Implications of rising bond yields in India

Implications of rising bond yields in India

Subject – Economy

Context – Bond yield rises nearly 6 basis points to a 24-month high of 6.52%

Concept –

What are bonds?

• A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental).
• In the case of companies, just like they share their equities with investors via stocks, they share the debt with investors via bonds. So bonds are units of debt issued by the companies and traded like stocks.
• A company issues bonds to raise money and they pay regular fixed interest to the bondholder. This interest rate is called the coupon rate. It is declared on the face value of the bond and remains fixed until maturity.
• However, since bonds are tradeable, they also give returns. These returns are called bond yields.

What are bond yields?

• Bond yields are returns you get when you buy a bond from the secondary market.
• Bond yields and prices move in opposite fashion — when bond prices rise, yields fall, and vice versa.
• But when the returns are higher, you would want to drop equities and flock to bonds.

Reasons for rise in bond yields –

The sharp rise in bond yields has been driven by a variety of triggers.

• Firstly, is the inflation which has been on a constant uptrend since June last year and has only started tapering in the last couple of months! The inflation rate is still above the RBI comfort level and inflation expectations continue to be elevated.
• Secondly, the Fed has already hinted at 3 rate hikes this year and the strong economic data hints at possibly 4 rate hikes. That has also kept Indian yields elevated in tune with global trends.
• Lastly, the markets are also factoring in a situation where the RBI may be forced to hike rates by 25-50 basis points this year to keep the yield differential attractive to global investors.

Implications of higher bond yields –

• Higher bond yields will create a problem for bank bond portfolios
  • Indian banks, especially PSU banks are among the largest holders of the government of India bonds. That is because banks are required to maintain statutory liquidity ratio (SLR) with the RBI as a safety net to protect their solvency. The SLR predominantly consists of government bonds and the RBI also uses this to meet the government’s borrowing program.
  • Bond losses are a major problem for banks as a rise in yields leads to a fall in bond prices and therefore these losses have to be booked by the banks. This could depress profits of banks and make any fund raising plans difficult.
  • Rising inflation pushes bond prices lower, thereby pushing yields higher.
• Rising bond yields is not great news for NAVs (Net Asset Value)of debt funds
  • Just like banks lose out on their bond holdings, debt funds holding on to these government bonds also see erosion in their NAV values.
  • This problem is more acute in case of mutual funds that are holding long-dated government bonds as these bonds are most vulnerable to a rise in bond yields.
  • The bottom line is that fall in NAVs reduces the wealth of investors, both retail and institutional.
• Indian corporates may be forced to borrow at higher rates of interest
  • As bond yields rise, the banks will have to raise the rates paid out on deposits to keep them attractive. But to compensate for that they are also forced to raise the lending rates to maintain their spread.
• Government borrowing programs will be impacted negatively
  • Higher bond yields will mean that the government will have to borrow at much higher rates, something it will not be prepared to do as it will sharply increase its borrowing cost.
• It could also have a negative impact on equity valuations
  • Equity valuations are done based on the discounted cash flow (DCF) method. Here the future cash flows are discounted to the current year by using the cost of capital as the denominator. The cost of capital is a weighted average of the cost of equity and the cost of debt.
  • If the bond yields go up then it means the cost of capital goes up and therefore current valuations are more depressed. That is one of the key reasons why markets have been down in the past 2 months.

How rising bond yields impact stock markets

• The yield of 10-year G-Sec is considered a benchmark and it reflects the overall interest rate scenario.
• In theory, a rising bond yield should be negative for equity prices because higher yields would make equity investments unattractive.
  • In other words, higher bond yields will make investing in bonds more attractive as compared to equities.
• Bond yields reflect the growth and inflation of an economy. When the growth is strong, yields would rise. It shows the economy is recovering or improving.
  • Due to growth: When growth is strong, cash flows and future earnings estimates improve. These improvements offset the negative impact of the rise in the discount factor that higher yields cause (more on this later). So the overall impact of equities is positive.
  • Due to inflation: But when yields rise and the growth is not strong enough, there is no factor to offset the impact of the high discount factor. This impacts the equity prices negatively.

What do rising bond yields mean?

• Bond yields are one of the metrics available for economists to judge the health of an economy, among others.
• When investors sell bonds, prices drop, and their yields rise. A higher yield spells greater risk. If the yield of 10-year bonds is higher than what it was when it was issued, then there would be a possibility that the government is financially stressed and may not be able to repay the capital. That said, g-secs are relatively stable.