Explained | How rising bond yields suck up FII flows to emerging equity markets

US 10-year treasury bond yields have been rising over the past few weeks on expectations of interest rate hikes and tapering of bond purchases by the Federal Reserve as it tries to tame accelerating inflation.

US bond yields have increased from 1.38 percent at the start of December 2021 to 1.95 percent on February 8.

Experts say inflation in the world’s largest economy may worsen before steps taken by the Fed start producing results.

What is driving the bond yields higher? 

A number of factors are pushing bond yields, which move in the opposite direction to prices.

First and foremost is quickening inflation. The US consumer price index probably jumped 7.3 percent in January from a year ago, the largest annual advance since early 1982, according to the median projection in a Bloomberg survey of economists.

As inflation accelerates, bond prices are forced down, which in turn push up bond yields, making them attractive to investors because they offer a risk-free return.

The reason for quickening inflation is the availability of easy liquidity and the hope of economic recovery.

Rising crude oil prices are also a cause of concern because they stoke inflationary pressure. The prices of other commodities have also risen sharply in recent weeks, adding to the pressure.

Higher fiscal and trade deficits also push bond yields higher.

Also read: What do rising bond yields signal to the markets?

Relationship between bond yields and equity markets 

Bond yields are the opportunity cost of investing in equity markets. When foreign portfolio investors (FPIs) invest in emerging equity markets like India, the cost of investing includes a hedging cost, also known as the risk premium.

For investors to be pulled into investing in equities, the market will have to justify the risk premium.

So, if a 10-year bond is yielding 4 percent an annum, the expectation of returns from the equity markets will be much more because the investor has to cover the hedging cost as well, which could be in the range of 5-7 percent.

The minimum expected returns from the equity markets will have to exceed 9-11 percent to compensate for the risk premium.

As bond yields increase, the opportunity cost of investing in equity markets also increases, which dents fund flows to the riskier equity markets.

The impact on emerging markets like India 

Given that government bonds are the safest investment avenue, offering a risk-free return to investors, they have become more attractive now as bond yields are inching up.

Considering the risk associated with equity markets in terms of volatility, the risk arbitrage between returns from bonds and returns from equities has become less attractive.

To ensure safe returns for their investments, FPIs are pulling funds from equity markets to invest in safer instruments like treasuries, resulting in the bearish phase in Indian and other emerging equity markets.

How long is this likely to continue? 

As bond purchases increase rapidly with more and more fund managers turning to them, the higher demand will result in higher prices because of a demand-supply mismatch.

This will ultimately drive yields down over a period of time, reducing the likelihood of investors earning a risk-free return, forcing them to drive funds to equity markets.

Until that happens, FPIs will continue to sell in emerging equity markets, leaving room for a higher correction from current levels.​