Rising bond yields: What it means for equity, debt investors
The global rise in yields does not mean a 'sell call' on equities, although returns will fall for existing debt investments
Indian financial markets and global financial markets right now have something in common: rising yields. By the end of third week of February, the average increase in India’s G-Sec yields across 3,5 & 10 years was around 31 basis points since the Union Budget on concerns of the market borrowing plans of the government. Things haven’t improved much. Currently, the 10-year G-Sec yield is now ruling at 6.25 per cent.
On the other hand, US yields have risen too. The 10-year US treasury yield has increased to nearly 1.5 per cent from 0.7 per cent six months ago, creating fear in the minds of investors across the globe. In this context, it is important for investors to understand how to read these changes for debt and equity investments.
Understanding rising yields
Simply put, rising yields on bonds means that bond prices are falling.
India’s G-Sec yields are not softening in a hurry. Research firm Acuité Ratings & Research expects India’s 10-year sovereign yield to rise to 6.40 per cent by March 2022.
From a classical economics standpoint, the rise in bond yields hikes up the cost of capital for companies. When the cost of capital rises for a company, it can affect earnings and, by extension, its valuations.
One thing is clear. Global and local central banks have kept interest rates low for long. So, the increase in yield is in-line with some normalisation that eventually had to happen.
Whenever the bond yield increases, investors are likely to withdraw from equities and look at bonds, who are offering higher money at lower risk.
Yet, it is also true that some investors are panicking too much on account of the rising yields. Rising yields is not necessarily a very bad thing. The global rise in yields does not mean a ‘sell call’ on equities.
In the US, the key premise on which bond yields are rising or rather normalising to pre-Covid levels is that US economic recovery will be faster than earlier envisaged resulting in rising inflation. Is US and Indian economic recovery bad for equities? No!
“In our view, equities as an asset class perform better in an environment of ‘rising growth’ and ‘moderate inflation’. For example, despite the rise in Indian bond yields from ~5 per cent to 9 per cent and US yields from 3.5 per cent to 5 per cent from 2003 – 2007 as demand-led inflation picked up, global stock markets including India had their best run as growth kept surprising on the upside,” says ICICI Securities.
However, do keep a close watch on the situation. You can take a negative stance when the environment has rising yields and slowing growth or stagflation. This happened in the 2012-2013 period when India GDP growth dipped to ~5 per cent while yields climbed to 9 per cent, coinciding with the taper tantrum. This is the worst environment for stocks.
How to play debt funds
Enough of explanation for equities, let us look at debt – specifically debt funds. The fundamental characteristic of your debt fund’s return is guided by yields. As yields move up the prices of bonds fall. This fall is sharper in longer duration bonds and slower in lower duration bonds.
But if yields move up, the fall in bond prices will be inevitable. So, when yield moves up, there can be losses in debt funds. When the yield up move is gradual, the fall in returns will be gentle. When the yield jump is sharp, the fall in debt fund returns will be sharp.
Do note that debt funds with longer duration are more sensitive than the ones with shorter duration.
The yield impact on debt funds’ existing investments will be progressively lower as and when the funds start buying bonds with higher coupon rate.
Note: If you would like to know what should be your portfolio strategy in an environment of rising yields, connect with the experts at Wealthzi.