Introduction
Investors purchase bonds based on the yield to maturity (YTM), which is the annualized return you will receive, provided you hold the bond until maturity. The level at which you purchase a bond is a function of, apart from the credit quality, the prevailing situation in the market. This ‘prevailing market situation’ is largely influenced by interest rates. In this article, we will explore how inflation and interest rates impact bond levels.
How it works – inflation
Financial markets, including bond market, are forward-looking. Markets work in anticipation of future events and actions. In this context, the preponderant future event is central bank rate action. Any central bank, e.g., the Reserve Bank of India (RBI), decides or influences the interest rate in the economic system. The central bank overnight rate, which in India is the repo rate (currently 6.5%), is the pivot around which interest rates in the system move. For the central bank to increase or decrease the repo rate, while there are multiple variables to consider, the most important variable is inflation.
When inflation is high, it is expected that the central bank will hike the repo rate. This would increase interest rates across the system. This, in turn, would slow down economic growth, reduce demand, and ultimately ease inflation. The central bank would lower the repo rate when inflation is low or under control, when they want to promote growth, or when there is an urgency, e.g., during the COVID period.
As and when inflation data are published, the market formulates a view on how this is going to influence future central bank rate actions. If the inflation data print is on the higher side, there is a probability of a rate hike in the future, and vice versa.
How it works – interest rate and yield
The usage of the terms "interest rate" and "yield" in the market can be somewhat synonymous, which may or may not be correct, depending on the context. For clarity, "interest rate" refers to the rates offered on deposits by banks and charged on loans by banks or NBFCs. "Yield" is the YTM on a bond, as mentioned earlier. When you purchase a bond during its primary issuance and hold it until maturity, your yield or YTM is the same as the coupon rate.
For example, if a company issues bonds with a face value of Rs 100, a 7-year maturity, and an 8% coupon rate, and you buy this bond and hold it until maturity, your yield is 8%. When you buy this bond in the secondary market, your yield could be higher or lower, depending on the price. For example, if the bond mentioned earlier is trading in the secondary market at a price of Rs 105, the coupon is a percentage of the face value, not the market price. Hence, for the same Rs 8 of coupon every year, you are paying a price higher than Rs 100. Accordingly, your yield is lower than 8%. Conversely, if the bond is trading in the secondary market at Rs 95, your yield or YTM is higher than 8%.
Interest rates, set by the RBI, have a foundational impact on bond prices and yields. Here's a streamlined look at their interaction:
RBI's Influence: The RBI controls short-term interest rates primarily through the repo rate, which is currently at 6.50%. This rate significantly influences other interest rates within the economy, including those offered on bonds.
Bond Prices and Yields: When the RBI changes interest rates, it directly impacts bond prices in the secondary market. For instance, if the RBI were to lower the repo rate, newer bonds might be issued with lower interest rates, making existing bonds with higher rates more valuable. Consequently, the prices of these existing bonds would increase, which in turn would lower their yields (since price and yield are inversely related).
Market Reaction: The bond market tends to anticipate future RBI actions. If investors believe the RBI will cut rates due to, for example, lower inflation expectations or other economic indicators, bond yields might start to decline in anticipation. This can happen even before the RBI officially announces a rate change.
Currently, with the repo rate holding steady since the last increase in February 2023 and the latest yield on the 10-year G-Sec yield sitting close to 6.901%, the market reflects a delicate balance of current RBI policy and investor expectations regarding future economic conditions. The narrower spread of approximately 40 basis points over the repo rate indicates that investors may be anticipating a stable to potentially easing interest rate environment going forward.
Conclusion
The central bank's policies significantly impact both bond yields in the secondary market and interest rates on deposits and loans. Yield levels in the secondary market move dynamically, often in anticipation of changes in the central bank’s rate policy. When inflation shows signs of easing, investors can expect the RBI to consider rate cuts, which may lead to a decrease in bond yields. Understanding these relationships helps investors position themselves effectively, making informed decisions on bond investment and portfolio management.
Disclaimer - Investments in debt securities / municipal debt securities / securitized debt instruments are subject to risks including delay and/ or default in payment. Read all the offer related documents carefully.