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A rise in bond yields is worrying Indian investors. Indian markets have seen major volatility in 2021 after a rally in 2020 on the back of easy monetary policy globally - the Nifty rose around 15% last year. Mint explains the connection between US bond yields and markets in India.

Why are US bond yields moving up?

An economic recovery in the US and a potential return of inflation are the main reasons for a surge in bond yields. These yields had sunk in mid-2020 as the Federal Reserve loosened monetary policy to support the US economy in the aftermath of the covid-19 pandemic. The Fed is expected to normalise its stance as inflation moves up. The prices of commodities have moved up sharply over the course of the year, and this is often a precursor to higher inflation. The yield on the benchmark 10-year Treasury note has moved from 0.91% at the start of calendar year 2021 to 1.72% on 19 March 2021.

How does this affect equity markets?

Higher bond yields are related to stock prices in two ways. First, government bond yields are a proxy for the ‘risk-free rate’ that is used to discount cash flows of companies. Future cash flows are less valuable than present cash flows and the discount rate allows them to be compared with present cash flows. The higher the risk-free rate, the higher is the discounting factor and hence the lower is the valuation of the stock. Second, higher yields mean higher borrowing costs for companies. This reduces the earnings available for shareholders as dividends.

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How does a spike in yields affect the Indian markets?

Since capital flows from one country to another, interest rate increases in large economies affect other large economies. The US is a source of flow into equity markets of other countries, including India, and a rise in rates in the US makes keeping money in domestic bonds lucrative for the country’s investors.

Which stocks are most vulnerable?

In general, companies with a lot of debt are at risk from rising interest rates. If bond yields in the US also eventually push up yields in India, this can affect the returns of such companies by increasing their borrowing costs. Rising US yields can also cause a depreciation of the rupee and this weakens the position of companies with borrowings in US dollars. Conversely, sectors such as pharma and tech with earnings in dollars can benefit from rupee depreciation.

How should investors respond to the risks?

Most experts expect monetary policy from the world’s central banks to remain accommodative and hence bond yields to remain broadly low. Hence, there is no reason to act in haste. However, you should keep this risk in mind while allocating more money to equities. Having some of your portfolio in dollar-linked assets such as US stocks can also partially hedge your risk. This can be done through mutual funds investing in the US or directly buying US stocks and bonds through RBI’s Liberalised Remittance Scheme.

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