The Relationship Between Interest Rates and Bond Prices
Created on 16 Dec 2020
Wraps up in 4 Min
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Updated on 10 Sep 2022
The Indian debt market is composed of long-term debt markets and short-term debt markets. When there is a trade-in debt securities with a maturity of less than one year, it is deemed as a money market transaction. Likewise, when there is a trade-in debt securities with a maturity beyond one year, it is considered a bond transaction. The RBI monetary policy has an impact on both the long-term debt markets and short-term debt markets. Let us take a closer look at how the RBI monetary policy affects the bond market.
What do you mean by bonds?
Bonds are fixed-income, debt securities issued by business entities to raise capital from investors for a fixed period. The bond-issuer promises to pay specific interest over the bond's life and the principal amount or the face value on its maturity. Bonds are usually issued by governments, corporate entities, municipalities, and other sovereign bodies. Bonds can be traded in a similar way to securities.
So what are bond returns?
Bond returns are referred to as bond yield, which is the return that an investor realizes on a bond. The easiest way to calculate the bond yield is to divide the bond coupon payment (interest rate paid on a bond) by the bond's face value. This is known as the coupon rate.
Coupon rate = Total Annual Coupon Payment / Par Value of Bond * 100%
More complex calculations of bond yield involve factoring the time value of money and compounding interest payments. These calculations then give various kinds of yields – yield to maturity (YTM), bond equivalent yield (BEY), and effective annual yield (EAY).
Relationship between bond prices and bond yields
There is an inverse relationship between bond prices and bond yields. If the bond prices fall, the yield rises and vice-versa.
Let us try to understand this by example. Suppose you hold an Rs. 1000, 10% bond with a maturity of 5 years. This means that you will get an interest of Rs. 100 (1000 x 10%) for 5 years and Rs. 1000 on maturity in year 5. If the interest rates rise above 10% resulting in a fall in bond prices, you decide to sell the bond. Imagine the interest rates for similar investments rise to (say) 13%. In such a case, the bond held by you will become unattractive to other investors because it generates only Rs. 100 in interest, whereas similar bonds are generating Rs. 130.
What is RBI monetary policy?
The monetary policy of the Reserve Bank of India (RBI) refers to how the RBI controls the economy's money supply. Its control over the interest rates does this to maintain price stability and achieve higher economic growth.
How exactly does the RBI monetary policy affect the bond prices?
Empirically, there is an inverse relationship between the RBI's interest rates and bond prices. This means that, when the interest rates rise, the bond prices tend to come down. Similarly, if there is a fall in the interest rates, the bond prices will increase.
You must be wondering how does this happen? Let us try to understand this through an example. Suppose you hold a 10% bond with a maturity period of 5 years. If the RBI slashes the interest rates by (say) 2%, then you as a bondholder are at an advantage because your returns from the bond are locked at 8%. However, the new bondholders will get returns that are 2% lower. This advantage is reflected in the higher bond prices so that the yield to maturity (YTM) is maintained at the market level.
Consider another scenario. You hold government bonds (G-sec bonds). You are in a position to benefit from falling interest rates by gaining through capital appreciation. This is why the government bonds usually outperform the others in times of falling interest rates. Bonds with longer tenures tend to gain more when the rates are falling.
Demand and supply triggers of bonds
There are two significant buyers of government bonds – banks and foreign portfolio investors (FPIs). Both these buyers make their decisions based on their outlook for rates and yields on bonds. Let us examine their perspectives:
Banks usually prefer a scenario where the interest rates fall because it leads to capital appreciation on their bond portfolio. This scenario allows banks to book treasury profits. The government can raise debt at lower yields in a falling rate outlook.
Foreign Portfolio Investors (FPIs):
The bond appetite of FPIs is determined by two critical outlooks provided in the monetary policy. They are:
- The spread of Indian benchmark yield:
The FPIs consider the spread of Indian benchmark yield over the yield in a matured market like the US. Indian bonds usually trade at a premium over the US benchmark yields. This attracts the FPIs towards Indian bond investments.
- Currency outlook:
The currency outlook stemming from the monetary policy is essential for the FPIs. The trading of Indian bonds at a premium over the US benchmark would be meaningful only when there is a stability between INR vis-à-vis USD.
Has the COVID-19 outbreak affected the bond market?
The Indian corporate bond market has remained thin even after several regulatory initiatives. It comprises less than 20% of the GDP as compared to 120% in the US. Therefore, the Indian bond market is a shallow market with large, concentrated, and leveraged firms.
The coronavirus outbreak caused many investors to flee the equity of other risky assets markets and seek refuge in the bonds. The result? This migration drove up the bond prices. To boost India's economic growth, RBI made unprecedented rate cuts, which supported this bond price rally. RBI's rate cuts led to an increase in bond prices, resulting in a fall in yields.
In a nutshell, the RBI monetary policy has significant and far-reaching implications for the bond markets. These implications can be in the form of rates, in the form of the entities' liquidity positions, and the institutions' risk appetite. The effect of the ongoing global pandemic has also impacted the monetary policy and, consequently, the Indian bond market. How will the Indian bond market fare post the COVID-19 crisis? Only time will tell...
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