Benchmark bond yields, along with interest rates, are rising in economies across the globe, but India had, until now, seen a very muted rise as compared to developed markets, like the United States. Now, as the yield on the benchmark 10-year government bond has risen by close to 37 basis points to touch 6.83%, experts are suggesting that this may be a cause for worry.
The rise in bond yield is mainly attributable to high inflation, trade and fiscal deficit, higher bank credit to deposit ratio and an imbalanced growth in industrial output.
So, what is a bond yield and how does a rise in bond yields impact investors? Here, we will address these questions and also explain how yields and bond prices are related.
Understanding bond and bond yield
For new investors, bonds are a type of loan that an investor lends to the issuing corporation or government. The interest payments made towards this loan mostly remain unchanged through the bond’s life. At maturity, the investor gets back the principal amount, provided that the borrower does not default.
Those who have been investing in debt securities or debt mutual funds may have come across the term bond yield, as any change in bond yields means changes to bond prices. In simple terms, bond yield refers to the returns to be availed from a bond investment.
Yield = coupon rate/bond’s market price
The calculation shows that there is an inverse relationship between a bond’s yield and its price. Thus, when bond prices rise, the yield drops. This means that when yield rises, bond prices fall.
Bond yields are inversely related to their prices. Let us understand how this works:
Suppose an investor invests in Rs. 1,000 5-year bond with a 10% yield. Every year in these five years, the investor gets Rs. 100 as interest. However, if the interest rate rises to 12.5%, the existing bond is no more attractive since it only earns Rs. 100. This tempts the investor to shift to a newly issued bond to earn Rs. 125. Thus, the bond price falls as its demand goes down.
What’s in the news
India’s benchmark 10-year bond yield climbed up in June’22 to reach the highest level since 2019. The yield has risen to as high as 7.5004%. This is a result of the RBI’s decision to hike interest rates for containing inflation. Whenever the central bank increases interest rates, there is a consequent drop in bond prices.
The fall in bond prices is mainly attributed to less attractive or similar returns offered by bonds vis-à-vis current interest rates. Thus, investors move towards fresh bonds that offer relatively better risk-free returns.
Impact of rising bond yields in India
Some of the implications of rising bond yield that can be seen in the Indian scenario are:
- Bank portfolios in trouble
Indian PSU banks are known to be the largest government bondholders due to the statutory liquidity ratio (SLR) requirement set by the RBI. Thus, PSU banks invest heavily in government bonds. Due to rising yields and falling bond prices, SBI alone reported a significant loss from bond holdings in Q1’22.
- Negative impact on debt fund NAVs
Similar to banks, debt funds that hold government bonds are also seeing their NAV getting eroded. The mutual funds that hold long-dated government bonds are especially in trouble since these bonds are highly impacted by the rise in bond yields. A fall in NAV also means reduced investor wealth.
- High borrowing costs for corporates
Since many large banks have hiked their lending rates in the past two months, the bond yields are on the rise and banks have to shell out more on deposits too. To compensate, banks have also hiked lending rates for corporates.
- Equity valuations are impacted
Since the sharp bond yield spike in February, the equity markets are also going through a major correction. Bond yields are impacting equity markets since equity valuations are based on the discounted cash flow (DCF) method. Thus, the future cash flows are discounted using the cost of capital. If the bond yield rise, the cost of capital rises and current valuations fall.
Every bond investor must understand the concept and computation of bond yields to aid in better decision-making before investing. Since rising bond yields can have various repercussions, as seen in the Indian financial markets, knowing the concept can give an investor a fair idea about when to sell a bond or whether to hold it till maturity.
Yield to maturity of a bond refers to a bond investment returns if the bond is held till maturity. It considers all future cash flows that the bond will fetch till maturity, including interest payments and value at maturity. YTM is, therefore, the rate at which the present value of a bond’s future cash flows will be the same as the current price of the bond.
Although bond investments are relatively safe, they do involve risks, such as interest rate risk, reinvestment risk, and default risk. The level of risk depends on the credit rating of the instrument.
Currently, retail investment in government bonds is mainly done through the mutual fund route, as the majority of the direct participants in government bonds include corporates and financial institutions.
Zero-coupon bonds, capital-indexed bonds, fixed or floating rate bonds, and bonds with a call/put option are some of the commonly available government bonds in India
Yes, bond yields are commonly used to gauge the economic situation of a country. The higher the yield, the slower the economic situation, which may sometimes lead to recession.