Bonds are the loans that one makes to corporation or government. Bond yield is a return an investor gets on that bond or on a particular government security. The major factors effecting the yield is the monetary policy of the Reserve Bank of India, especially the course of interest rates, fiscal position of the government, global markets, economy and the inflation. A fall in interest rates makes bond prices rise, and bond yields fall and rising interest rates cause bond prices to fall, and bond yields to rise.
Bond yields are inversely proportional to equity returns, when bond yields decline, equity markets tend to outperform, and when yields rise, equity markets tend to fall. Traditionally when bond yields go up, investors start reallocating investments away from equities into bonds.
Also rise in bond yields raises the cost of capital for companies, which in turn reduces the valuations of the stocks. A cut in repo rate reduces the cost of borrowings, leading to a rise in share prices and vice versa.
How will the economy and stock market is impacted?
When bond yield rises RBI has to offer higher yield to investors. Borrowing costs also increase when government plans to raise money from the market. RBI stabilizes the yields through open market operations. Besides government borrowing costs are used as benchmark for pricing loans to business and consumers, any increase in yields will be transferred to economy.
While valuing equities, investors add the equity risk premium they seek to a risk free rate to compute the expected rate of return. Long bond yields reflect the growth and inflation mix in the economy. They also rise when inflation is higher.
When growth is strong, impact of higher growth in terms of cash flows, dividends offsets the negative impact of the rise in yields.
Investors can recognize that there are alternative opportunities out there including both for the underperforming stocks as well as incrementally more attractive bonds.
How high yields impact Foreign Portfolio Investors (FPI)?
Bonds yields play an important role in FPI flow. When bond yields rise, FPI’s move out of the equity markets. When bond yield goes up, it results in capital outflows from equities in debt.
A higher return in treasury bonds leads investors to move their asset allocation from more risky equity markets to Treasury bonds which is the safest investment instrument. So continuous rise in yields in developed markets put more pressure on Equity markets. Even a rise in domestic yields would see allocation moving from equity to debt.
Bond Yields in India and USA:
In India During first half of 2020-21, bond yields were below 6%. However it changed after Budget when government raised its borrowing programme for current fiscal. India 10-year benchmark bond touched 6.20%. India bonds have moved from 5.76% to 6.20% in line with the rise in US yields. In USA, bond yields was 0.31% in March 2020 which stayed at 1.40% recently.
Factors that investors need to keep in mind:
Investors will have to keep an eye on both domestic and global developments while investing in them. If inflation and interest rates in the economy are the key factors that determine yields, they are in turn affected by various other factors such as economic growth, money supply, government borrowing, global liquidity.
Investors may invest in good quality undervalued stocks on basis of their fundamentals