Rise in Bond Yield - Causes and Impact

What is the issue?

Yields are rising on government securities or bonds in the United States and India.
This has triggered concern over the negative impact on other asset classes, especially stock markets, and even gold.

What are bonds?

A bond is a debt investment.
Corporates or governments issue bonds directly to investors, instead of obtaining loans from a bank.
This is to raise money and finance a variety of projects and activities.
The investor buys the bonds and loans money to the entity and in turn receives fixed interest.
This is for a defined period of time (till maturity date) and a variable or fixed interest rate (coupon rate).

How are bond prices, bond yields and interest rates related?

Price - Face value is the money amount the bond will be worth at its maturity.
It is also the reference amount the bond issuer uses when calculating interest payments.
The issuance price of a bond is typically set at par, usually $100 or $1,000 face value per individual bond.
But a bond's price changes on a daily basis, just like that of any other publicly-traded security.
The actual market price of a bond depends on various factors including:

Interest rates - The price of a bond primarily changes in response to changes in interest rates in the economy.
For instance, say the investors get a better return in corporate bond either due to rise in their rate or due to fall in rate of government's bond.
- This would make the corporate bond much more attractive.
- Investors in the market will bid up the price of the bond until it trades at a premium that equalizes the prevailing interest rate environment.
Yield - In simple terms, yield is the amount of return that an investor will realize on a bond.
If the investor holds the bond to maturity, s/he will be guaranteed to get the principal amount back plus the interest.
However, a bond does not necessarily have to be held to maturity by the investors.
Instead, investors may sell them for a higher or lower price to other investors.
The bond prices and yields generally move in opposite directions.
This is because, as a bond's price increases, its yield to maturity falls.
E.g. for a bond purchased with a par (face) value of $100, and a 10% annual coupon rate, its yield would be 10% (10/100 = 0.10)
If the bond price fall to $90, the yield would become 11% (10/90 = 0.11).

How have bond yields moved in the recent past?

During the first half of 2020-21, bond yields were mostly below 6% due to effective yield management by the RBI.
However, this changed after the Budget, when the government upped its borrowing programme for the current fiscal.
- It has announced an aggressive borrowing plan for FY22.
The yield on 10-year bonds in India moved up from the recent low of 5.76% to 6.20%.
This was also in line with the rise in US yields.
- Bond yield in the US, which was at 0.31% in March 2020, touched 1.40% recently.
The development has led to concerns in the stock market.
Notably, benchmark Sensex fell 2,300 points in the past week.

What is the significance?

There are over Rs 70.55 lakh crore of outstanding government securities (G-Secs).
The government is also planning to borrow more from the market through G-Secs.
So, the movement of yields in the coming months becomes significant.

What caused the recent rise in bond yields?

The major factors affecting the yield are -
1. the monetary policy of the RBI, especially the course of interest rates
2. the fiscal position of the government
3. government’s borrowing programme
4. global markets, economy, and inflation
With the pandemic’s impact, Finance Minister has pegged the fiscal deficit for 2021-22 at 6.8% of GDP.
- The original target was 3.5%.
The government aims to bring it back to below 4.5% by 2025-26.
A fall in interest rates makes bond prices rise and bond yields fall and vice versa.
In short, a rise in bond yields means interest rates in the monetary system have fallen.
In other words, the returns for investors (those who invested in bonds and government securities) have declined.

How has the rise in yield affected stock markets?

The sudden rise in domestic and global bond yields recently moderated the enthusiasm of equity market participants around the world.
Traditionally, when bond yields go up, investors start reallocating investments.
They shift away from equities into bonds, as they are much safer.
As bond yields rise, the opportunity cost of investing in equities goes up.
Equities become less attractive.
Also, a rise in bond yields raises the cost of capital for companies.
This, in turn, compresses the valuations of their stocks.

How will the borrowing programme and economy be impacted?

When bond yields rise, the RBI has to offer higher cut-off price/yield to investors during auctions.
This means borrowing costs will increase.
- And this happens at a time when the government plans to raise Rs 12 lakh crore from the market.
However, RBI is expected to stabilise yields through open market operations and operation twists.
Also, government borrowing costs are used as the benchmark for pricing loans to businesses and consumers.
So, any increase in yields will be transmitted to the real economy.

Will high yields impact the flow of FPI funds?

Traditionally, when bond yields rise in the US, FPIs (foreign portfolio investment) move out of Indian equities.
Also, it has been seen that when the bond yield in India goes up, it results in capital outflows from equities and into debt.
A higher return on treasury bonds in the US leads investors to move their asset allocation from more risky emerging market equities or debt to the US Treasury.
So, a continued rise in yields in developed markets may put more pressure on Indian equity markets.
India will likely witness an outflow of funds.
Even a rise in domestic bond yields would see allocation moving from equity to debt.

How does the future look?

Yields have already risen across the world, and they are almost certain to rise further in the US.
This will happen especially if the Biden administration gets its $1.9 trillion package over the line.
A slow but steady rise will allow other asset classes to adjust.
However, a rapid increase in the US yields will likely have deeper implications.

What should investors do?

Bond yields move on account of various factors.
So, investors will have to keep an eye on both domestic and global developments while investing in them.
With the RBI now allowing retail participation in G-Secs, investors need to be watchful of developments before taking a decision.

Source: The Indian Express

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