Across the globe, bonds compete with stocks for the funds floating around in the larger financial world. Generally, bonds are considered to be low-risk instruments and do not suffer from the same volatility as shares. Trading in shares of companies is typically marked by a lot of ups and downs. However, shares can potentially often offer a higher return than bonds. Consequently, whenever the stock market is rising, funds flow from the bond market into the stock market. The principle works in the opposite direction as well, that is, when there is too much volatility in the stock market, and far too much risk, funds exit the stock market and move into the bond market.
Before we move on to tackling the impact of rising bond yields on the Indian markets, let us have a look at the basics first.
What is a bond?
When you are in need of funds, you approach a bank for a loan. However, when governments, municipalities or corporations are in need of a fund, they issue bonds to raise loans from a large number of borrowers. When you hold a bond, it means that you have given a loan to a government or a company. IN return for holding the bond, the company or the government gives you interest. The company or the government is called the issuer. The price paid for purchasing the bond is called the face value of the bond, otherwise also known as par value or the principal. The interest that you receive on the bond is called a coupon.
Let us assume that you buy a corporate bond with a par value of Rs 1000 which pays interest of 10%. Therefore the face value of the bond is Rs 1,000 and the coupon is Rs 100.
What is a bond yield?
Bond yield is the return you earn on a bond. It is calculated as coupon amount/bond price. So, taking the above mentioned example, the yield will be 10%.
Let’s assume that after purchasing the bond, you find yourself suddenly in need of cash and wish to sell the bond. When you go to the bond market, you will not be able to sell it at the same price. Several factors influence the bond price, and it is quite likely that your bond would have either risen or fallen in value.
In case the bond price would have increased to, say Rs 1,200, then your yield will be 8.33% (100/1200)
In case, you sell it at a lower price, say Rs 700, then your yield will be 14.28% (100/700)
When do bond yields rise?
Everytime the central bank of a country feels that there is too much liquidity in the market which is stoking inflation, the central bank chooses to increase the short-term interest rates which leads to a fall in the bond price. The interest rate or the rate at which commercial banks borrow money from the central bank is the base rate for all bonds being doled out in a certain currency.
In case, the market expects the central bank to reduce interest rates, the bond yields fall as well while the bond prices rise.
If the markets expect the central bank to hike interest rates, the bond yields rise as well while the bond prices fall.
As a rule, remember that bond yields and bond prices move in opposite directions.
How does the rise in US bond yields affect Indian equities?
In the mid-2020s, with the advent of the Covid pandemic, the US Federal reserve reduced the interest rates and consequently, the yield of its benchmark 10-year treasury note also sunk. Simultaneously, as the US economy continues to gradually reopen and the scourge of Covid subsides, inflation is moving up as well. Prices of a number of commodities have also been spiking since the beginning of the year, and the market is interpreting the increase in commodity prices as a heralder of inflation. Quite naturally then, yields on the 10-year Treasury note have been sliding up from 0.91% at the beginning of the year to 1.72% in March.
Bond yields can be seen as representing the opportunity cost for investing in equities. The US Treasury note is considered to be the safest bond in the world and is considered to be a risk-free rate. For investors to be pulled into investing in equities, the market will have to justify a risk-premium. When the bond yield in the US rises, the cost companies have to pay for raising capital also goes up. Rising bond yields put additional pressure on companies to give higher returns to their investors, failing which they might liquidate their investments and choose to park their funds in US bonds.
When bond yields rise, foreign institutional inflows shift from Indian equities to the safe haven of US bonds. A spike in US bond yields also leads to a depreciation in rupee which hurts the bottom line of companies which have borrowed in US dollar denominations. On the other hand, companies in sectors like pharmaceuticals and tech that earn a good portion of their earnings in US dollars benefit highly from rupee depreciation.
What is the impact of rise in bond yields?
It will soothe the nerves of Indian investors to know that central banks across the world would like to maintain interest rates at a low in order to help a post-pandemic economy to recover. As long as the US federal reserve maintains an accommodative stance, one can reasonably expect FII inflows to keep coming into Indian markets.