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Context:

Recent reports from Bank of Baroda (BoB) Research suggest that the yield on benchmark 10-year bonds will remain "soft" (meaning low or declining) in July, indicating lower borrowing costs for the government and potentially a positive sign for the economy.

What is a Bond?

When you buy a bond, you are essentially lending money to a borrower, which could be a government (like the Indian government issuing "government bonds") or a corporation. In return for this loan, the borrower promises to:

• Pay Regular Interest: Make periodic interest payments to you, known as "coupon payments," throughout the bond's life.
• Repay Principal: Return the original loan amount (the "face value" or "par value") to you when the bond "matures" (reaches its "term to maturity").

What is Bond Yield?

Bond yield is the total return an investor expects to receive annually from a bond over its term to maturity, expressed as a percentage. It is a more dynamic figure than the fixed coupon rate because it accounts for the bond's current market price.

How is Bond Yield Calculated?

Bond Yield = (Coupon Amount / Current Market Price of the Bond) × 100

For example, if you hold a bond that pays ₹70 interest per year, and its current market price is ₹950, your yield would be (70 / 950) × 100 = 7.37%. If its current market price is ₹1,050, your yield would be (70 / 1050) × 100 = 6.67%.

Factors Affecting Bond Yield

• Coupon Payments: Higher coupon payments generally lead to higher yields, assuming the price remains constant.
• Prevailing Market Price:  Bonds are traded in the secondary market (after their initial issuance), and their prices fluctuate based on demand and supply.

Bond Yield v/s Bond Price: An Inverse Relationship

When Bond Prices Rise, Yields Fall => If the market price of an existing bond increases, and its coupon payment is fixed, the yield (return relative to the price you paid) effectively decreases.

When Bond Prices Fall, Yields Rise => If the market price of an existing bond decreases, its fixed coupon payment represents a higher percentage return on the lower price, thus increasing the yield.

Why this Inverse Relationship?  

Bond yields are heavily influenced by the prevailing interest rates in the economy (like those set by the Reserve Bank of India).

Falling Interest Rates => If the RBI lowers interest rates, newly issued bonds will likely offer lower coupon rates. This makes existing bonds (issued when rates were higher) more attractive because they offer better returns. Increased demand for these older, higher-coupon bonds drives their prices up, which, in turn, pushes their yields down (to align with the new, lower market rates).

Rising Interest Rates => If the RBI raises interest rates, new bonds will offer higher coupon rates. Existing bonds with lower fixed coupon rates become less attractive. Investors would prefer new bonds offering higher returns. This reduced demand for older bonds drives their prices down, consequently pushing their yields up (to make them competitive with the new, higher market rates).

Source: 

THE HINDU