Hi there 👋🏽

Bond yields have been rising up recently and this motivated me to read more about it and understand how the yields influence the economy, what levers does RBI has, and many such things! If this sounds interesting to you, I am hoping that most of your questions would be answered by the end of this article!

Let us cover some of the important terms first-

Bonds - Instruments to raise funds or borrow money.

Let us say that I take Rs 95 from my friend today and decides to pay back Rs 100 after one year. In this case, Rs 95 would be the price of the bond and Rs 100 would be the redemption value (also called face value). Further, I am the issuer/seller of this bond and my friend is the buyer.

Yields - It is the annual return one for a bond. For simplicity, consider it to be the interest rates for the bonds.

In the above case, my friends earn an interest of Rs 5 for a year, and the interest rate would be around 5.26%, which is referred to as the yield for the bond. You would notice that the price of the bond and the yield move in the opposite direction!

The government is the biggest issuer of bonds. It issues bonds to raise money to fund expenditure.

Why are yields going up?

A massive government bond issuance of 12L cr rupees for FY22, and an additional borrowing of 80k cr this year has led to the rising yields.

Well, the global yields are also going up, because of the recent talks about the US planning for a $1.9T stimulus package.

As the bond issuance increases, the supply of bonds increases, which means buyers would be willing to pay less price for the bonds and thus higher yields.

What does higher yield mean?

A higher yield implies higher borrowing costs for the government, something that the RBI would want to control.

Since bond yields are increasing, which means higher interest rates for the lenders, people would want to buy bonds and thus invest their savings here, which would decrease the investment in the equity markets.

The same goes for the FII investments. US yields were close to 0 earlier and now the increasing yields would decrease the inflow of money from FIIs (in the equities).

This is the expected reason for the recent decline/correction in the equity markets.

Further, when FIIs start selling they take back $s leading to less $s and increasing the $ value, which implies shelling out more Indian rupees to buy 1$. (So from Rs72/1$ to Rs 73/1$).

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What role does RBI play?

Let us consider RBI to be the merchant banker the GOI. As we saw above, that the RBI would want to keep the yields in check, let us see what measures have been taken and what are the options it has?

  1. Open Market Operation (OMO)

OMO is a mechanism by which RBI buys or sells government bonds. Recently, RBI has done a couple of OMOs to buy bonds, giving a higher price to the seller, thus decreasing the yields.

However, the recent failures of the OMOs might imply that the high yields will sustain for some time.

  1. Allowing more players

Recently, RBI has allowed retail investors to directly buy/sell bonds, thus leading to demand increase, price increase, and thus lower yields.

  1. Increasing [LCR]/[SLR]

  2. Increasing the [HTM] limit of bonds for banks

  3. Floating-rate bonds: Floating rate bonds are bonds where the coupon rate (consider interest for now) every six months. This also means that the risk decreases, so yields decrease (when the lender has less risk, less interest would be charged). This also comes with a downside when the lender/issuer/government would have to pay higher coupons in case of higher yields.

  4. Few other ways

What’s the tradeoff?

When RBI sells bonds:

Supply increases -> Price decrease -> Yields increase -> Higher borrowing cost for the government

When RBI buys bonds:

Demand for bonds increase -> Bond prices increase -> Yields decrease -> Interest rates decrease -> Cheaper Loans -> More liquidity/money with people -> Demand of products increase -> Price of products increase -> Inflation increases

Hence, RBI needs to strike a balance!

What happened during the last year?

With the onset of the pandemic, supply decreased -> Prices increased -> Inflation increased. Liquidity is another factor that influences inflation. Higher the liquidity more is the money with the people, and with more money chasing the same goods, inflation increases.

To keep the inflation in check, RBI can control liquidity, so it increases the repo rates (rates at which banks borrow) leading to an increase in lending rates and thus decreasing liquidity.

However, in case of a pandemic like Covid with job losses, business suffering, RBI would have to reduce repo rates, so that people can borrow cheaply and spend this money to keep the economy in check - leading to inflation because of increasing liquidity. Further, RBI also bought bonds to inject liquidity.

A similar situation prevailed in the US, decreasing interest rates led to a large inflow in the emerging markets leading to rising in Indian equities.

Further, when FIIs start buying they inject $s leading to more $s and decreasing the $ value, which implies shelling out less Indian rupees to buy 1$. (So from Rs72/1$ to Rs 70/1$).

In this case for a company like India, the exports will suffer because we sell in dollars which now has less value - To prevent this, RBI starts buying $s so as to maintain $ value. Since RBI is paying people/companies to buy $s, liquidity further increases.

The US had put India on its currency manipulation list- https://indianexpress.com/article/explained/currency-manipulation-explained-india-us-currency-watchlist-7108379/

How does all this affect gold?

In the case of pandemics, when gold is considered a safer option, prices increase.

When yields increase and so do the interest rates, people would not prefer gold, a non-interest paying asset. So the demand falls and thus the prices.

Taper tantrum?

In 2013, Fed decided to scale back the liquidity injections, which led to the belief that the interest rates/yields would rise. As a result, FIIs started selling their investments in emerging markets, including India, which led to a fall in stock prices.

Take-aways

  • When yields increase, equity falls, $ increases, gold prices fall.
  • When yields decrease, liquidity and inflation increase.
  • RBI uses OMOs (open market operations) to buy/sell bonds to control liquidity. The other tools are repo rates and the various ratios to be maintained by banks.
  • The institution also tries to maintain inflation rates, facilitates government to borrow money at considerable yields, and keeps the rupee value steady by buying and selling $s.