Explained: What to make of rising bond yields, for now and near future

Borrowings and bonds

Higher government borrowing through issuance of securities, especially when inflation is high, will push up yields on bonds and result in a fall in bond price.

A higher yield means the government will have to pay more as return to investors, leading to a rise in the cost of borrowing. This will impact the financial system, and put upward pressure on general interest rates.

If the RBI opts for normalisation of monetary policy and intervenes less in the market, interest rates are bound to go up. However, the RBI has tools like auctions and open market operations (OMO) purchases to keep a check on rising yields.

Higher government borrowing means the market will have to absorb a greater supply of bonds in the coming months. Bond yields have been rising across the world on the back of higher inflation and plans for policy normalisation. The yield on 10-year benchmark bonds has increased almost 110 bps from pandemic-era lows. It has risen by 43 bps in the last one month, and was at 6.89% on Thursday.

Rising crude prices, inflation risks, and signals of interest rate hikes by the US Federal Reserve have also contributed to the hardening of bond yields. A section of the market attributes the rise in yields to the RBI’s plan to exit its accommodative stance in the coming months.

Seeing the writing on the wall, buyers of government bonds have been demanding higher yields in the recent past. In the state development loan (SDL) auction, yields on 10-year securities of UP and Uttarakhand were 7.28% and 7.25% respectively.

Could yields rise more?

Analysts expect yields to hit 7% in the near term, and touch 7.5% in the next fiscal. “We expect the 10-year bond yield to rise to 6.9-7% by the first half of FY23,” said Abheek Barua, Chief Economist, HDFC Bank.

Interest rates are expected to move up in the wake of large government borrowing and supply-demand mismatch in government bonds, removal of monetary support by RBI, and increase in policy rates as the central bank focuses more on inflation management.

Strong intervention by RBI and efficient management of the borrowing programme can stabilise the yield below 7%. The forthcoming RBI monetary policy review will be closely watched for the committee’s views on the Budget, and any measures to manage yields.

Impact on investors

Rising yields mean investors expect a rise in interest rates and are, therefore, selling the bond papers they are holding. Since a rise in interest rates would result in decline in bond price of existing bonds (and thereby capital loss on sale before maturity), investors rush to sell in order to limit capital loss.

Debt investors will be impacted by the rise in yields. 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. Corporate bonds, which are priced higher than government bonds, will also be impacted, as will the equity markets.

“We believe the risk to equity market is likely to emanate from the bond market in the near term,” said S Naren, ED and CIO, ICICI Prudential AMC.

A rise in bond yield would make relatively less risky debt investments more attractive for investors. Not only can this reduce the funds flow into equities, it could also result in an outflow of funds from equities.

An increase in interest rates in the economy will raise the cost of borrowing for companies and impact net profit margins, which could also hurt the equity markets.

The ways forward

Investors with hold to maturity (HTM) products should not panic seeing the mark to market (MTM) impact. Experts say even others should not, because when the bonds mature, mutual funds would buy higher interest rate products. However, some advise that debt fund investors who have to exit over the next one year should move out now — while those who can stay with the product for the next three years should stay put.

For new investors looking to invest in debt funds now, advisors say the approach should be of gradual investment over the next six months, as yields may rise further.

“Either you can hold cash for some time and invest when rates rise, or deploy all the money for the long term. The right approach would be to keep some component liquid and deploy as the rates go up,” Vishal Dhawan, founder, Plan Ahead Wealth Advisors, said.

Expecting further hardening of yields over the next six months, Surya Bhatia, founder, AM Unicorn Professional, said, “If you have to invest, do it gradually over the next six months and go for a 3-5-year investment horizon.”

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