Demystifying the Impact of Rising Bond Yields

Demystifying the Impact of Rising Bond Yields

  • Reading time:5 mins read

The Indian Stock Market performed extraordinarily during the last year with Sensex and Nifty crossing the 50k and 15k Mark albeit the global pandemic. One of the main catalysts of this growth was the emergence of India as a major player in the MSCI Index driving the inflow of foreign investors to the domestic country. With the Fed injecting high liquidity in the market and interest rates at an all time low it was the perfect time for Foreign Portfolio Investors to take on risky investment avenues outside their own country.  

However, this utopian era ceased to continue over the last few days with the markets dipping constantly making new lows everyday – this can be majorly attributed to the rise in US Treasury 10 Year Bond Yields and the G Sec Bonds in India.  

What does the yield of a Bond mean?   

Bonds are considered to be one of the safest investment options, bond yields act as a measure to judge the performance of these bonds.

Simply put the yield of a bond means the amount that it pays each year in interest as a percentage of its current price. For example, if a bond is sold at Rs. 100 and pays Rs 5 per year, its yield is 5%. When the price of a bond goes up, its yield goes down – if that same bond is now being sold for Rs. 105, its yield would be 4.76% (5/105). And the same applies the other way around – if the price of that bond dropped to Rs. 95, its yield would go up to 5.26% (5/95). A bond’s yield (as per its current price) is, effectively, its current interest rate.  

Why are bond yields rising?

In case investors are suspicious of the performance of the economy as a whole and the prospects of private firms in the country, they turn to government bonds as these have little or no chance of default and offer varying timeframes. This will increase the demand for bonds thereby increasing their price, this ultimately reduces it’s yield.

Now imagine the opposite scenario, if borrowing becomes cheaper, the economy is coming back on track, companies are showing path breaking performance in times of crisis – it becomes prudent to disinvest from bonds and invest in companies (domestic or international) through the stock market.

This thereby decreases the price of bonds, increasing their yields (generating better returns than before). We are currently in the second scenario where investors preferred to invest their money in emerging markets with a bullish outlook.

How have bond yields performed overtime?

The yield on 10-year bonds in India moved up from the recent low of 5.76% to 6.23% in line with the rise in US yields from 0.52% in August 2020 to 1.56% on 5th March 2021, that is a 3x increase.

The average increase in government securities yields across 3, 5, and 10 years has been around 31 basis points since the Budget. Corporate bonds rated ‘AAA’ and SDL spreads have jumped by 25-41 basis points during this period.

In the UK, 10-year bonds rose 40 basis points in February to touch 0.76% this week.

In essence, this means investors find lending to the government a better alternative than lending to the Indian firms via the stock markets which is a major contributor to the recent dip.

The rising bond yields have also led to the firming up of the US dollar against other major currencies like Euro and Yen. If the yields in the US continue to move up beyond 1.5 per cent and the US dollar also strengthens, then it can trigger the withdrawal of funds from risk assets like equities and riskier regions like emerging markets eg. India.

In spite of the rising bond yields that had their long shadow on the markets, the Indian equities ended the week in green, with a gain in excess of 2 per cent, after two consecutive weekly losses. On Friday, Sensex and Nifty50 closed the week at 50,045 and 14,938.10 respectively, up by ~2.80 per cent each.

How exactly do Bond Yields affect the Stock Market?

It is not surprising that the US economy is one of the largest economies in the world, investing in US treasuries is one of the safest bets and if such bond yields are rising then they become an even more attractive proposition. The US treasury attracts foreign investors from across the world.

As a result many global investors pull out their funds from emerging markets like India and prefer investing in US Bonds or the prospects of the US Economy.

It is intuitive to think about the concept of opportunity cost here, consider an example where the bond market in India had a yield of 3% and the Stock Market could promise returns of 10% (arbitrary figure), the opportunity cost of investing in Bonds and not in equity thus would be this gap of 7%.

Now that the Bond Market has an interest of 6%, this opportunity cost of return foregone has dropped to 4% but at least a return of 6% is more or less guaranteed unlike the 10% return in the Stock Market.

Another impact of the rise in G Sec Bond Yields is that it will increase the cost of borrowing for companies as they would now need to shell out more money as coupon payments to incentivise the investors to prefer them over their government counterparts. This hits the valuation of companies and markets readjust accordingly to the future prospects.

When growth is strong, the impact of higher growth in terms of cash flows or dividends more than offsets the negative impact of the rise in yields, causing equity share prices to trade higher.

What Lies Ahead?

In case the Central Bank decides to step in to stabilise the coupon rates on bonds we can see some stabilisation in prices and the stock market combined. Till then, we might still witness some outflow of funds and profit booking by foreign investors.