Yields of 10-year G-secs (or the 10-year government bonds) have been falling sharply and almost continuously of late. At the end of trading sessions on July 16, these yields were trading at a 30-month low.
So why does a fall in government bond yields matter?
The way the bond market functions, the yield, or the interest rate earned, on a government bond — especially the 10-year one — is a good indicator of the prevailing interest rate in an economy.
If yields on government bonds (also called government securities or G-secs) are falling, it is reflective of a downward movement in interest rates applicable for the broader economy as well. For the average consumer then, the rate of interest that she will pay for say, a new car this Diwali, will likely be lower than a year ago or indeed, the present.
And what exactly are G-secs?
In simplest terms, a G-sec is an IOU given by the government to anyone who lends it money. Like every entity in an economy, the government too needs to borrow to carry out its functions. The G-sec is the government’s vehicle to borrow from the public.
What makes G-secs attractive?
In any investment, apart from the reward (that is, the rate of return or rate of interest), the other key factor is the level of risk. G-secs are appealing because they are considered to be among the safest of investments — the sovereign is not expected to default or go bankrupt. However, as is always the case, the price of a safe investment is modest returns.
How are yields calculated?
Every G-sec 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. And then there is the yield, which is the effective rate of interest that one earns when one buys a bond.
Now 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 every year for the next 10 years, and will pay back their Rs 100 at the end of the tenure. In this instance, 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.
But say, there was just one bond, and two buyers (people willing to lend to the government). The actual selling price of the bond may in such a scenario go from Rs 100 to Rs 105 or Rs 110 because of the bidding war between the two buyers. Importantly, even if one buys the same bond 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%.
But what is the relation between G-sec yields and interest rate in the economy?
The way bond yields function implies that they are in close sync with the prevailing interest rate in an economy. With reference to the above example, only if the interest rate in the broader economy is 5% will the bond’s selling price be the same as the bond’s face value. If there is any discrepancy, the market will ensure it is removed.
For instance, 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 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.
So, are interest rates likely to fall in the coming future?
The yields of G-secs have been falling, and are now at the lowest level since the November 2016 demonetisation exercise. The fall has been faster since the announcement in the Budget that the government would limit its borrowing. A lower supply of bonds, without a change in demand, has effectively pushed up prices and, in the process, brought down yields.
Moreover, the RBI is concerned about the low inflation and deceleration in economic growth, and is expected to further cut interest rates in its forthcoming reviews. The falling bond yields are, thus, pointing to where the interest rates are likely to be in the coming months.