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Why Does the Yield of a Bond Fluctuate

31 May 2023

Introduction 

The Reserve Bank of India (RBI) paused the hike in the repo rate in its Monetary Policy Committee meeting in April 2023. While home loan borrowers were relieved, the bond market didn’t take the news very well. The repo rate trend is one of the several factors that can lead to fluctuations in bond yields and prices. 

What Do We Understand by Bond Prices and Yields?

  • Bonds are debt instruments that companies and governments issue to raise capital from investors. By issuing a bond, the government borrows money from the public, and the investing public lends money to the issuing party, i.e., the government or the company.
  • Just as in the case of any loan arrangement, bonds also come with an interest rate, known as the coupon rate.
  • The coupon rate is the interest rate based on the face value of the bond and remains fixed until the maturity of the bond. Therefore, the fluctuation of a bond yield has nothing to do with the changes in the coupon rate.
  • Once a bond is issued, it enters the secondary market, where it can be traded by investors. This is similar to the trading of stocks in the secondary market after an initial public offering (IPO).
  • The bond price is subject to changes in the secondary market, depending on its demand and supply at a given point in time. 
  • Bond prices and bond yields have an inverse relationship: if the bond price falls in the secondary market, its yield will increase, and vice versa. 
  • For example, the face value of a bond is Rs 1,000, and the coupon rate on the bond is 5%. If the bond price falls to Rs. 900 in the secondary market, its yield rate at this point will increase from 5% to 5.55%.
  • Going back to the RBI’s repo rate pause, a fall in the bond yield indicates that bond prices increased in the aftermath of the pause.

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What Are the Key Reasons for Fluctuations in Bond Yields?

Various factors influence bond yields. Mostly, these include the rate of interest, bond tenure, and issuer’s repayment capacity. Some key factors are given below:

  • Movement of the market interest rate

  1. The prices of bonds and the prevailing rate of interest tend to move in the opposite direction. An increase in the rate of interest leads to a fall in bond prices, and vice versa. 
  2. Since bond prices and bond yields have an inverse relationship too, the bond yield and prevailing rate of interest tend to move in the same direction. 
  3. Bonds have a fixed coupon rate, so when the prevailing interest rate increases, it makes the coupon rate less attractive. 
  4. To keep the new bonds attractive, issuers offer a higher coupon rate, which reduces demand for the lower-yield bond, leading to a fall in prices. 
  • Remaining tenure of the bond

  1. As a bond inches towards maturity, its price moves towards its face value. The closer it is to maturity, the faster it will move towards par value.
  2. A bond with five years to maturity will see its price rise or fall at a lower rate compared to a bond with, say, one or two years to maturity.
  • Issuer’s financial robustness

  1. The bond prices also react to any apparent changes in the issuer’s repayment capacity.
  2. If any of the influential rating agencies downgrade the rating of an issuer, the bonds issued by the issuer are almost certain to see a fall in price.
  3. One of the most common reasons for a rating downgrade is the likelihood of an issuer defaulting on its bond obligations. 

Conclusion

  • To summarise, bond investors must keep an eye on inflation, apart from the aforementioned reasons.
  • High inflation can wipe out the returns of any investment, and bonds are no exception.
  • Nevertheless, due to their fixed returns, bonds are considered a safe addition to any investment portfolio.  
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