By Ruma Dubey
There is one very important thing which happened, immediately after Moody’s upgrade. No, not the Padmavati row nor Miss World; it is RBI.
RBI on Friday decided to scrap the proposed huge Rs.10,000 sale of bonds via open market operations (OMOs), scheduled for 23rd Nov. This news, many say is the real reason for the over 400 points jump of the Sensex on Friday.
The bond markets are inextricably linked to the yields. So today morning, the yields have reacted accordingly to this news - the 10-year bond yield fell to 6.905%, coming down almost by 14.50 bps; this was the biggest slide over the past 12 months.
Thus we could not help but wonder what this whole thing was about and went about ‘educating’ ourselves, getting the basics clear.
So what exactly are these OMOs?
In simple terms, OMOs are the market operations conducted by the Reserve Bank of India by way of sale/ purchase of Government securities to/ from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis. When the RBI feels there is excess liquidity in the market, it resorts to sale of securities thereby sucking out the rupee liquidity. Similarly, when the liquidity conditions are tight, the RBI will buy securities from the market, thereby releasing liquidity into the market.
Why does RBI do this OMO?
RBI is not allowed to buy Govt bonds but needs to do so from the open market. When it needs to buy bonds, it prints rupees and this stokes inflation. And when it sells, it removes rupee from the market – when RBI sells bonds, the banks will get these and pay with rupees to RBI where it gets ‘extinguished.’ This helps suck out excess liquidity. RBI has conducted nine OMO sales in 2017, all of which took place in the second half of the year.
Why did RBI cancel this one?
The moment the news from Moody’s came, yields had as such fallen by 13 bps. Plus there are already fears of rising oil prices which could stoke inflation further. Fiscal slippages, a rate hike by Fed in Dec and no rate cut in India any more in 2017; thus based on these facts, at this juncture, sucking out more liquidity would have made the markets jittery and hence the cancellation.
What is the co-relation between bonds and yields?
They both, the price of the bond, which is the face value of the bond is inversely proportionate to the yields. Imagine the price and yield sitting on a see-saw. When price goes up, yield will come down and when price goes down, yield will come down. This is probably the most simplistic way of understanding this concept.
What about interest rates and bond markets?
Interest rates and yields move in the same direction, so that naturally means interest rate and bond price move in opposite direction.
How to calculate bond yields?
It is simple math – coupon rate/face value of bond.
Suppose you have a Rs.1000 face value bond and coupon rate of 7%, then the yield is 70/1000 = 7%.
How to co-relate interest rate, yields and bond prices?
An increasing bond price means yields will be going down. And when will bond prices rise? When there is demand. And when will the demand for bonds rise? Demand for bonds rise when people seek safer havens – that is usually how this works. And demand drops when other markets are safer. At the end of it, even bonds at some point of time, reflect more of sentiments.
How do yields give an indication of the stock markets?
If yields go up, it means there is trouble on the horizon and this always indicates a negative market condition. Yield and risk go hand-in-hand. Higher the yield, higher is the risk – so you get paid as per the risk in the market.
How does this affect you as a trader and as an investor?
Bonds are traded in the market unlike a fixed deposit, which is why yields and interest rates need to be taken into account. When bonds are traded in an open market, yield will be the profit which you make on the purchase of bond. Thus when bond prices rise, yields will fall and that will make purchasing the bond in the open market much attractive as the face value would have got adjusted upwards to adjust the lower yield.