Bond yields on the benchmark 10-year Government Securities have been on an uptrend since July 2017 and have gained over 120 basis points since then. What will be the impact of rising bond yields and what will be the effect of rising bond yields on stocks? The chart below captures the rising bond yields in India of the benchmark 10-year bonds..
Chart Source: Bloomberg
The sharp rise in bond yields has been driven by a variety of triggers. Firstly, is the inflation which has been on a constant uptrend since June last year and has only started tapering in the last couple of months! The inflation rate is still above the RBI comfort level and inflation expectations continue to be elevated. Secondly, the Fed has already hinted at 3 rate hikes this year and the strong economic data hints at possibly 4 rate hikes. That has also kept Indian yields elevated in tune with global trends. Lastly, the markets are also factoring in a situation where the RBI may be forced to hike rates by 25-50 basis points this year to keep the yield differential attractive to global investors. But what are the implications of higher bond yields. There could be 5 key implications..
1. Higher bond yields will create a problem for bank bond portfolios
Indian banks, especially PSU banks are among the largest holders of the government of India bonds. That is because banks are required to maintain statutory liquidity ratio (SLR) with the RBI as a safety net to protect their solvency. The SLR predominantly consists of government bonds and the RBI also uses this to meet the government’s borrowing program. In the last quarter results, SBI reported a huge loss due to two factors viz. rise in NPAs and bond losses. Bond losses are a major problem for banks as a rise in yields leads to a fall in bond prices and therefore these losses have to be booked by the banks. This could depress profits of banks and make any fund raising plans difficult.
2. Rising bond yields is not great news for NAVs of debt funds
Just like banks lose out on their bond holdings, debt funds holding on to these government bonds also see erosion in their NAV values. This problem is more acute in case of mutual funds that are holding long-dated government bonds as these bonds are most vulnerable to a rise in bond yields. In fact, the bond prices have crashed so hard in the last few months that bond traders have almost implored the RBI to enter the market and protect prices by buying up at lower levels. The bottom line is that fall in NAVs reduces the wealth of investors, both retail and institutional.
3. Indian corporates may be forced to borrow at higher rates of interest
In the past couple of months quite a few large banks have started upping their lending rates. That is a direct consequence of rising bond yields. As bond yields rise, the banks will have to raise the rates paid out on deposits to keep them attractive. But to compensate for that they are also forced to raise the lending rates to maintain their spread. It may be recollected that demonetization resulted in a glut of liquidity in the banking system bringing down yields sharply. That advantage may be nullified by the rise in yields and it may hinder the nascent recovery in the capital investment cycle.
4. Government borrowing programs will be impacted negatively
The government of India has already decided to exceed on its fiscal deficit commitments by 30 basis points in the next two years. This will mean the government will have to consistently keep hitting the bond market to raise funds. But higher bond yields will mean that the government will have to borrow at much higher rates, something it will not be prepared to do as it will sharply increase its borrowing cost. This is not great news considering that the government needs to borrow heavily to meet its budget in the next 1 year. Higher yields could be a major dampener to the government borrowing program.
5. It could also have a negative impact on equity valuations
Since February when the bond yields saw a sharp spike, the equity markets have also corrected sharply. While the LTCG tax was partially responsible, one of the key reasons was the global trend of rising bond yields. But why does rising bond yields impact equity markets. Remember, equity valuations are done based on the discounted cash flow (DCF) method. Here the future cash flows are discounted to the current year by using the cost of capital as the denominator. The cost of capital is a 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. That is one of the key reasons why markets have been down in the past 2 months.
The moral of the story is that rising bond yields has a series of repercussions for the Indian financial markets. A lot will depend on how much longer this trend lasts and how much higher the bond yields travel!