-vis supply of bonds causing bond yield to rise.
• Rising inflation pushes bond prices lower, thereby pushing yields higher: As inflation rises, central banks will increase short-term interest rates in an effort to cool down the economy. Additionally, rising inflation expectations lead to an increase in long-term rates, which are largely determined by market activity. The inverse relationship between interest rates and bond prices means that higher rates equal lower bond prices.