Out of favour

Out of favour

Context

More people are losing their love for Indian bonds. Foreign investors have been net sellers of over $1 billion in Indian debt this month, almost cancelling out inflows since the beginning of the year. Domestic investors were already spooked by a widening fiscal deficit, so foreign selling now has managed to add pressure on the market

Why foreign investors are withdrawing from bond market?

• Increase in interest rates in developed countries: Earlier, developed countries had low interest rates to propel growth. They kept the currency in circulation rather than giving more interest rates but now the Interest rates are increasing in developed countries also. Hence, difference between interest rates of India and developed countries is coming down
• Rupee depreciation fear: As rupee depreciates investor have to shell out more money to buy dollar
• Increasing fiscal deficit
  • Interest burden on government will increase i.e. increased revenue expenditure meaning government will have less money available for capital investment. It will lead to crowding out of private investor meaning less money is available for private investor to borrow

What is bond yield?

Government issues bonds to borrow from the market. Bond is just a piece of paper on which it is written that government shall pay an interest plus the principal, to the purchaser at the end of a specific time period. The interest is always paid on the face value of the bond.

Let us suppose a friend of yours purchases a bond of Rs 30 @10% yearly, from the government. It means the government will be liable to pay an interest of Rs 3 (yearly) to the borrower.

Consider a situation in which your friend needs money immediately and decides to sell his bond. This selling (and purchasing) of the bond will be done in secondary market. Here many sellers and buyers of the bonds are available.

Now, if there is an ample supply of bonds in the secondary market due to any reason i.e. there are many sellers of the bonds in the market compared to the buyers, your friend here will face a situation wherein buyer will be the king meaning your friend will have to sell his bond at a lower price than the price for which he purchased it. Let us assume that he sells it at Rs 20 to a buyer.

Keep in mind that the buyer here shall continue to get the interest of Rs 3 as promised initially by the government as interest is calculated on face value of the bond i.e. Rs 30 in this case. This means that the buyer will get an interest of Rs 3 on a bond worth Rs 20 while your friend was getting the same interest on a higher price of Rs 30.

Clearly, the buyer will gain here as he is getting an interest of 15% (as Rs 3 is 15% of Rs 20 while it was 10% of Rs 30)

In the above case, bond price went down (from Rs 30 to Rs 20) while bond yield increased (from 10% to 15%)

For prelims you can remember the following statement,

When bond prices go down, bond yield go up

Now, seeing the increased bond yield, more and more buying of the bonds will ensue leading to increased demand of the bonds and we know that a quantity in increased demand will command a higher price. So, an increased demand will propel the bond prices up thereby leading to a reduction in bond yield, which will further lead to reduction in demand

All hail the invisible hand!!!

Why Bond yield is rising?

• Government is planning to step up borrowing process ahead of elections means government will issue more bonds leading to an excess of bonds in bond market which will decrease the bond prices and we know that when that happens bond yield goes up
• Breaching of fiscal deficit targets means more borrowing
• Less lending by Public Sector Banks
• Depreciation of rupee will lead to selling of bonds by foreign investors leading to excess supply in the market which pushes the bond prices down leading to higher bond yields