Bond Baba: Why Are There Two 10-Year Bonds With Different Yields?

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Bond Baba goes into some theory today. There are apparently two 10 year bonds, both maturing in 2026. One has a 6.97% coupon and the other, a 7.59% coupon. Yet, the market prices for both indicate very different yields! One is at 6.82% and the other, at 7.09% – why?

The Vagaries of Bond Issuance

Did you know that the Government raises money by selling bonds every single week? Did you know that this adds up to an issuance of Rs. 30,000 cr. each week? Did you know that there’s about 45 lakh crore (45 trillion) rupees worth bonds out there?

Every week, the RBI conducts auctions for “G-Secs” or “Government Securities” on Friday. Nowadays, there are about Rs. 14,000 cr. of auctions every week, and multiple bonds are sold. Last week alone, we saw bonds sold that matured in 2022, 2030, 2034 and 2044. (Here’s the link)

How does this work? Assume a government has no bonds, and it’s April 2016. It wants to now borrow. It tells people: Look, I’ll borrow money from you, and pay you some interest every year, and repay you the principal after 10 years.  I want to borrow X crores. Why don’t you tell me what you’ll demand in terms of interest rates? And then RBI will conduct an auction. Banks and other participants bid in terms of how much they would be happy to give the government at the interest rate they want. The RBI collates the bids and takes the lowest interest rate at which all the X crores can be borrowed. Let’s say that is 4,000 cr. at 7.6%. Then the government issues a bond maturing 10 years later paying a coupon of 7.6%. That is, we have a 7.6% 2026 bond that’s been issued.

(We have just seen how a bond was issued in an auction by “yield”. Or, a yield-based auction.)

This is a marketable security. So a bank can pay the government and hold the bond, and then sell the bond to someone else. In this process, the market price of the security – measured as Rs. 100 – will change – perhaps it went up to 104 or such, and the yield (which is how you measure the return of the security over the longer term) fell to 7.4%.

Now the government wants to borrow again. RBI will then be the intermediary and say, okay let’s do another 4,000 cr. of this same bond (which pays a 7.6% coupon) but this time, we won’t ask people how much interest rate they want, we’ll ask them what price they wish to pay.

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So banks and mutual funds bid – let’s say they bid Rs. 103.5 overall, the lowest price at which the 4,000 cr. can be sold. That becomes the price of the auction – which might translate into a yield of 7.4%. So the 7.6% bond (that’s the interest they pay on the face value of the bond each year) is being sold at 7.4% – meaning the price has gone up. This was a price-based auction.

That way, in the market the yields change often, and issuance also keeps going up. The government over time realizes that it can’t just have a big payout after 10 years, so it issues 5 year bonds, 15 year bonds, 20 year bonds also – and spreads the amount it requires among those bonds.

And Then, When Things Get Out Of Balance…

So let’s say things have been hunky dory for 6 months. It’s now November 2016, and people are saying we have a bond, but it’s not a 10 year bond, it’s a 9.5 year bond. And worse, the government has been issuing it so much that there’s now 90,000 crore rupees that is outstanding in that bond itself!

This is where RBI gets all antsy. More than 90,000 cr. to be paid out in one big tranche is what they don’t particularly like.

So then they issue a new bond – again through a yield-based auction. And so, further issues of that bond will be through price based auctions. Investors will have two bonds to choose from, if they look at the bond market – one that matures in April 2026, and one that matures in November 2026.

Typically, all investors tend to choose the “liquid” bond which happens to be the 10 year. So they will slowly shift their holdings from the old 10 year to the new 10 year.

And Here’s Why The Yield Difference

Okay, let’s look at reality now. (The earlier stuff was an example)

  1. There was a bond issued in Jan 2016, which was the 7.59% coupon.
  2. This was the 10 year bond all the way till very recently – the most liquid bond that was traded. While it was issued at 7.59% it’s price slowly went up as the rate cut expectations went up, and currently the yield on it is 7.08%.
  3. However, issuance has now reached about 87000 cr. (See link)
  4. And also, the bond is now less than 9.5 years away.
  5. So a new bond was issued through a yield based auction on 6 Sep 2016. (See the auction results)
  6. The new bond was at 6.97%.
  7. Now there’s just 8,000 cr. of this new bond, but about 87,000 cr. of the new bond.
  8. And most participants want to move to the new bond because they want to be in the 10 year term.
  9. So what do we have? A new 10-year that has only 8,000 cr. out there (low supply) and hajaar people looking to sell the old-10 year and move to the new 10-year (high demand).
  10. So the price of the new 10 year goes up, and the old 10 year, relatively, goes down.
  11. As supply of the new 10 year increases from more auctions – there will be a 10 year bond auction once in two weeks – the prices will normalize. But the new 10 year will become the most traded bond and the old one will see less action.

This happens every six months. See this chart, taken in 2012-13, of the various bonds that became the new 10-year and then matured and so on:

10-Year-Bonds

As you can see, new 10 years always trade at lower yields (meaning higher prices) to begin with and then they will move their way around.

The older bonds don’t always have the same liquidity but they retain some trading element through the year.

It’s not usually as bad in more developed bond markets. Because it is nonsensical to pay a lot more for a bond that matures just six months earlier, bond market players will come in and balance things out better. India will see this in the next decade or so, perhaps. This article remains relevant till then.

Does This Means Rates Will Fall?

In one word: No. (If rates fall, that would be independent)

Watch the above chart. In May 2013, yields were around 7%, of a new 10 year bond. Then yield went up to 9% and interest rates went up too. (There was a crisis) In the middle of the crisis there was yet another 10 year shift, and even that bond was trading lower, however rates did not go down at all for a long time after that.

The bond market is weird. Just because yields are lower on some bond doesn’t mean rates are going to drop. It could just be demand and supply, like we have seen.

Bond Baba says we need to understand some of this now, because soon, we will be able to buy these bonds through banks and brokers. (Not yet, but soon)They come at Rs. 10,000 per bond – but the wholesale market only trades them at Rs. 5 crore per trade (5000 bonds). Perhaps the retail market will also be allowed, like in Sovereign Gold Bonds, where such bonds will have a smaller lot size as well. And then we can lock in rates for as long as 40 years, if we like! Here’s to an education that helps us get there.

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