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How does a rise in US bond yields impact the Indian equity market

08 Feb 2024

Introduction:

Globally, funds circulate in the broader financial landscape, creating competition between bonds and stocks. Bonds are generally perceived as low-risk investment instruments, exhibiting less volatility than stocks. The stock market often experiences significant fluctuations, characterised by frequent highs and lows. Despite this volatility, stocks have the potential to yield higher returns than bonds.

Consequently, during upward trends in the stock market, capital tends to shift from the bond market to the stock market. Conversely, when the stock market becomes excessively volatile and risky, funds exit the stock market and flow into the bond market, following the same principle in the opposite direction. The same thing happens when bond yields across the world rise.

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This article discusses the impact of rising US bond yields on the Indian stock markets in detail. But before that, you must know what bonds are and when bond yields rise.

What is a bond?

In the financial markets, a bond is a debt security that represents a loan made by an investor to a borrower, typically a government or corporation. When an entity issues a bond, it essentially borrows money from investors in exchange for periodic interest payments and the return of the principal amount at maturity. Bonds are a crucial component of the fixed-income market, offering investors a relatively stable and predictable income stream compared to more volatile investment options like stocks.

The entity that issues a bond is known as the issuer. It can be a corporate house or government. The price you must pay to purchase a bond is called its face value or par value. The coupon rate represents the annual interest rate applicable on the bond price, and the maturity date is when you will receive your bond’s principal along with the interest.

What are bond yields, and how do they rise?

In simple words, bond yield refers to the return you can generate by investing in a bond. For example, suppose you have purchased a bond offering 12% interest at a par value of Rs. 1,000. However, after one year, you need money to tackle an emergency and decide to sell off your bond. The current market price of your bond is Rs. 1,050. So, in this case, your bond yield would be [(1050-1000)/1000 * 100], i.e., 10.5%.

Whenever a country's central bank feels that an excess of liquidity in the market is contributing to inflationary pressures, it opts to raise short-term interest rates. This decision, in turn, triggers a decline in bond prices. As a result, bond yields decline. Similarly, when the central banks choose to increase short-term interest rates, bond prices move up, leading to a rise in bond yields.

The impact of US bond yields rise on the Indian equity markets

Recently, the central bank of the United States of America (USA) – the Federal Reserve – announced multiple rate hikes to control the inflation in the US economy. As a result, the US bond yields have risen significantly, nearing their highest levels in the last 16 years. Although it indicates that the inflation in the country is rising and the cost of borrowing is increasing, the rise in bond yields is a good sign for global bond investors.

The following pointers explain the direct and indirect impact of US bond yields on the Indian equity markets:

  • A rise in US bond yields can attract foreign investors looking for higher returns to withdraw their investments from India, leading to a temporary decline or uncertainty in the equity markets
  • US bond yields can trigger a strengthening of the US Dollar. This, in turn, may lead to a depreciation in the value of the Indian rupee. A weaker rupee can lead to decreased profitability for Indian companies, causing their shares to fall
  • The Indian central bank – the Reserve Bank of India – can also increase its lending rates, increasing the borrowing costs for companies. As a result, their profit margins may suffer, and the value of shares may decline.

To conclude

In the interconnected global financial landscape, any significant financial move in any part of the world may affect the Indian equity markets. A rise in US bond yields may impact foreign investments in India and may weaken the value of the Indian currency, causing temporary uncertainty in the stock markets. As an investor, you must proceed with caution during these times. 

 

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