Explained: Government bond yields and impact on equity markets

One of the ingredients of equity valuation is the cost of capital which is directly linked to government bond yields. So if the bond yields rise, the implied cost of capital increases.

March 08, 2021 / 06:54 AM IST

Government bonds can sometimes be more volatile than equity. Yet it is considered risk free investing. How can both be true? It can be if you run a managed strategy or you are a buy and hold investor.

A bond has primarily two sources of returns- carry and price return. It also has primarily two sources of risk which are default risk and duration risk.

Carry returns comes from carrying the bond to maturity. It is similar to a bank earning EMI from monthly loan payments. While EMIs are monthly, bonds pay coupon once or twice a year. Interestingly, some bonds don't pay coupon at all. Such bonds are called Zero Coupon Bond. The returns in this case come from only the difference between the purchase price and sale price.

The beauty of bonds is that the future sale price is known today. It is like a put option. You are promised a sale price that is issued at face value upfront at the time of purchase. This is precisely the source of risk as well. The risk comes from the implicit promise to pay in the future. A promise that can be broken due to lack of funds. This is what is usually called bond default at maturity. A default could also be an inability to pay coupons.

Government bonds in India for Indian investors are virtually risk-free because RBI can print money to pay government bond obligations. The flip side is that incessant printing devalues the rupee. Hence, you might get back the investment in rupee terms, but you might lose in purchasing power terms as the rupee slips lower compared to say USD.

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There is also another source of risk-return - which is linked to reinvestments and duration risk. It is driven by how the price of bonds move depending on new auctions of government bonds. These auctions are conducted by RBI and the great news is that now retail investors can be part of this auction via the NSE Go Platform. This is an app from NSE where after registration, you can invest in government bonds and state loans of all maturity without brokerage. NSE has made this platform available to retail investors who via non-competitive bidding, can receive the weighted average price or yield of auctions for State Loans, Treasury Bills and longer-dated Government Securities. The investments are in multiples of Rs 10,000. So far, retail investors have received 100 percent allocation compared to oversubscription from institutions. It is easy and worth consideration.

Now let us ask about what happens if at the next auction by RBI the best price government bond can get, changes. For example, as of February 28, 2020, or about a year ago, the interest rate the government was willing to pay for borrowing for 91 days was 5.08 percent while after a year, it is about 3.17 percent. The 10-year bond yield was 6.65 percent on February 28, 2020, but dropped to as low as 5.96 percent in January 2021 and has recently gone up and was 6.34 percent on February 26. Though it might seem small fluctuations, this has almost wiped off 50 percent of the gains from yield compression over the last 1 year. It is like a 50 percent drawdown in the world of equity. This why it is volatile.

Hence, bond prices can be volatile before it matures but ultimately converges. This is because while market yield varies, the yield to maturity is constant. It is like your FD rates might change, but your FDs have the interest rate locked in when you open your fixed deposit with a bank. Like the bank, the government is committed to this interest rate - even though it might be lower than what it can borrow for now. Bond prices will also be affected by RBI cutting rates or supply-demand dynamics. Though it might seem complex, the good news is that for individual investors, bonds are volatile if you trade before maturity but are risk-free investment if you hold to maturity.

But what if you are a trader? This is where experienced treasury managers or absolute return bond fund managers strategize this duration risk by hedging, using interest rate derivatives or can also average out based on future auctions. This is the domain of institutions and so far retail investors found it difficult to play here. However, with NSE Go and the availability of credit default swaps and interest rate derivatives, this can offer huge potential for active management in the bond space.

In an interview with IIFL, Vikram Limaye, MD & CEO at NSE said, “To improve participation of retail investors, NSE in the last year has opened multiple channels for investing in government securities. This new feature of the goBID app will allow KYC compliant individuals having a demat account to seamlessly invest in government securities and help increase retail participation.”

Having learnt a bit about bonds lets now connect bonds to equities. Value of equity is broadly current equity capital plus the sum of expected free cash flow till perpetuity. This expected future cash flow is discounted to present value. To illustrate the present value concept, imagine you needed Rs 10 lakh in 5 years. How much do you need to put in a fixed deposit today? The amount you need to put today is the present value of the bank deposit of 10 lakhs. Similarly, we can calculate the present value of cash flows in future from expected company earnings. This cash flow is used to value equity.

One of the ingredients of equity valuation is the cost of capital which is directly linked to government bond yields. So if the bond yields rise, the implied cost of capital increases. This means, for the same cash flow, if the bond yields rise the discounted cash flow value will be smaller. Therefore, rising bond yields can make equity prices go down. This is what we recently saw in the US as well as partly in India. The 10-year yield pre-budget was 5.96 percent which is about 6.24 percent now. This would lead to bond prices dropping by 0.30 percent/5.29 percent or roughly 6 percent. Roughly wiping out 1 year worth of returns in one month. If bond yields go back down to pre-budget levels, 1-year return could be near 10 percent from here. Better than 6 percent in fixed deposit right? If you want to play this swing, look at Gilt mutual funds available from many AMCs. Remember to invest only in direct ones as the trail fees can be very high. As a general house view, we are overweight on government bonds.

The reason bond yields rise could be due to good or bad outcomes in the economy. It could for example be due to inflation from weaker rupee and hence more expensive oil imports, or consumption-led inflation where demand increase or supply shocks due to low production during the lockdown, or due to expected higher default risk and perhaps lower credit rating, or could be people selling risk-free bonds for risky equity. Usually its a mix of one of these as well as the overall supply-demand of government bonds. For example, if the government thinks that it is paying too much yield, it might not borrow as aggressively and this tight supply can drive down yields.

In the latest budget, the government announced massive outlays for infrastructure and the market quickly priced a higher supply of government bonds and hence the yields moved up. However, looking at CPI data, inflation has not caught up enough for RBI to hike rates we think. Also, slight inflation usually points to a healthy economy where people demand more. Hence, we think the yields may compress on the back of lower than expected inflation that can benefit both bond and equity investors in the medium term. Moreover, states like Puducherry have already started cutting VAT on fuel which can have a deflationary effect because of fiscal adjustments. Also, India recently had a current account surplus which usually makes the rupee stronger against the USD. This could cool inflation too as oil imports become cheaper. Broadly, we remain bullish on government bonds as an investment choice given current higher yields and expected lower yields in the future.

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
Abhishek Banerjee

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