Economy · Explained
A bond may promise a fixed interest payment, but its market price can keep changing. Understand face value, coupon, yield, the price-yield relationship, the yield curve and the factors that move India's bond market.
In one line
A bond is a tradable loan. Its coupon may remain fixed, but its market price changes as investors' required return changes. That is why bond prices and yields generally move in opposite directions.
Start with the simplest question: What is a bond?
When the Government of India needs to borrow money, it can issue a government security. An investor who buys that security is effectively lending money to the government. In return, the investor receives interest according to the terms of the security and gets the principal back at maturity.
The same basic idea applies to corporate bonds. A company or financial institution can borrow from investors by issuing a bond. The important difference from an ordinary loan is that a bond can generally be traded after it is issued. That creates a market price.
In India, government securities such as dated G-Secs are an important part of the fixed-income market. The Government also issues Treasury Bills for shorter maturities. Corporate bonds, state government securities and other debt instruments form additional parts of India's bond market.
What is bond yield?
Yield is the return an investor expects from a bond relative to the price paid for it. It is different from the coupon rate. The coupon is a feature of the bond itself, while the yield changes with the price at which the bond is bought and the cash flows that remain.
For a new bond issued at its face value, the coupon rate and the initial yield may be the same in a simple fixed-rate example. But once the bond starts trading in the secondary market, its price can move and its yield can move with it.
Coupon vs Yield: Do not confuse the two
Coupon: The fixed interest payment promised by the bond, usually expressed as a percentage of face value.
Yield: The return an investor expects based on the bond's current market price and remaining cash flows.
If a ₹100 bond pays ₹7 a year, its coupon payment remains ₹7. If the bond's market price rises to ₹105, the investor buying it today is paying more to receive the same ₹7 payment. Its yield therefore falls.
Why do bond prices and yields move in opposite directions?
This is the most important relationship to understand in the bond market. The reason is simple: the coupon on an existing bond is fixed, but the return investors demand in the market keeps changing. The price of the existing bond has to adjust so that its return becomes competitive with the return available on new bonds.
Imagine that the Government of India issued a bond with a face value of ₹100 and a fixed coupon of 7%. The bond therefore pays its holder ₹7 every year, regardless of what happens to market interest rates later.
Now suppose interest rates rise and newly issued government bonds begin offering investors a yield of, say, 8%. An investor comparing the two bonds would naturally prefer the new bond: why pay ₹100 for an old bond that pays only ₹7 a year when a new bond can offer a higher return?
The old bond does not stop paying ₹7. Its coupon is still fixed at 7%. Instead, its market price has to fall. At a lower purchase price, the same ₹7 annual coupon becomes a higher percentage return for the new buyer. The fall in price therefore makes the old bond competitive with the higher yields available in the market.
This is the key idea: the bond's cash payment has not changed; its price changes so that the return earned by a new buyer changes.
The reverse happens when market yields fall. Suppose new government bonds are now offering only 6%. The old bond paying a fixed ₹7 suddenly looks attractive. Investors may be willing to pay more than ₹100 to acquire those higher fixed payments. As the market price rises, the return available to a new buyer falls until it becomes broadly competitive with the lower yields available elsewhere.
Think of it this way: the coupon is fixed, but the market price is flexible. When the required return changes, the price moves until the old bond offers a competitive return.
That is why bond prices and market yields generally move in opposite directions.Coupon is not the same as yield
This distinction is extremely important. The coupon rate is the interest promised by the bond on its face value. The yield is the return an investor earns based on the price actually paid for the bond.
For example, a ₹100 bond with a 7% coupon pays ₹7 a year. If you buy it for ₹100, the coupon represents 7% of what you paid. But if the same bond falls to ₹90 in the market, you are still receiving ₹7 a year. Relative to the ₹90 you paid, that fixed coupon represents a higher return. This is why the market yield rises when the bond price falls.
Likewise, if investors bid the bond's price up to ₹110 because its fixed ₹7 coupon has become attractive, the same ₹7 payment represents a lower return relative to the price paid. The yield therefore falls.
The rule to remember
Market yield ↑ → Existing bond price ↓
Market yield ↓ → Existing bond price ↑
Coupon stays fixed; market price adjusts.
Interactive: Move the market yield and watch the bond price
Illustrative 10-year bond: face value ₹100, annual coupon ₹2. The relationship below follows the example used in the source explainer.
When the required yield is equal to the 2% coupon, the bond trades around face value.
The calculation behind this idea is simple: the market price is the present value of the future coupon payments plus the principal repayment. When the required yield used to discount those future payments rises, those future payments are worth less in today's money, so the bond's price falls. When the required yield falls, the present value of those future payments rises, so the bond's price rises.
Bond pricing with a simple Indian example
Suppose a government bond has a face value of ₹100, pays a fixed coupon of 2%, and has 10 years remaining to maturity. It therefore pays ₹2 each year and returns ₹100 at maturity.
If investors require a 2% yield, a price of about ₹100 makes sense because the bond's coupon matches the required return.
Now imagine the required yield falls to 1%. The bond still pays ₹2 a year. Nothing has changed in the bond's promise. But new investments now offer a lower return, so the existing bond's fixed ₹2 payment looks relatively attractive. Investors are willing to pay more than ₹100 for it, pushing its market price higher.
If the required yield rises above 2%, the opposite happens. The fixed ₹2 coupon becomes less attractive compared with newly available investments. Investors will pay less than ₹100 for the old bond, and the lower price raises the return available to the new buyer.
This is why you should never say that a bond's coupon changes when market interest rates change. The coupon on an already-issued fixed-rate bond normally remains unchanged. It is the market price that moves, causing the bond's yield to change.
Primary market vs secondary market
The bond market has two stages that students often mix up.
Primary market
This is where the issuer raises money by selling a new security to investors. In India's government securities market, new government borrowing is conducted through auctions. The price or yield at which investors acquire the security determines its initial market terms.
Secondary market
After issuance, investors can trade the security with one another. The government does not receive a new ₹100 every time the bond changes hands. Instead, the market price changes according to demand, supply and the return investors require.
| Feature | Primary market | Secondary market |
|---|---|---|
| Who buys? | Investor buys from the issuer/auction process | One investor buys from another |
| Purpose | Raises fresh funds for the issuer | Allows investors to trade existing securities |
| Price/yield | Established through the issue process | Changes with market conditions |
What is the yield curve, and why does it matter?
The yield curve is a graph that shows the yield investors demand on similar bonds with different maturities. In India, the most important example is the Government of India securities (G-Sec) yield curve.
Think of the government borrowing money for different periods: one year, two years, five years, ten years and even longer. Each maturity can have a different yield. When these yields are plotted against their maturities, we get the yield curve.
In simple terms: the yield curve shows how the cost of government borrowing changes as the borrowing period becomes longer.
Horizontal axis = maturity. Vertical axis = yield.How should you read it?
Start from the left, where shorter maturities are shown, and move towards the right, where longer maturities are shown. Then look at whether the line goes upward, stays broadly level or moves downward.
The shape matters because a one-year yield and a ten-year yield are influenced by different considerations. Short-term yields are closely connected to current monetary-policy conditions and expectations about the RBI's near-term actions. Longer-term yields also reflect expectations about future interest rates, inflation, economic growth, government borrowing and longer-term risks.
Why doesn't the 10-year yield simply equal the 1-year yield?
A 10-year bond locks the investor into a fixed set of payments for much longer. Over those ten years, inflation, interest rates and economic conditions can change. Investors therefore price the bond according to what they expect to happen over the longer period and the risks they take by committing their money for longer.
For example, if investors expect inflation and interest rates to remain higher in the future, they may demand a higher yield on longer-term bonds. If they expect interest rates to fall significantly in the future, longer-term yields can be lower.
This is why the yield curve should be viewed as a market-based signal, not as a forecast issued by the RBI.
Interactive: Explore the four basic yield-curve shapes
Select a shape. The examples below are illustrative, designed to show how the curve is read. They are not current market yields.
Normal: Longer-term yields are higher than shorter-term yields. This can be consistent with expectations of higher future inflation or interest rates, stronger growth, or compensation for taking longer-term risk.
The four shapes you should know
Normal or upward-sloping: Long-term yields are higher than short-term yields. This can be consistent with expectations of stronger growth, higher inflation or higher future interest rates. Investors may also demand extra compensation for longer-term risks.
Flat: Short- and long-term yields are broadly similar. This often indicates that the market sees considerable uncertainty about the future path of interest rates, inflation or growth.
Inverted: Short-term yields are higher than long-term yields. This can occur when current short-term rates are high but investors expect interest rates and inflation to decline in the future. In some economies, persistent inversions have preceded economic slowdowns, but an inverted curve is not a guaranteed recession signal.
Humped: Medium-term yields are higher than both short- and long-term yields. This can occur when investors expect rates or inflation to rise for a period before easing later.
Why does the yield curve matter in India?
The yield curve connects the bond market with the wider economy.
For the RBI: The short end of the curve responds strongly to monetary-policy expectations, liquidity conditions and expectations about the repo rate. The longer end can respond more to inflation, growth, borrowing and global factors.
For the government: It shows the borrowing cost associated with different maturities. If long-term G-Sec yields rise, raising money through longer-term government securities can become more expensive.
For banks and companies: G-Sec yields act as important reference points in financial markets. Corporate bonds generally offer a higher yield than comparable government securities because investors also require compensation for credit and other risks.
For investors: The curve helps them decide whether to hold shorter- or longer-maturity bonds and how much interest-rate risk they are willing to take.
Do not confuse the level with the shape
This is an important exam and market concept. The level tells us whether yields are generally high or low. The shape tells us how yields at different maturities compare with one another.
For example, suppose the 1-year G-Sec yield rises from 6.2% to 6.7%, while the 10-year yield rises only from 6.8% to 6.9%. Both yields have increased, but the gap between them has narrowed. The curve has therefore become flatter.
Remember this
The yield curve is a map of interest rates across different maturities. Short-term yields are more closely linked to current monetary-policy conditions, while longer-term yields incorporate expectations about future inflation, growth, interest rates and longer-term risks.
What makes bond prices move?
The price of a bond is ultimately determined by what investors are willing to pay for its future cash flows. That willingness changes as economic conditions and market expectations change.
Why do long-term bonds usually offer a different yield from short-term bonds?
A five-year or ten-year bond locks money into a fixed return for much longer than a short-term bond. During that period, inflation, interest rates and economic conditions can change. An investor therefore faces more uncertainty and may demand additional compensation for taking longer-term risk.
This is one reason a normal yield curve often slopes upward. But it is not a rule. If investors believe future interest rates will fall sharply, longer-term yields can fall below short-term yields, creating an inverted yield curve.
Demand and supply: the market mechanism
There is another simple way to understand bond prices: demand and supply.
When demand for a particular bond rises, its price tends to rise. Because the bond's future payments have not changed, paying more for those same payments means the buyer earns a lower yield.
When the supply of bonds rises, all else equal, the price tends to fall. A lower price makes the bond's future payments more attractive, so its yield rises.
Interactive: What happens when bond demand changes?
Investors compete more strongly for the bond, so they are willing to pay a higher price for its fixed cash flows.
Government bonds and corporate bonds are not priced the same way
The basic price-yield relationship applies to both. But investors also care about the probability that they will receive the promised payments.
Government securities issued by the Government of India in rupees are generally treated as having very low credit risk. Corporate bonds carry additional credit risk, because a company can face financial difficulties and may fail to make payments as promised.
That is why a corporate bond with the same maturity as a government bond will generally need to offer a higher yield if investors perceive greater risk. The extra return compensating for this additional risk is commonly reflected in the bond's spread over a government benchmark.
What happens when the RBI changes its policy rate?
The RBI's policy rate is an important starting point for interest rates in the economy. A change in the policy rate can affect the short end of the yield curve quickly. But long-term bond yields do not necessarily move by the same amount because they also depend on expectations about future inflation, growth, government borrowing and future policy rates.
For example, if markets believe that the RBI will keep monetary policy tighter for longer because inflation is expected to remain elevated, bond yields may rise. Existing fixed-coupon bond prices would generally fall.
Conversely, if investors expect lower future policy rates and lower inflation, longer-term yields may fall. Existing bonds with relatively attractive coupons can then become more valuable, pushing their prices higher.
A useful exam connection
Monetary policy → market interest rates → bond yields → bond prices → borrowing costs and investment decisions.
This is part of the broader monetary policy transmission process. The yield curve helps explain how changes in policy conditions can influence interest rates at different maturities.
Three risks investors watch in bonds
Credit risk is the possibility that the issuer will not make an interest or principal payment as promised. Investors generally demand a higher yield when they perceive greater credit risk.
Liquidity risk arises when a bond may be difficult to sell quickly without accepting a large price concession. Less liquid bonds can therefore require a higher yield.
A longer-term fixed-rate bond is more exposed to changes in interest rates. If market yields rise, the price of an existing fixed-rate bond generally falls. Investors may demand additional return for accepting this uncertainty.
Why does this matter outside the bond market?
Bond yields influence much more than the portfolios of professional investors.
Government borrowing costs matter for public finances. Corporate bond yields affect the cost of raising funds for businesses. Banks use market interest rates as important reference points when pricing loans and investments. Savers and investors also compare the return available on bonds with deposits, equities and other assets.
This is why a sharp movement in the government bond market can eventually affect the broader economy. The bond market is one of the channels through which expectations about inflation, monetary policy and economic growth are translated into financial conditions.
What should a student remember?
Quick check
1. If the market yield on comparable bonds rises, what usually happens to the price of an existing fixed-coupon bond?
2. If demand for a particular bond increases, what generally happens?
The bottom line
A bond is simply a tradable loan, but its market price is constantly being reassessed. The issuer's promised cash flows may remain fixed, while the return investors demand changes with interest rates, inflation, economic expectations, risk, demand and supply.
That is the key to understanding bond pricing: when the required yield rises, the price of an existing fixed-coupon bond generally falls; when the required yield falls, its price generally rises.
Once this relationship is clear, the yield curve becomes easier to understand. It is simply the market's picture of the yields investors require across different maturities, and it provides an important window into monetary policy, inflation, growth expectations and financial conditions.
