A gradual rise in bond yields globally has created a panic in the equity markets. Indian frontline benchmarks - the S&P BSE Sensex and the Nifty 50 - lost nearly 2 percent in intra-day trade.
At the global level, US Treasury yields vaulted to their highest since the pandemic began on expectations of a strong economic expansion and related inflation. Back home, the 10-year government bond yield jumped to 6.18 percent on Thursday, February 25.
The benchmark bond (10-year tenor) yields had fallen to 5.6 percent during the peak of the pandemic crisis but have since been rising and jumped 31 bps since the Budget. Year to date, the yields have crept up 16 bps in 2021 so far.
Acuit Ratings now expects the 10-year sovereign yields to rise from 6 percent in March 2021 to 6.40 percent by March 2022 given that the Reserve Bank of India may hike the repo rate by 25 bps going forward given the likely rate and liquidity normalisation expected next fiscal.
What is bond and bond yield?
Simply put, bonds are loans the one makes to a corporation or government. The interest payments remain largely unchanged over the life of the loan. Moreover, one receives the principal at the end of the loan tenure if the borrower doesn't default.
Bond yield, on the other hand, is the return that an investor gets on that bond or on particular government security.
Bond yield and bond prices
A fall/rise in interest rates in an economy pushes up/pulls down bond prices. However, bond yields fall/rise in this situation.
This happens because if RBI, for example, decides to increase interest rates, the bond's price (which is offering similar return as the current interest rates) would fall because its coupon payment is less attractive now on a relative basis. Therefore, investors would chase new bonds with better risk-free return.
Why do bond yields rise?
Bond yield is the return an investor gets on that bond or on a particular government security. The major factors affecting the yield is the monetary policy of the Reserve Bank of India, especially the course of interest rates, the fiscal position of the government and its borrowing programme, global markets, economy, and inflation. With the pandemic upsetting the calculations, Finance Minister Nirmala Sitharaman has pegged the fiscal deficit for 2021-22 at 6.8% of GDP (the original target was 3.5%), and aims to bring it back under 4.5% by 2025-26.
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. In short, a rise in bond yields means interest rates in the monetary system have fallen, and the returns for investors (those who invested in bonds and govt securities) have declined.
Inflation expectation and bond yields
A rally in the stock market tends to raise yields as money moves from the relative safer investment bet to riskier equities. However, if the inflationary pressures begin to look up, investors tend to move back to bond markets and dump equities.
How bonds affect stock markets?
When valuing equities, investors add the equity risk premium they seek to a risk-free rate to compute the expected rate of return. Usually, the easiest way to estimate the risk-free rate is to default it to the long government bond yield. This is why long bond yields matter to equities.
Now, theoretically, given that the long bond yield is the risk-free rate, a higher bond yield is bad for equities and vice versa. But one must also remember why bond yields are changing and not just the direction of change.
“Long bond yields reflect the growth and inflation mix in the economy. If growth is strong, bond yields are usually rising. They also rise when inflation is going higher. The impact of these two situations is different for equities,” explains Ridham Desai, equity strategist at Morgan Stanley, in a co-authored note with Sheela Rathi and Nayant Parekh.
When growth is strong, the impact of higher growth in terms of cash flows or, more precisely, dividends more than offsets the negative impact of the rise in yields, causing equity share prices to trade higher.
“The gap between real GDP growth and the 10-year bond yield correlates well with share prices, underpinning the point made above. Indeed, to the extent that growth accelerates in the coming months faster than the rise in bond yields, share prices should be fine,” says Desai, adding that Indian equities/bond valuations are at the top end of their 2010-21 ranges.
“If growth accelerates from here, as we expect, it is likely that equities break this range on the upside, consistent with the fundamental relationship,” he believes.
How should investors trade?
Morgan Stanley suggests two scenarios for investors. Under the first scenario, where growth accelerates, portfolios should be positioned in domestic cyclicals, rate-sensitives, and mid- and small caps.
Under the second scenario, where inflation makes a rapid return, the brokerage advises investors to bet on technology, healthcare, and consumer staples.
Why are bond yields rising?
Inflation
For many, rising inflation expectations are the simplest reason for the yield ascent.
The combination of a recovering U.S. economy thanks to vaccination efforts, trillions in fiscal relief and accommodative monetary policy are expected to deliver the kind of inflation that hasn’t been seen since the 2008 financial crisis.
Bond-market forecasts of consumer prices are suggesting inflation could surpass the central bank’s target for a protracted period, and some investors are penciling in at least 3% inflation this year even if they are less sure if such sustained price pressures could last.
The 10-year break-even rate spread, which tracks expectations for inflation among holders of Treasury inflation-protected securities, or TIPS, was at 2.15%. That is well above the Fed’s typical annual target of 2%.
Scott Clemons, chief investment strategist at Brown Brothers Harriman, says another factor that could push prices higher later this year is the pent-up savings among U.S. households forced to stay at their homes and restrain their spending in restaurants, leisure and travel.
Once the COVID-19 pandemic is put to bed, consumers would unleash their savings upon the economy, spurring prices for services higher and leading to the kind of elevated price pressures that would usually prompt the central bank to raise rates.
But as part of the central bank’s new average inflation targeting framework, the Fed is likely to stand pat and allow the economy to run hot, adding to concerns that the Fed won’t protect longer-dated Treasury’s from reflationary forces.
Insufficient Fed action
Indeed, the lack of willingness on the part of the central bank to lean against rising bond yields has emboldened the bond bears this week.
Fed Chairman Jerome Powell underlined that the central bank would support the economy for as long as necessary, and that the Fed would clearly communicate well in advance when it starts to contemplate tapering asset purchases.
"It’s all just talk,” said Ed Al-Hussainy, senior interest rate and currency analyst at Columbia Threadneedle Investments, in an interview.
Al-Hussainy said until the central bank backs up its words with concrete actions, such as tweaking its asset purchases, yields could keep moving higher.
Some market participants were unimpressed by the Fed’s nonchalant tone, noting that senior central bankers like Kansas Fed President Esther George kept repeating that higher bond yields reflected improving economic fundamentals and were therefore not a cause for concern.
Thursday’s moves helped to drive selling in equities, with investors repricing those investments as rates jolt higher. The Dow Jones Industrial Average, the S&P 500 index and the Nasdaq Composite Index all finished sharply lower on the session.
Forced sellers
Market participants also suggested yields were moving beyond fundamental forces, and that inflation fears weren’t enough to explain why rates were moving up at such a ferocious pace.
“A lot of this move is technical,” Gregory Faranello, head of U.S. rates at AmeriVet Securities, told MarketWatch.
He and others suggest the yield surge may have been a case of selling causing more selling, as investors caught offsides were forced to close their bullish positions on Treasury futures, in turn, pushing rates higher.
Ian Lyngen, a rates strategist at BMO Capital Markets, pointed the finger at so-called convexity hedging.
The idea is that holders of mortgage-backed securities will see the average maturities of their portfolio rise in line with higher bond yields, as homeowners stop refinancing their homes.
To offset the risk around holding investments with higher maturities, which can increase the chance of painful losses if rates rise, these mortgage-backed debtholders will sell long-term Treasurys as a hedge.
Usually, selling associated with convexity hedging isn’t powerful enough to drive significant bond-market moves on their own, but when yields are already moving swiftly, it can exacerbate rates swings.
How has the rise in yield affected stock markets?
The sudden rise in domestic and global bond yields recently moderated the enthusiasm of equity market participants around the world. The “taper tantrum” of 2013 showed the relationship between bond yields and stock markets — a sudden rise in bond yields caused markets to slide, as mass bond selling was witnessed. “Bond yields are inversely proportional to equity returns; when bond yields decline, equity markets tend to outperform, and when yields rise, equity market returns tend to falter. This could be one of the reasons for the Nifty’s correction this week,” said Nirali Shah, Head of Equity Research, Samco Securities.
Traditionally, when bond yields go up, investors start reallocating investments away from equities and into bonds, as they are much safer. As bond yields rise, the opportunity cost of investing in equities goes up, and equities become less attractive.
Also, a rise in bond yields raises the cost of capital for companies, which in turn compresses the valuations of their stocks. That is something that investors see when RBI cuts or raises the repo rate. A cut in the repo rate reduces the cost of borrowing for companies, leading to a rise in share prices, and vice versa.
How will the borrowing program and economy be impacted?
When bond yields rise, the RBI has to offer a higher cut-off price/yield to investors during auctions. This means borrowing costs will increase at a time when the government plans to raise Rs 12 lakh crore from the market. However, RBI is expected to stabilise yields through open market operations and operation twists. Besides, as government borrowing costs are used as the benchmark for pricing loans to businesses and consumers, any increase in yields will be transmitted to the real economy.
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