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What is yield in the context of a bond?

Yields are the returns from investing in a bond. Current yield on a bond is dependent on its price and its coupon or interest payment; that is, coupon payment divided by the bond’s face value. Bond prices and bond yields are inversely related. As bond prices rise, yield on it declines, and vice versa. Government bond yields are indicative of a country’s inflation and interest rate expectations. During periods of high inflation, newer debt issuances are compelled to offer higher yields. As interest rates rise, bonds yields can look uncompetitive. Bonds are owned due to their lower risk profile and predictable cash flows.

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What is fuelling the rise in US bond yields?

Inflation in the US has been on a steady rise, touching 8.2% in September. To counter this, the US Federal Reserve has been raising interest rates aggressively. Fed rates are currently in the range of 3.75-4%, and is expected to approach 4.4% by early next year. Thus, the quantitative restrictions approach adopted by the Fed to counter multi-decade high inflation has resulted in the bond yield on US 10-year bonds surging to 4.163% on 4 November from 1.512% on 2 January. In India, benchmark bond yield has increased to 7.469% on 4 November from 6.46% in early January.

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Why should India worry about this development?

The prospects of comparative improvements in the US capital markets lead to foreign portfolio investors (FPIs) withdrawing from the Indian capital markets. FPIs have been net sellers in India, with net withdrawals of $21.86 billion in 2022 so far. Higher bond yields reduce the attractiveness of equity markets as against fixed income securities.

What are the other major repercussions?

The net outflow of dollars has led to the rupee depreciating to 81.962 against the dollar on 4 November from 74.37 on 3 January. Weakening export markets, which have widened the trade deficit and reduced dollar inflow, has worsened the situation for the rupee. Rupee depreciation has also led to landed costs of crucial imports rising and leading to cost-push inflation in the country. On the flip side, with US bond yields increasing, RBI has been extending its US bond buying spree.

What is the way out of this situation?

The Reserve Bank of India has been doing its best through market intervention. To limit rupee depreciation, it continued selling dollars in the foreign exchange market. Keeping in mind that foreign investors still consider India a preferred investment destination, government can minimize FPI withdrawals with fresh reform measures. But, with the parliamentary elections ahead, the government’s hands are tied in terms of major reforms.

Jagadish Shettigar and Pooja Misra are faculty members at BIMTECH.

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