How the rising bond yields affect you
Typically, bond prices fall when yields move up, which means bad news or negative sentiment. But how will this movement impact your investments?
With both the Union Budget and Monetary Policy now behind us, there is a lot of uncertainty in bond markets where the benchmark 10-year g-sec yield has remained elevated, signalling negative sentiment and risk.
Some negative news is priced in already. Budget-day reaction saw the benchmark 10-year g-sec yield move up to levels of around 7.86% in intra-day trade. Bond prices fall when yields move up, signalling bad news or negative sentiment. The benchmark yield is currently about 7.50%.
The monetary policy has left rates unchanged and maintained a neutral stance. While 5 of the 6 monetary policy committee members voted for no change in rates, one voted for a 25 basis point increase in policy rate. This itself signals concerns on inflationary pressures, which the bond market has been pricing in. The Reserve Bank of India (RBI) in its monetary policy commentary has now raised its inflation estimate for Q4 and for the first half of the next financial year to above 5%. It’s uncertain whether this itself will trigger a rate hike. However, what’s clear is that bond yields are likely to remain elevated for now. One basis point is one hundredth of a percentage point.
All this activity around rising bond yields has implications not only for your debt allocation but also the equity market too. Should you be worried? Globally too sovereign bond yields have moved higher, triggering a sharp sell-off in equity markets across the globe.
Bond market expectation
There is more than one factor behind the confusion and selling in the domestic bond market. It is a combination of fundamental factors that have turned negative, coupled with excess supply of g-secs that is causing the yield to remain high. According to Ajay Manglunia, co-head, fixed income advisory, Edelweiss Financial Services, “With crude oil prices moving up last year, there is concern that inflation may rise and there is no certainty where crude prices may pause. Second, in the US, it is expected that rate hikes will be more aggressive this year. Bond traders are already sitting on losses and have no appetite to buy more in this market environment.”
Crude oil prices touched a high of around $70 per barrel (Brent Crude), up from around $45 in July 2017. This fast-paced rise in crude prices has been a cause for concern as India imports around 70% of its crude oil requirement, and higher prices are not only going to increase the import bill but also fuel price rise in other goods and services that use fuel.
While there is no certain way to predict how crude oil prices will move, the other two components—domestic inflation and supply side issues—may be easier to resolve.
According to Shankar Raman, head-third party products and investment advisory, Centrum Capital Ltd: “Bond markets can get a positive surprise if Goods and Services Tax (GST) revenues stabilises in the coming months and food price-based inflation is managed well through supply management, implementation of direct debit for farmers and minimising crop wastage. On the technical side, the bond supply issue could be tackled by making available a defined block of Indian (government) securities for foreign institutional investors.”
Bond markets are nervous right now. How yields move in the coming weeks will depend a lot how change in inflation data impacts RBI’s neutral stance going forward. If inflation moves significantly above RBI’s estimated 5.1% level, then it may have to shift focus to managing inflation over growth, which will be a substantial risk for bond markets.
What to do
In December 2017, Mint Money had cautioned that investors in various fixed-income securities needed to lower their return expectations (read it here).
Despite rising yields, corporate bonds are not seeing much transactional activity; hence debt fund accrual yields haven’t benefitted yet.
According to Manglunia, “For g-secs, the supply is constant and yields have been rising, but activity on the corporate bond side is subdued. Corporates are not ready to accept that these rates will sustain and prefer to wait and watch before coming to the market. Moreover, the gap in yield—between market borrowing and bank borrowing—is lower now, making the latter a preferred choice at the moment.”
Dynamic bond funds are already seeing a shift towards lower duration. Median duration in the dynamic bond category had dropped from 5.79 years in June 2017 to 4.37 years at the end of December 2017 and is expected to be even lower for the January-end portfolios. This potentially reduces marked-to-market risk and makes returns less volatile, at least for the time being.
On the deposit side, private banks had already hiked their base rates by 5-10 basis points in January this year, signalling a marginal increase in deposit rates. A trend confirmed by senior bankers speaking at Mint’s Annual Banking Conference that took place on 6 February 2018.
Given this yield move in the 10 year g-sec of over 100 basis points in 6 months, is there a contrary opportunity to buy into this correction in the bond market?
This is unlikely as trading losses are already present and market participants are wary of taking fresh positions. Retail investors in any case need to stay away from such short-term opportunistic moves as timing an entry and exit is not easy for them. For your strategic medium-term debt allocation, short-term bond funds are still the most appropriate tool on a 3-year post-tax basis.
Impact on equity
The negative sentiment in the bond market has now spilled over to equities too. The biggest impact can come from inflationary expectations. According to Nishant Agrawal, managing partner and head – family office, ASK Wealth Advisors Ltd, “While higher bond yields do make equities look relatively expensive, one can’t correlate this fall mainly to rising yields in the domestic bond market. It’s more likely that the global market activity is impacting our equity markets too. However, if domestic yields continue to remain high and we see higher inflation, fixed deposit rates and small savings rates go up, it may reduce the flow of investor money into equity which was primarily lured by the falling rate trend.”
If rates were to go up, it will also have a negative impact on corporate margins and earnings expectations will start to get lowered. This in turn will affect the expectation on equity-market returns negatively. Last, with global quantitative easing getting reversed gradually, the liquidity-driven rally in global equity markets is expected to slowdown its pace. Higher bond yields will also see a share of institutional money getting shifted out of equity. All this will have an impact of slowing down the pace of equity market returns for the time being.
Be ready for the risk, and hence volatility in equity returns, but don’t shift your long-term equity allocation. This remains an asset class that will continue to beat inflation in the long term, helping you to create wealth.
Raman said, “At the moment, we are neutral on both equity and debt, but on the equity side what is true for the US is not so for India. Here we are very clearly settled into a better macro framework. Lower sustainable interest rates and inflation level can mean a sustained higher price-to-earning (P-E) rating in equity. Current valuations though are beyond that level and markets could very well remain range bound till earnings recover.”
So, what should you do? Reduce risk in your debt allocation and keep to accrual funds; at the same time sit tight on your long-term equity allocation but be aware of the short-term risk.
Designation and quote of Nishant Agarwal updated.
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