What does Bond Yield say about the Economy?

30 Dec 2020  Read 811 Views

The government of India has been announcing many welfare programs for various sectors of the economy to offer all possible help to its citizens. To implement these schemes, it naturally requires a huge amount of funds. 

So where will these funds come from? 

Taking additional debt can be a very problematic option as the government can sink deeper into the debt pile, and that will further have a bearing on the economy.

Among the additional sources of funds for the government, is the bond market. Economists, mutual fund managers, policymakers, and traders in equities and commodities keep an eye out for the numbers coming from the bond market.

The government securities and bonds may not affect an individual's finances, but the bond yield indicates where the country's economy is heading.

So, let us first understand what a bond yield is.

What is Bond Yield?

Bond yield is a return of the investor's investment in bonds. In its most basic form, the bond yield would be equal to the coupon rate. You'll perhaps recall that the coupon rate is the rate at which interest is paid out on bond. 

Companies and individuals use the bond valuation method to determine the fair value of the bond.

Let's take a look at the bond valuation techniques to understand it better.

What is Bond Valuation?

Bond valuation is a method to calculate the fair value of the bond. The fundamental principle of bond valuation is that its value is equal to the sum of the present value of its expected cash flows.

Bond Valuation Method

The process of bond valuation involves three steps, which are as follows:

1. Estimating Cash Flow

The estimated cash to be received in the future from investment in bonds is called cash flow. Only two types of cash flow can be received from the bonds: Coupon payments, and the principal amount at the maturity period.

Coupon payments are received at regular intervals as per the bond agreement and the final coupon and the principal amount at maturity, which is the usual cash flow cycle of the bond. There are some situations in which bonds do not follow these flows. 

The Zero-coupon bonds might be a reason for this unusual pattern as they do not offer coupon payments. Before estimating the actual cash flow for the bond valuation, analysts consider these factors.

2. Determining the Appropriate Interest Rate to Discount Cash Flows

This is the second step after estimating the cash flow. To avoid risk, the minimum interest required for the investor is available in the marketplace as default-free-cash flow. 

Default-free-cash flow is from the debt instruments that are completely risk-free and have zero chances of default. Such securities are issued by the Reserve Bank of India. 

Suppose, an investor wishes to invest in bonds. If the investor is considering investing in a corporate bond, then he must have expectations of getting higher returns compared to other government bonds. But there is a slight chance that corporate bonds might default. On the other hand, government bonds are never going to default. Higher returns always come up with higher risk. 

3. Discounting the Expected Cash Flow

After getting the value of expected future cash flow and the interest rate used to be discounting the cash flow, we need to determine the present value of cash flows for bond valuation. Money that has been invested today to generate specific future value is called present value cash flow, but it is commonly known as discounted value. 

The present value of cash flow depends on two determinants:

  • When the cash flow will be received (timing of cash flow)
  • The required interest rate (mostly known as the Discount rate)

Calculating the present value of each expected cash flow is the first step. After this, all the present values are added together, and the sum of all these values is the value of the bond. 

The formula for calculating the present value of cash flow.

Present Value Formula For Bond Valuation

Present value n = Expected cash flow in the period n/ (1+i)^n  

where, 

n = expected time for receiving the cash flow

i = rate of return or a discounted rate of return

After getting the present value of each individual cash flow years from now, the next step is to add all individual cash flows to get the bond value.

Bond Value = Present Value 1 + Present Value 2 + ……. + Present Value n

                                       

What do Bond Yields indicate about a Country's Economy?

Conventional metrics employed by economists to diagnose the health of a country's economy embody inflation, disposition rate of the financial institution/central bank of the country, rate, and national income. Apart from these, bond yields are also a discerning means of gauging the path of an economy. 

As investors sell government bonds, the costs drop, and yields increase. A better yield indicates a larger risk. If the yield offered by a bond is far above what it actually was once issued at, there's a chance that the corporate or government that issued it, is financially stressed and might not be ready to repay the capital.

The enhanced risk with such bonds is offset by larger returns, adding to their charm. 

The 10Y Bond of the Indian Government is expected to trade at 5.98 per cent by the end of this quarter. 

Government bonds are comparatively a lot more stable; however, low demand at auctions indicates low capitalist confidence within the country's economy. 

India's benchmark 10-year bond encompasses a yield of 7.39%, above that of Greece's 4.36%. The Greek government is presently rebuilding its economy when a sovereign debt crisis drained liquidity in the aftermath of the 2008 monetary crisis. 

The long-term bond yields within the U.S. and the U.K. are 2.76% and 1.36%, whereas the monetary times of a 10-year government benchmark is 1.27%.

The monetary times define the yield on a riskless bond as roughly being "equal to the speed of growth within the economy, and the speed of inflation." 

In this situation, the bond yields would mirror gross domestic product growth; however, the connection between yields and economic activity is a lot advanced, particularly within the case of developing countries like India. 

A full host of things including recessions, inflation, and bank discounts set by central banks, will have a sway on bond yields.

In developing countries like India, where the government is among the most important investors within the economy, bond yields are often a helpful parameter in assessing its economic health.

It is often noted that at the peak of the recession of 2008, the economy grew at solely 3.89% whereas the yield on the benchmark 10-year government paper was 7.529%. For the financial year 2018, the bond price took a beating; however, the government borrowed a lot within the type of bond issuance to tide over the slump in economic activity. However, the trend of loose correlation between economic growth and bond yield has held control within the following years.

Unlike in countries where non-public enterprise drives the engine of growth, the trend of high bond yields is worrying in the case of India, since it reflects on the capitalist sentiment that's not entirely favourable to the prospect of the government seizing a lot of debt.

                                           

Final Thoughts

The yield of India's benchmark long bond certificate remains beyond peers in developing economies. Government payment is anticipated to extend within the run-up to the overall elections. 

Inflation or expectations of inflation will approach bond yields since any gains created by securities will crumble by an increase in prices. The inflationary impact of certain newly announced schemes, like that concerning the farm sector, remains unknown. 

With larger government payments lined up this fiscal, the trajectory the yield curve can take up within the few months may hold the key to predicting what the future holds within the run-up to the general elections.

About the Author: Divyanshu kumar | 49 Post(s)

Divyanshu is currently pursuing a Master's degree in Financial economics. Growing up, he has always been interested in codes and numbers which he has gradually learnt to express in words too.

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