Take guard! Yields are going up everywhere.
A deteriorating macroeconomic environment is to blame.
In India, the 10-year benchmark bond yield briefly breached 8 per cent on Friday — for the first time since December 2014. This came a day after the US yield hit 3 per cent.
Rising yields make equity investors sweat as bonds turn attractive from the returns point of view. There are expectations that yield may continue to creep up.
“The pressure on long-maturity central government bonds is likely to continue as state government bond dynamics will take a new turn, given the transparent mark-to-market framework,” Ashish Vaidya, Executive Director and head of trading at DBS Bank India, told ET.
How it works
Hardening bond yields are considered as negative for stocks markets. The yield on bonds becomes more than that of equities.
In India, equities had been attractive for the last 3 years because yields were headed down. On a year-to-date basis, 10-year bond yield in India has increased by more than 61 basis points. Compare that with the Sensex, which has gained 4 per cent during the same period.
With bond yields headed higher since July last year, investors and asset allocators are going back to the drawing board. They may find debt relatively more attractive than equity in risk-adjusted terms.
There is another explanation on why higher yields spell tough times for equities. When rates go up, the cost of debt jumps. So does the cost of capital. This cost of capital is used to discount future cash flows to arrive at valuation of companies. A higher cost of capital depresses valuation of equities, according to Angel Broking.
In its June meeting, the Reserve Bank's MPC (Monetary Policy Committee) voted 6-0 to hike the repo rate by 25 bps to 6.25 per cent. This hike — the first in four and a half years — should be seen as a reversal in the interest rate cycle, said Pankaj Pathak, Fund Manager-Fixed Income, Quantum Liquid Fund & Quantum Dynamic Bond Fund.
Sanjeev Zarbade, Vice-President, PCG Research, Kotak Securities, in a chat with ETNow said, “The way we are looking at the markets is that there are clearly macroeconomic concerns on the horizon. Cost of borrowings also started to go up, with bond yields now almost 8 per cent right now. So, it is not a very sweet spot so far as the equities are concerned and by and large we believe one needs to be a bit cautious.”
Whats in it for debt investors?
The central bank has made its policy stance Neutral. Which essentially means all options are open. The regulator is likely to take a flexible approach and not be plain hawkish.
The 10-year government bond yield, Pathak said, will likely remain 7.70-8 per cent for now and move above towards 8.25 per cent if the markets expect the RBI to hike rate by more than 50 basis points.
“We continue to maintain our neutral stance on rates over the medium term. However, we keep looking for signs of mispricing in market and position to exploit the opportunity tactically. We advise investors to have a longer timeframe if they invest in bond funds and should also consider the possibility of capital losses in the short term,” Pathak explained.
Fixed maturity plans are back
Fixed maturity plans — FMPs in short — from firms such as HDFC, Tata, SBI, Aditya Birla Sunlife, ICICI Prudential, Kotak, Reliance and DHFL Pramerica with a tenure of 1,098-1,442 days either have already opened or are going to open next week for subscription. It shows FMPs are back in the game.
FMPs are closed-ended funds with a fixed tenure and structured in such a way as to give you double indexation benefits, thus improving your post-tax returns. There is no interest rate risk for investors as the maturity profiles of the fund and bonds are matched.
Dhirendra Kumar, CEO, Value Research, in an interaction with ETNow said, “Fixed income funds should be an essential part of any investor's portfolio.”
Why are bond yields worked up?
The hike in bond yields for the last one year now has been attributed to investors concerns about the fiscal slippage in FY18 and a higher-than-expected deficit target for FY19. A higher fiscal deficit leads to a spike in government borrowings, especially when governments revenue generation is sluggish.
There are inflationary concerns, to boot. That's especially so, given the Budget proposal to raise minimum support prices (MSPs) on crops.
Rising crude oil prices are putting addition pressure on Indias balance sheet.
When macroeconomic indicators turn weak, bond yields push higher, resulting in a drop in its prices. And investors seek more returns on bonds to compensate for the risks involved.