In recent news, the Reserve Bank of India’s (RBI) initiative to increase purchases of Government Securities (G-Sec) under the Government Securities Acquisition Programme (G-SAP) resulted in the yield on the benchmark 10-year bond falling below 6%. The yield of the 10-year G-Sec is a significant measure in the Indian financial sector as it reflects the general conditions of the interest rate.
Key Definitions
A bond yield refers to the returns an investor makes on a bond, calculated using the formula: annual coupon rate divided by the current market price of the bond. Bonds are instruments used to borrow money, issued by either a country’s government or a company looking to raise funds. The coupon rate is the interest rate paid by bond issuers on the bond’s face value.
Understanding Bond Yield Movements
The general movement of bond yields is dependent on trends in interest rates and can lead to capital gains or losses for investors. An increase in bond yields results in a decrease in the bond’s price. Conversely, a drop in bond yield is advantageous for the investors as the bond’s price will rise, thus generating capital gains.
The Impact of Decreasing Bond Yields
The recent decline in bond yields can be attributed to the economic uncertainty caused by the Covid-19 pandemic. In April 2021, the RBI launched the G-SAP, leading to a subsequent decrease in G-sec yields. This fall in yields can have several impacts such as better equity markets, a reduction in the cost of capital and lower risk of bankruptcy.
Equity Markets and Bond Yields
Lower bond yields often mean better performance for equity markets as money begins to shift from debt investments to equity investments. A downfall in bond yields tends to result in the equity markets outperforming by a larger margin, while an increase in bond yields can lead to a slump in the equity markets.
The Effect on Cost of Capital
A rise in bond yields corresponds to an increase in the cost of capital. The future cash flows are discounted at a higher rate, compressing the valuations of these stocks. Consequently, when the RBI cuts the interest rates, it usually results in positive growth for stocks.
Risk of Bankruptcy and Bond Yields
Higher bond yields can also signal an increased risk of bankruptcy for corporates, as they may have to pay higher interest costs on debt. Companies—especially mid-cap and highly leveraged ones—become more vulnerable as debt servicing costs increase.
Reserve Bank of India’s Stance on Bond Yields
The RBI aims to maintain lower yields to reduce government borrowing costs and prevent an upward movement in market lending rates. An increase in bond yields might put pressure on the banking system’s interest rates leading to a hike in lending rates.
About Government Securities Acquisition Programme (G-SAP)
In response to the current economic climate, the RBI introduced the secondary market G-SAP 1.0 for FY 2021-22. It’s a part of RBI’s Open Market Operations (OMOs), where the RBI commits upfront to a specific amount of Open Market Purchases of G-Secs.
Objective and Significance of G-SAP
G-SAP aims to avoid volatility in the G-sec market due to its central role in pricing other financial market instruments. The program provides certainty to bond market participants regarding the RBI’s commitment to supporting the bond market. Additionally, it helps reduce the difference between the repo rate and the 10-year government bond yield, consequently reducing the aggregate borrowing cost for the Centre and states in FY 2021-22. Lastly, it promotes a stable and orderly evolution of the yield curve amidst comfortable liquidity conditions.
Understanding Repo Rate and Yield Curve
Repo rate is the interest rate at which RBI lends money to commercial banks. A yield curve is a line that plots yields (interest rates) of bonds of equal credit quality but differing maturity dates. The slope of the yield curve gives an idea about future interest rate changes and economic activity.
