Bonds and bond yields have been in the news of late. India's benchmark bond yields (10-year bond yields) closed 0.08 percent lower at 7.31 percent on February 7.
They have been easing since the Budget announcement on February 1 in which Finance Minister Nirmala Sitharaman announced lower-than-expected borrowing numbers.
And that is why bond prices are rising.
Let's first understand what are bonds and bond yields and how they work.
What are government bonds?
Governments need money to function. They need funds for various purposes such as to finance the fiscal deficit or fund large infra projects.
They have several ways to raise money and one of the most basic ones is taking loans from public.
When governments need a significant amount of money, they issue bonds, the smaller parts of the capital they need. When the government issues bonds, they are known as government bonds. They are for a specific time duration and carry a fixed interest rate.
For example, let's assume a country needs ₹1 crore for a project. Instead of taking this amount from one entity, the government of the country slices up this amount into smaller units, say ₹10,000. Thus, it takes ₹10,000 from 1,000 lenders and gives them a document which is called the bond.
The government usually pays regular interest and returns the full principal when the bond matures.
In simple terms, government bonds are debt instruments issued by governments, in which the lender lends money to the government for a fixed time period.
One important thing about government bonds is that they are not issued only when there's a need for fund, they are also used to regulate the money supply in the system.
Some examples of government bonds are treasury bills, sovereign gold bonds, dated government securities, cash management bills, fixed-rate bonds, floating-rate bonds, inflation-indexed bonds, etc.
What are bond yields?
Bond yields are returns you get when you buy a bond.
Bond yields and prices move in opposite directions; when bond prices rise, yields fall, and when bond prices fall, yields rise.
Let's understand why this happens.
Let's assume you buy a 10-year bond worth ₹1,000 with a coupon rate of 10 percent. This means you will get an interest of ₹100 per year.
What will happen if the price of that bond falls to ₹800? In that case, the interest or bond yield will become 12.5 percent.
And what happens if the bond price rises to ₹1,200? The bond yield will fall; it will become 8.33 percent.
Bond yields rise when the economic outlook is bright. Economic growth tends to give rise to inflation which drags bond prices lower. When bond prices fall, yields rise.
Is there a relationship between the bond and equity market?
The bond market and stock market influence each other. Risk-averse investors may prefer bonds because they are less volatile.
Also, a higher bond yield is bad for equities because it can lure investors to avoid riskier equities.
When interest rates are rising, bonds become more attractive which may trigger profit-booking in the equity market and inflow in the bond market. The reverse happens in a low-rate environment.
Investors who want to adjust their investments according to the market situation can go for dynamic asset allocation mutual funds or balanced advantage funds.
These hybrid funds invest across sectors including equity funds, real estate, stocks and bonds and change their allocation from time to time.