Explained: Why bond yields are rising, and what it means for markets and investors

The big jump

The yield on benchmark 10-year government bonds has shot up by 149 basis points to 7.50% in the last one year. Since the start of the year, long-term yields have risen by over 100 bps, and short-term yields by over 150 bps.

Bond yields have been rising across the world amid higher inflation and plans for policy normalisation. Seeing the writing on the wall, buyers of government bonds have been demanding higher yields. “Data showing further increase in inflation leading to higher-for-longer inflation expectations may result in further increase in bond yields and correction in markets. We expect inflation in India to trend down sharply in the second half of FY23 on high base effects but note upside risks to inflation from higher-than-expected domestic food prices and global fuel prices,” said a report from Kotak Securities.

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What it means

The rise in yields means markets have already factored in the worst of the rate movements. This also hints at the possibility of overnight rates rising to 6%-plus over the medium term. With current repo rates at 4.90%, this implies incremental rate hikes of more than 100 bps have been factored into bond yields. The rise indicates that the cost of funds in the financial system is rising and so are interest rates. A section of the market also attributes the rise in yields to the RBI’s plan to exit from its accommodative stance and tighten interest rates in the coming months.

The rise means the government will have to pay more as yield (or return to the investors), leading to a rise in cost of borrowings. This will put upward pressure on general interest rates in the banking system. Further, if the RBI opts for normalisation of the monetary policy and intervenes less in the market, interest rates are bound to go up.

Analysts say expectations of higher inflation and the possibility of a rate hike can trigger a flight of capital from bank fixed deposits to RBI sovereign guaranteed bonds, as the difference in yields is now almost 150 bps.

Bond investors…

The rise in yields means investors expect higher interest rates and are selling their bonds, because higher rates would result in a decline in the bond price of existing bonds (and thereby capital loss on sale before maturity). Debt investors are set to get impacted. When yields rise and bond prices fall, net asset values of debt funds, which hold a sizeable chunk of government securities in their portfolios, will also decline. It will also impact corporate bonds, which are priced higher than government bonds.

The RBI’s change of stance on liquidity is likely to impact corporate spreads, especially AAA-rated bonds, when compared to government securities. The yield curve presents material opportunities for investors in the 4-7-year segment, and also offers a significant safety margin given the steepness of the curve. For investors with a medium-term investment horizon (3 years+), incremental allocations may offer significant risk reward opportunities. For investors with a short-term horizon (6 months-2 years), floating rate strategies are attractive as interest rate resets and premiums offer competitive “carry” and low volatility, said Kotak Securities.

… and equity investors

Rising bond yields are generally not good news for equity investors as they raise the cost of funds for companies and start hurting their earnings. It thus leads to outflow of funds from equities towards a less risky debt instrument. The CIO-debt of a leading mutual fund said that if a sovereign instrument starts paying 8%, it definitely attracts investors, “However, since the earnings of companies continue to be strong as of now, the impact will not be much. As and when higher interest rates start hurting companies’ earnings per share, it will put pressure on equity markets as outflows from equities will be higher.”

Traditionally, bond yields have an inverse relationship with equities as a rise in bond yields means that the risk premium on equities will have to go up.

What to expect now

Market participants say it is tough to figure out the peak in the current market as global uncertainties remain. However, markets have already factored in a rate hike of another 100 basis points by RBI. While the yields may rise by another 25-50 basis points depending on the government’s borrowing programme and global oil prices, debt fund managers say investors can go for short-term duration investment for 1-2 years. “A 3-year AAA-rated paper is trading at a yield of around 7.25%. Even if the yields were to rise by 50 bps over the next one year, if an investor remains invested for two years, he came make an annual return of 7%, which is good,” said the CIO of a leading mutual fund.