Significance of Yield in Bond Market
Bond yield is the return an investor realizes on a bond. The bond yield can be defined in different ways. Setting the bond yield equal to its coupon rate is the simplest definition. The current yield is a function of the bond’s price and its coupon or interest payment, which will be more accurate than the coupon yield if the price of the bond is different than its face value.
When equity markets are bullish, we say “The Sensex has “gone up” or “Equity prices have “gone up”
BUT
When bond markets are bullish, we say “yields” have “gone down”
Why??
When bond markets move up, we say that the “yields” have gone down whereas when bond markets fall, we say the “yields” have gone up.
Thus, there seems to be an inverse relationship between the markets and the “yields”
However, it is quite the opposite with Equity Markets where the “SENSEX” is said to go up with rising markets and go down with falling markets,
Thus, there seems to be a direct relationship between the equity markets and the SENSEX.
In equity markets a business offers its shares to investors who are willing to take a risk on the business succeeding and thereby making big gains.
In a bond market the business raises debt capital where the investors invest money for a fixed period at a particular rate of interest.
When the bond markets are bullish (positive) it means there are many investors who are willing to lend money.
In such a situation the business can expect to raise capital at a lower interest rate or “lower yield”
Hence, we say that “when bond markets are bullish the yields fall”.
Let me explain with an example.
Let’s say I issue a debt paper of ₹100 each at 10% interest p.a.
This means that an investor who lends me ₹100 for one year will earn ₹10 at the end of the year. Thus, at the end of the year I will return
₹110 (₹100 + ₹10)
In a bullish market there are several investors who want to invest and papers are in short supply.
In such a situation, perhaps I would find an investor who is willing to pay ₹105 for my debt instrument for which I had paid ₹100 to the original issuer for earning a 10% interest.
In this situation I become the issuer to the new investor who purchased the debt paper from me for ₹105.
The earning of the new investor works out to be ₹110 – ₹105 = ₹5
And the amount of interest he earns works out to (Profit/Invested amount) x 100 = {5 / 105} % = 4.7%
Thus, we see that when the market is bullish the yields come down and one is able to raise capital at lower interest rate.
