RBI’s bid for Moderate bond yield and its significance

The yield on the benchmark 10-year bond has fallen below 6%. The Reserve Bank of India’s decision to step up purchase of government securities under the government securities acquisition programme (G-SAP) had been one of the great reasons behind this reduction of yield.

• The change in the yield depends on trends in interest rates which can result in capital gains or losses for investors.
• If an individual holds a bond carrying a yield of 6%, a rise in bond yields in the market will bring the price of the bond down.
• On the other hand, a drop in bond yield below 6% would benefit the investor as the price of the bond will rise, generating capital gains.

Relation between bond yield and market

• A negative relationship exists between the bond yields and equity markets.
• The higher level of bond yieldsenhances the opportunity cost of investing in equities, which makes the equities less attractive.
• A decline in bond yield is positive for the equities markets.

G-SAP and the bond yield

• G-SAP has engendered a softening bias in G-sec yields.
• The announcement of a bond-buying programme, the G-SAP has played a crucial role in turning the market sentiment
  • The cancelling and devolving government debt auctions are giving tough signals to the bond yields.
  • The fall in bond yields in India could also be due to a sharp decline in US Treasury yields or the economic uncertainty caused by Covid-19.

Impact of reduced yield on markets and investors

• A decline in yield is good for the equity markets because money starts flowing out of debt investments to equity investments. As the bond yields go down, the equity markets tend to outperform by a bigger margin and as the bond yields go up equity markets tend to down.
• The going up of bond yields show that corporates will have to pay a higher interest cost on debt. As debt servicing costs go up, the risk of bankruptcy and default also increases and this makes mid-cap and highly leveraged companies vulnerable.
• The yield on bonds is normally used as the risk-free rate when calculating the cost of capital. When bond yields go up, the cost of capital goes up.
• That means that future cash flows get discounted at a higher rate.
• This compresses the valuations of the stocks.
• Whenever the interest rates are cut by the RBI, it becomes positive for stocks.
• US monetary policy direction and Fed bond yields could be the biggest risk factors for the Indian bond market in 2021.

Role of RBI in keeping a lower limit

• The RBI has been aiming to keep yields lower as it reduces borrowing costs for the government while preventing any upward movement in lending rates in the market.
• Any rise in bond yields will put pressure on interest rates in the banking system that will lead to a hike in lending rates. RBI wants to keep the interest rates steady to kick-start investments.

Conclusion

During the “taper tantrum” episode of 2013, the Indian bond yields spiked and the value of the rupee collapsed within a few months. India’s macro position and external accounts are in much better shape than in 2013. Nevertheless, Indian markets will not be immune to any such shocks in the global sphere. Over the medium term, inflation and potential monetary policy normalisation will also play a major role in shaping the interest rate trajectory.