Increase in bond yields: Impact on investors

As bond yields rise, banks may raise the rates paid out on deposits to keep them attractive and increase the lending rates to maintain their interest rate spread

This was expected and it also indicates that the pace of recovery in the country and across the world is improving and is moving in the right direction in spite of the presence of SARS-CoV-2 variants.

The government of India 10-year bond yield increased to a 23-month high of 6.62% tracking with the global rise in bond yields amid prospects of rising interest rates. The increase in bond yield is attributable to the country’s high inflation, growing fiscal, trade deficit, varied industrial output growth and rise in bank credit to deposit ratio. How the increase in bond yields will impact equity investors, let us discuss in detail. What are bonds and bond yields? Bonds are basically an acknowledgement of debt wherein an investor to a borrower who is typically a corporate or government.

Bonds are units of debt issued by the companies/government and traded like shares. As companies/government issues bonds to raise money, they pay a fixed interest to the bondholders which is popularly known as the coupon rate. It is declared upfront and payable on the face value of the bond and remains fixed until maturity. As bonds are tradeable, they also give returns. These returns are called bond yields. For example, if an investor buys a 10-year bond worth ?10,000 with a coupon rate of 5%, he will get an interest of Rs 500 per year.

But while trading, if the bond price falls to ?8,000, your yield will become 6.25% (?500/ ?8000*100). Thus, bond yields and prices move in opposite directions, when bond prices rise, yields fall, and vice versa.Why do yields rise? Several factors contribute towards the rise in the bond yields. Primarily yields are rising owing to the hopes of economic recovery, significant vaccination counts. So, on the hopes of economic recovery rising, inflation is also rising. Rising inflation pushes bond prices lower, thereby pushing yields higher. In addition to the above, crude oil price jumped to the highest level since November.

Impact on equity investorsOne could observe that many banks have started enhancing their lending rates, due to the rising bond yields. As bond yields rise, the banks are expected to raise the rates paid out on deposits to keep them attractive. In order to compensate for that they are forced to raise the lending rates to maintain their interest rate spread.  Thus, companies may be forced to borrow at higher rates of interest which will have an impact on their projects and ultimately on the profits. Generally, equity shares are valued using discounted cash flow methods wherein the future cash flows are discounted to the current year using the cost of capital as the denominator.

The cost of capital is the weighted average of the cost of equity and the cost of debt. If the bond yields go up then it means the cost of capital goes up and therefore current valuations are more depressed.Empirical evidence and past data confirms that whenever the bond yield increases, investors including institutional investors, prefer to withdraw from equities and look at bonds. This was expected and it also indicates that the pace of recovery in the country and across the world is improving and is moving in the right direction in spite of the presence of SARS-CoV-2 variants.

The write is a professor of finance & accounting, IIM Tiruchirappalli

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INVESTMENT MATRIX

The increase in bond yield is attributable to high inflation, growing fiscal, trade deficit

As companies/ government issues bonds to raise money, they pay a fixed interest known as coupon rate

Bond yields and prices move in opposite direction, when bond prices rise, yields fall, and vice versa

If lending rates rise, companies will have to borrow at higher rates which will impact their profits

If the bond yields go up then the cost of capital of companies goes up which affects their valuations

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