Rising bond yields have emerged as a major threat to the equity market rally. Yield on the 10-year bond in India moved up from the recent low of 5.76% to 6.13% on February 23, 2021. A sharp rise in domestic as well as global bond yields has prompted a sharp correction as the market closed in red for the fifth consecutive trading session.
Why bond yields are rising in India?
The government's announcement of a massive borrowing program and rise in fiscal deficit are the primary reasons behind the spike in bond yields.
Market borrowing of the central government is projected at Rs 12 lakh crore in FY22. To facilitate this, RBI could increase the supply of government bonds in the market. It could result in bond prices to decrease, putting pressure on yields in the process.
Let's understand how it impacts the stock market?
Equity market shares an inverse relationship with bond yields. Therefore, when bond yields decline, equity markets tend to outperform. And, as bond yields rise, equity market returns tend to falter. here's how it happens:
1) Flight to safety :
India offers higher interest rates on bonds, compared to the developed nations. Hence, with rising bond yields, global investors find Indian debt more attractive. It leads to capital outflows from equities and inflows into debt.
2) Increased cost of borrowing :
With higher yields on government bonds, investors will demand higher yields on corporate bonds as well. With that, corporates will have to pay a higher interest cost on debt. Higher debt servicing cost directly impacts corporate earnings. As earning gets impacted, investors would prefer the safety of fixed income instruments against the volatility of stocks. Hence, stocks become less attractive.
3) Impact on valuations :
With rising bond yields, cost of capital also goes up. It means future cash flows get discounted at a higher rate, compressing the valuations of stocks. That is one of the reasons why the stock market underperforms when bond yield increases.
RBI holds the key :
RBI has the task of supporting the government's borrowing program ahead of it. For that, managing bond yields will be crucial to keep the borrowing cost down.
The market would want RBI to constantly intervene through its open market operations. The central bank has recently adopted a practice of
canceling the bids if it could not find bidders at reasonable rates. Last week, it devolved the papers worth Rs 11,000 crore on primary dealers as it could not find bids at reasonable rates.
RBI has also resorted to capping the bond yields in the event of excessive selling. The central bank has tweaked its auction method for a series of difficult-to-sell bonds. It has now introduced a uniform price threshold that will apply to all bidders. It will help significantly to keep the yields at the desired level.