The Yield Curve – 9
Now that we understand the interest rate of a bond is inversely related to the price and more importantly, higher the return, higher the risk. So, if someone is offering you a higher yield on anything, automatically the mind should go “Kuch gadbad hai!”. It does not mean you should not invest but should find out what the ‘gadbad’ is and then take a call. If you are okay with the risk for the increased interest rate, do go ahead.
Actually, the financial media makes it more confusing. If you see a ticker showing the stock prices of companies, the ones that are going up are shown in green. So, say, I look at Asian Paints and see that green arrow next to it, I feel happy, a stock that I own is doing well and has gone up. But whenever there is talk of bonds and the yield has gone up, the arrow next to it is also green! Isn’t that misleading because it means the bond is doing badly!!
Now, it becomes really interesting.
The Yield Curve – 10
We now know that the yield of the company bonds reflects the strength of the company. Can we apply this funda to countries also?
I have reproduced below, the yields of one-year bonds issued by governments of various countries:
If you want to check out some more, click on the following link:
Does it amply reflect the financial strengths of the various countries?
The Yield Curve – 11
So, until now, we know the following:
• The bond market is the largest of all markets. The wealthiest invest in this market.
• The yield of the bond varies inversely to its market price.
• The higher the yield of the bond, the higher is the ‘gadbad’ in the company or country issuing it.
The lesson to understand is that – with all the smart wealth managers and financial experts that are at the beck and call of the wealthy, they do not move their investments from one place to another because of a higher return! They always consider a ‘premium’ for the risk taken. Most of us would gladly shift our fixed deposits from one bank to another because that one gives 0.5% higher interest!!
We will tackle the Yield Curve from the next one.
PS. I had sent out an appeal for donations to a Trust a couple of days back. The response has been very encouraging. Some of you had asked for photos of the actual place. I visited the place today morning and took some photos. Do send me a message if you want me to send you the photos or any other details. Thanks once again.
The Yield Curve – 12
Say, we lend money for a year, we would know the person / bank / country is financially okay for a year and we can loan the money at say 6% interest.
If the money was lent for say, 3 years, you would be less certain about the financial situation of the company at the end of that period. So, you’re taking a higher risk and expect to be compensated with a higher interest rate, say 7%.
What if you are lending money for 30 years? The uncertainty increases dramatically, so you would expect an interest rate which is much higher, say, 12%.
This is where the concept of the yield curve comes in. If we plot the time (in years) on the Y-axis and the yield in %age on the Y axis, we should normally get a line that starts close to the X-axis and then progressively moves upwards as it moves to the right.
The Yield Curve is generally used as a measure of predicting a country’s future financial state. Has been rather accurate over a long period of time.
I have made a table and plotted a Yield Curve for India’s Government bonds with tenures of 1 year to 30 years -actual data taken from www.investing.com.