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Why You Should Worry about a Spike in Bond Yields 😲

Bond yields in the US have surged to a 17-year high, at 5%. This has sent yields across the globe higher, and put pressure on equities. Last week, the Indian markets fell by 1%, the US and UK by 3% and China by 4%.

Why is this happening?

The spike was seen after comments from US Fed officials indicated that more rate hikes are coming through the year; to bring inflation down to the 2% target. Inflation data isn’t expected to be the most encouraging as prices have shot up on account of the conflict in the Middle East, and as producing countries cut supplies. Moreover, the strength in the US economy leaves room for rate cuts without tipping the economy into a recession.

Why should I care?

US treasury yields are considered to be the benchmark for any investment. A rise in the yields increases the expected return for any other investment. This pushes asset prices downward. Additionally, liquidity tends to move to US bonds in such situations, which now offer higher yields, slowing down or even reversing flows into riskier assets, like Indian equities.

What’s the impact?

Yields on junk-rated emerging market bonds climbed the most. With borrowing costs increasing, the probability of default increases; affecting low rated bonds. Even investment grade bonds saw a spike in yields, indicating these too aren’t immune from the sell-off. Markets were affected throughout Asia, the Middle East and Latin America.

Has it impacted India?

Yields on ten year Indian government bonds rose by 5bps in the last week. Yields have been rising, not just because of the US yields, but since the last monetary policy meeting of the RBI. The RBI in its last meeting indicated it will sell bonds through Open Market Operations (OMO), while not talking about quantity and timing. This move is expected to drain excess liquidity out, to control inflation. Since this announcement, bond yields have been up 15-20 bps.

What happens to the markets?

Higher yields in the US, across emerging markets, and in India are expected to keep equity markets under pressure. Look at it this way, US bond yields just hit 5%. The Indian markets trading at a valuation of anything above a PE of 20x would increasingly be irrational. A PE of 20x implies an earnings yield of 5% (earnings yield is the inverse of PE). Why would an investor invest in a risky asset like Indian equities for 5% if they’re getting US treasury for 5%?

What to do?

We see near-term pressures on the markets on account of elevated inflation fears, a continued high-rate regime across the world, regressive monetary policy in the form of rate hikes / bond sales, and adverse liquidity on account of rising yields. However, the medium to long term picture continues to be favourable for Indian equities given structural strength, and relative outperformance. We’d remain invested keeping our vision strong on the long term.

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