As the finance minister announced the government’s massive borrowing target in this year’s budget, the yield of the 10-year G-sec rose by 17 basis points to 6.85 percent. The ongoing geopolitical tensions have perpetuated this trend of the 10-year G-sec yield being close to the 7 percent mark. Bonds are debt instruments issued by central governments, state governments, or corporations to raise funds for various operations. As corporations share equity with investors via shares, they share debt via bonds.
For an investor, bond yields are the returns made by investing in them. Hence, like any other investment instrument, the return on a bond or the bond yield is an important determinant of profitability. The upward trend enables investors to reap the benefits of bond yields.
How are bond yields calculated?
A bond’s yield is the annual return from investing in the bond and is dependent on the price and its coupon rate. For instance, a bond worth Rs. 10,000 with Rs. 500 coupon payments paid annually will have a yield of 5 percent.
Why are bond yields rising?
This year’s budget pegged the government’s gross market borrowing for FY23 at Rs 14.95 trillion, double the target of the previous fiscal year. This surprisingly high target pushed the G-sec yields to close to 7 percent as higher targets mean increased bond supply.
- There exists an inverse relationship between the price and yield of a bond. As supply increases and bond prices go down, bond yields rise and vice versa.
- Moreover, the market was anticipating India’s sovereign bonds to be included in the global bond market indices and bring in foreign funds into the market. Such an inclusion would have supported the demand for and eased the bond yields. However, this inclusion has been put on hold.
- Lastly, bond yields have been rising due to economic recovery and the expectation of higher prices.
- The current geopolitical tensions and high inflation figures around the globe are other reasons for rising bond yields. Inflation affects bond yields as investors factor in the capital loss due to inflation in the yields.
Why do bond yields rise when prices increase?
Price determines the bond yield and prices depend on demand and supply factors. If the supply of bonds increases, the price comes down and vice versa. Thus, if the price of a bond with a 5 percent yield increases from Rs. 10,000 to Rs. 10,500, the yield will come down to 4.7 percent. If the price comes down to Rs. 9,500, the yield will rise to 5.2 percent.
Benefits of bond yields
In comparison to fixed-deposit with low returns and an uncertain stock market, such high-yield bonds are lucrative investment instruments.
Investors can earn higher returns by increasing their exposure to bonds in their portfolios.
This is also useful in spreading out their investment risk.
Moreover, as bonds are fixed-income instruments, they provide a predictable income stream and help in offsetting exposure to volatile equity instruments.
Higher future price and wider spread
Bonds are tradable instruments. In bond trading, the aim is to sell at a price higher than the buy price and benefit from the spread between the buy and sell price. As mentioned earlier, the inverse relationship between bond yields and prices would mean that a rise in yield brings down the price of a particular bond.
However, as rising yields attract more buyers and increase the demand, the price of the bond would increase after some time. Medium to long-term investors can benefit from selling a bond at a future date when the prices rise due to increased demand.
Suppose an investor has a bond portfolio of five bonds, each with a five-year maturity. Each year one bond matures and is replaced by a new bond.
If bond yields go down, this bond portfolio’s value will appreciate as the prices rise. Similarly, as yields go up, this portfolio’s value will decline initially as the bond prices decrease.
However, as maturing bonds are replaced with new bonds with higher yields, the portfolio earns more income in a scenario of rising yields. Thus, having an adequate investment horizon and reinvesting at higher rates is highly beneficial in the long term.
How are other instruments impacted by rising yields?
Rising bond yields indirectly impact many other investment instruments such as equities. A company’s cash flows in subsequent periods are discounted with the cost of capital. Higher yields translate to a higher cost of capital. As bond yields rise, corporations have to borrow funds at higher rates, thus, increasing their cost of capital and bringing down their equity valuation.
As bonds become more attractive as compared to other instruments, they would attract more investors to the bond market. While this is a positive for the bond investors, this outflow of funds from other markets is a con for investors investing in those markets.
Debt funds are negatively affected by high bond yields. As yields rise and bond prices come down, the NAV (net asset value) of debt funds depreciates. A decline in NAV erodes the wealth of mutual fund investors.
Banks move to increase their deposit rates to keep them attractive and competitive with bonds. However, to raise deposit rates, banks need to increase lending rates. Thus, while depositors benefit from increased deposit rates, borrowers lose. Higher lending rates also increase the cost of borrowing for corporations.
What investment strategies to adapt to benefit from high bond yields?
- Investors should reduce their exposure to long-term bonds and increase more short and medium-term bonds in their portfolios. Long-term bonds keep your funds locked in for a long time, stopping you from reinvesting at higher rates.
- Though short-term bonds have lower yields than long-term bonds, they are less risky. As they mature sooner than longer-term bonds, an investor can reinvest his funds at higher rates and make up for the losses. Shooter term bonds are also less sensitive to price drops.
- Use the bond ladder strategy. A bond ladder is a portfolio consisting of a series of bonds maturing at various dates to benefit from an upswing in yields. For instance, suppose the bonds mature at 1-year intervals. Once a bond matures, the funds are reinvested at the prevailing higher bond yields. This way, an investor can mitigate the interest rate risk and benefit from rising bond yields.
- Invest in floating rate bonds which are also known as floaters. Such bonds have a variable rate of interest linked to a benchmark rate and reset at regular intervals. The risk of losing out on higher yields is mitigated as the rates on floaters increase when the prevailing rates increase. The best time to invest in floating-rate bonds is when rates are low and expected to rise.
Factors like inflation, economic recovery, and government announcements affect bond yields. One of the many benefits of bond yields is the higher returns that can be accrued in comparison to other assets like deposits or equities.
Moreover, investors can also benefit from a wider spread between buying and selling prices while trading when the prices go down with higher yields. However, rising bond yields also impact other assets like equity and mutual funds and make borrowing costlier.
Investment strategies like bond ladders and reduced exposure to long-term bonds can be adopted to make the most of rising bond yields.