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News: The Reserve Bank of India has hiked rates to rein in inflation, which is expected to remain above 7% until at least September. However, with this, the bond yields have also risen to their highest levels in three years.
How do we interpret this rise?
• The rise in yields means markets have already factored in the worst of the rate movements.
• The rise indicates that the cost of funds in the financial system is rising and so are interest rates.
• The rise means the government will have to pay more as yield (or return to the investors), leading to a rise in cost of borrowings.
• This will put upward pressure on general interest rates in the banking system.
What is the impact on different class of investors?
• The rise in yields means investors expect higher interest rates and are selling their bonds, because higher rates would result in a decline in the bond price of existing bonds (and thereby capital loss on sale before maturity).
• Debt investors are set to get impacted. When yields rise and bond prices fall, net asset values of debt funds, which hold a sizeable chunk of government securities in their portfolios, will also decline.
• It will also impact corporate bonds, which are priced higher than government bonds.
• Rising bond yields are generally not good news for equity investors as they raise the cost of funds for companies and start hurting their earnings.
What is the relationship between Bond Price and Yield?
• A bond’s price moves inversely with its yield or interest rate; the higher the price of a bond, the lower the yield.
• The reason for the inverse relationship between price and yield is due, in part, to bonds being fixed-rate investments.
• Investors might sell their bonds if it’s expected that interest rates will rise in the coming months and opt for the higher-rate bonds later on.
• Conversely, bond investors might buy bonds, driving the prices higher, if they believe interest rates will fall in the future because existing fixed-rate bonds will have a higher rate or yield.
Bond Yields VS Equity?
• Bond yields have an inverse relationship with equities as a rise in bond yields means that the risk premium on equities will have to go up.