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Saturday, July 31, 2021

Explained: Bonds, yields, and inversions

As talk of a recession gets louder globally, bond yields are being keenly watched. A government bond yield curve most accurately reflects what investors think about current and future economic growth prospects.

Written by Udit Misra , Edited by Explained Desk | New Delhi |
Updated: August 21, 2019 2:25:25 pm
bond yields, what are bond yields, yield curve, what is yield curve, yield inversion, what is yield inversion, government bonds, corporate bonds, indian express explained Every bond has a face value and a coupon payment. There is also the price of the bond, which may or may not be equal to the face value of the bond.

Bond yields have featured in news reports both globally and within India in recent months. In India, government bond yields fell sharply in the wake of the Union Budget, although they have come off the lows in the past few weeks. Internationally, US treasury bond yields plummeted last week, but they too have moderated after it became clear that governments almost everywhere have shown the desire to boost economic growth.

What are bonds?

A bond is an instrument to borrow money. It is like an IOU. A bond could be floated/issued by a country’s government or by a company to raise funds. Since government bonds (referred to as G-secs in India, Treasury in the US, and Gilts in the UK) come with the sovereign’s guarantee, they are considered one of the safest investments. As a result, they also give the lowest returns on investment (or yield). Investments in corporate bonds tend to be riskier because the chances of failure (and, therefore, the chances of the company not repaying the loan) are higher.

What are bonds yields?

Simply put, the yield of a bond is the effective rate of return that it earns. But the rate of return is not fixed — it changes with the price of the bond. But to understand that, one must first understand how bonds are structured. Every bond has a face value and a coupon payment. There is also the price of the bond, which may or may not be equal to the face value of the bond.

Suppose the face value of a 10-year G-sec is Rs 100, and its coupon payment is Rs 5. Buyers of this bond will give the government Rs 100 (the face value); in return, the government will pay them Rs 5 (the coupon payment) every year for the next 10 years, and will pay back their Rs 100 at the end of the tenure. In this case, the bond’s yield, or effective rate of interest, is 5%. The yield is the investor’s reward for parting with Rs 100 today, but for staying without it for 10 years.

Different types of yield curves

Why and how do yields go up and down?

Imagine a situation in which there is just one bond, and two buyers (or people willing to lend to the government). In such a scenario, the selling price of the bond may go from Rs 100 to Rs 105 or Rs 110 because of competitive bidding by the two buyers. Importantly, even if the bond is sold at Rs 110, the coupon payment of Rs 5 will not change. Thus, as the price of the bond increases from Rs 100 to Rs 110, the yield falls to 4.5%.

Similarly, if the interest rate in the broader economy is different from the initial coupon payment promised by a bond, market forces quickly ensure that the yield aligns itself with the economy’s interest rate. In that sense, G-sec yields are in close sync with the prevailing interest rate in an economy. With reference to the above example, if the prevailing interest rate is 4% and the government announces a bond with a yield of 5% (that is, a face value of Rs 100 and a coupon of Rs 5) then a lot of people will rush to buy such a bond to earn a higher interest rate. This increased demand will start pushing up bond prices, even as the yields fall. This will carry on until the time the bond price reaches Rs 125 — at that point, a Rs-5 coupon payment would be equivalent to a yield of 4%, the same as in the rest of the economy.

This process of bringing yields in line with the prevailing interest rate in the economy works in the reverse manner when interest rates are higher than the initially promised yields.

What is happening to US govt bond yields at present? What does it signify?

The global economy has been slowing down for the better part of the last two years. Some of the biggest economies are either growing at a slower rate (such as the US and China) or actually contracting (such as Germany).

As a result, last week, US Treasury bond yields fell sharply as there was confirmation of slowdown in Germany and China. Reason: investors, both inside the US and outside, figured that if growth prospects are plummeting, it makes little sense to invest in stocks or even riskier assets. It made more sense rather, to invest in something that was both safe and liquid (that is, something that can be converted in to cash quickly). US Treasury bonds are the safest bet in this regard. So, many investors lined up to buy US Treasury bonds, which led to their prices going up, and their yields falling sharply.

The fall in the yields of 10-year government bonds showed that the bond investors expected the demand for money in the future to fall. That is why future interest rates are likely to be lower. A lower demand for money in the future, in turn, will happen only when growth falters further. So government bond yields falling typically suggests that economic participants “expect” growth to slow down in the future.

Of course, the bond yields are just “suggesting” this – they do not “cause” the growth to “reduce” in the future.

And what is a yield curve, and what does it signify?

A yield curve is a graphical representation of yields for bonds (with an equal credit rating) over different time horizons. Typically, the term is used for government bonds — which come with the same sovereign guarantee. So the yield curve for US treasuries shows how yields change when the tenure (or the time for which one lends to the government) changes.

If bond investors expect the US economy to grow normally, then they would expect to be rewarded more (that is, get more yield) when they lend for a longer period. This gives rise to a normal — upward sloping — yield curve (see chart).

The steepness of this yield curve is determined by how fast an economy is expected to grow. The faster it is expected to grow the more the yield for longer tenures. When the economy is expected to grow only marginally, the yield curve is “flat”.

What then is yield inversion, and what does it mean?

Yield inversion happens when the yield on a longer tenure bond becomes less than the yield for a shorter tenure bond. This, too, happened last week when the 10-year Treasury yield fell below the 2-year Treasury yield.

A yield inversion typically portends a recession. An inverted yield curve shows that investors expect the future growth to fall sharply; in other words, the demand for money would be much lower than what it is today and hence the yields are also lower.

How good is yield inversion at predicting a recession?

Although US Commerce Secretary Wilbur Ross was quoted as saying Monday that “eventually there’ll be a recession but this inversion is not as reliable, in my view, as people think”, yet US data show historically that barring one episode in the mid-1960s, a yield inversion has always been followed by a recession.

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