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B. Venkatesh

INVESTORS are concerned about further rise in crude prices, as that would lead to higher bond yields. What is the relationship between oil prices and bond yields?

When you invest in a bank deposit or bonds, the interest you receive is the compensation for delaying your current consumption of goods and services.

Suppose you postpone your decision to buy a house and instead invest in a 5-year fixed deposit paying 6 per cent per annum. What if property prices rise 10 per cent in 5 years? Your decision to postpone current consumption would be costly.

So, if you are concerned about rising inflation, you will prefer to consume now rather than invest in fixed deposits or bonds. If you do not invest, banks will not have enough money to lend to businesses. That will hamper business expansion and affect economic growth. To make investments attractive, interest rate has to compensate for inflation.

Now, petrol and diesel are consumed by all businesses. If crude oil prices rise further, the cost of producing goods and services will also increase. That will, in turn, lead to higher inflation. And higher inflation will prompt investors to demand higher interest rates.

Interest rates and bond prices are inversely related. If interest rate moves up, bond prices decline. Why? Suppose a 10-year bond that pays 7 per cent per annum trades at Rs 100.

Assume that a rise in inflation forces the RBI to offer an interest of 8 per cent for new issue of 10-year bonds. There will be no demand for existing 7 per cent 10-year bonds because it offers lower interest rate. So, its price will decline to yield the market rate of 8 per cent. And that is a cause for concern for bond dealers.

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