Understanding Bond Yields In India

When building an investment portfolio, in addition to traditional equity investments, retail investors can invest in debt-based securities. Bonds are one of the most popular debt investment instruments among retail investors. Government and private corporations issue bonds to meet a variety of operational needs ranging from having to fund Infrastructure projects and Business expansion to ensuring ample availability of working capital. 

The annualised return on a bond, i.e., the net annual earnings on the bond investment, is known as the bond yield. In India, yields on government bonds are on the rise. In this article, we attempt to answer why bond yields are rising in India. Further, we shall also try to analyse the impact of the same on investors and the economy as a whole.

Why Are Yields on Government Bonds Rising in India?

The government issues bonds to meet a variety of its obligations. When the central and state governments indulge in higher-than-budgeted borrowing, it needs to raise additional funds through the issuance of fresh bonds in order to meet the augmented borrowing needs. Promising a higher yield on these fresh issuances guarantees the government a faster way to mobilise funds. Governments optimise this. As market rates follow suit, the cost of borrowing also witnesses an upsurge.

While this means that new investors earn a higher rate of return on their investments, it also puts upward pressure on the interest rates in the banking system. In the backdrop, older issuances promising relatively lower yields witness a drop in prices on account of increased divestment on account of investors being equipped with more lucrative investment options.

What Rising Bond Yields Mean for Investors

Typically, bond yields have an inverse relationship with bond prices. When the bond yield on fresh issuances rises, the prices of older issuances go down. As a result, if you wish to sell your bonds in the secondary market before maturity, you will incur losses.

This is because new investors prefer to buy new bonds issued by the government, which promise higher bond yields in India. Existing investors will be more cautious in purchasing new bonds, as they are saddled with existing bonds that they can sell only at lower prices. You can view here India’s 10-Year Bond Yield historical data and 5-Year Government Bond Rate in India. The 1-Year Government Bond Rate in India is 6.307% as of August 13, 2022. 

What Rising Bond Yields Mean for RBI 

A rise in bond yields puts more pressure on the Reserve Bank of India (RBI), the government’s debt manager, to restore balance in the financial system. It may do so by raising market wide interest rates in the coming months. RBI may also try to attract Foreign Portfolio Investment (FPI) to purchase government bonds. Alternatively, the apex bank might itself step in to purchase the bonds to create a demand-supply balance. 

Some of the other notable implications of rising bond yields are:

Loss of profitability for banks

Indian banks, particularly public sector banks, are some of the largest holders of Government of India bonds. The RBI mandates banks to maintain a certain Statutory Liquidity Ratio (SLR) to safeguard individual bank level solvency.

SLR is the minimum percentage of deposits banks must maintain in the form of liquid assets that can easily be converted into cash. Treasury bills, government-approved securities, government bonds, gold and cash reserves are some of the forms these liquid assets take. The SLR mandate contributes significantly to the subscription of short tenured government securities.

When bond yields rise, banks can run into huge losses due to a reduction in bond price and hence, overall value. If they move to sell the bonds, they will do so at significant losses.

Lower NAVs of debt funds

Debt mutual funds invest a portion of their funds in government bonds. The rise in bond yields, which in turn has a domino effect of lowering bond prices, will also impact how a debt fund performs. Lower bond prices directly affect the Net Asset Value (NAV), which is the unit price of any mutual fund scheme. Typically, when the NAV of the mutual fund decreases, the overall value of your investment in the debt mutual funds reduces, thus reducing the wealth of retail investors. 

Indian corporates borrowing at higher rates of interest

As bond yields rise, banks may consecutively hike lending interest rates. They must do this to make up for the deficit caused by the lower bond prices of their existing bond assets. Incremental borrowing by corporations must happen at the revised higher interest rates and this might discourage them from making capital investments all together.

Negative impact on government borrowing programs

As the government promises a higher bond yield, it means government borrowing has become a more expensive proposition. This sends the government into higher debt, which is not a positive state for the economy. This means development will cost much more for the general public. Such a strategy lacks overall financial integrity and it is not sustainable in the long term. 

Effect on stock market valuations

Higher bond yields mean that bond prices are lower and that lending rates will rise. Overall this means that the cost of accessing capital is much higher. This dynamic can impact equity valuations negatively. As equity valuations go down, the overall wealth of retail and institutional investors will go down. 

Conclusion

Government bonds are a unique instrument leveraged by the central government and state governments to raise funds and create a benefit for institutional and retail investors. However, increasing bond yields is a short-term solution for over budget federal spending. This practice can trigger multiple consequences that can negatively impact the economy and the wealth-creation potential.

It can affect the overall investment strategies of retail investors since the rising of bond yields has a domino effect on equity valuations, the NAV of debt funds, interest rates, and the price of bonds for existing holders. The fact that even an instrument that promises to pay a fixed return has an array of complex intricacies linked to it further strengthens the argument on why one would need to incorporate thorough due diligence prior to making investment decisions of sorts. An ideal portfolio needs to incorporate the right kind of diversification not only in terms of the nature of instruments used but also with due consideration given to the investment horizon.. 

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