Last Updated on December 29, 2021 at 6:09 pm
If you are actively following the financial news nowadays, you might have read that ‘US Bond Yields Rising’ and that this is causing the volatility that we see currently in the Indian Stock Market. This article will try to understand what US Bond Yields are, why they are rising, and how exactly it affects the Indian, or indeed any other, stock market.
About the author: Arjun Budhraja is an MBA in finance with fifteen years of experience in the finance sector. He currently is an entrance exam CAT, GMAT, Law, BBA, etc.) coach. His interests include Personal Finance and Equity Markets. The opinions expressed in the article are solely the author’s and do not reflect the opinions of freefincal.
Defining Bonds & Bond Yields: A Bond is basically a piece of paper, a contract, under which the borrower (in this case, the US Government) borrows money from a lender and promises 2 things – to pay a certain rate of interest every year (or every quarter/ every 6 months) and to return the borrowed amount in full after the end of the borrowing period.
Let’s say US Government borrows $100 from Adam at the interest rate of 2% per year for a period of 5 years. Now, they will pay $2 each at the end of Year 1, Year2, Year 3, and Year 4. At the end of the 5th year, they will pay back $102 ($2 interest & $100 original amount).
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Further, in this example, the yield (or the return) that Adam gets in Year 1 is 2%, calculated by dividing the interest received by the Bond’s price (2 divided by 100).
Now let us consider a scenario where Adam needs his money back for some purpose after only 2 years of lending it. The government would not consider this request right now since they have issued bonds for 5 years and are not legally required to repay them before the end of those 5 years.
So Adam can’t get his money back from the government before the end of 5 years. Instead, he would search for some other buyer. At this point, 3 possibilities are there:
- Interest Rate is the same at 2% – In this case, Adam could easily find a buyer willing to pay $100 for the bond he owns since the new investor would not differentiate between the bond that Adam owns and a new one issued by the US Government. This is because the new investor’s yield (return on capital) is the same.
- The interest rate has gone up to 4% – In this case, Adam would have a problem. The bond that he owns has a yield of only 2%, whereas an investor can easily lend the money to the US Government at a 4% return on new bonds. Any new investor would prefer to buy a new bond for $100 being issued by the US Government and receive $4 as interest rather than buy Adam’s bond for $100 and earn only $2.
- This would mean that Adam would have to sell his bond at $50 to match the 4% yield offered by the new bonds of the US government. This will lead to a big loss for Adam if he decides to sell. However, if he does not sell, he can receive $2 every year and $100 at the end of his 5 years.
- Interest Rate has reduced to 1% – Now Adam would stand to gain considerably. He can sell his bond for $200, and still, the yield would be the same for a new investor. Here, it is in the interest of Adam to sell his bond and gain $100 immediately.
Of course, I have taken extreme examples here to explain the concept. Normally, interest rates would move much slower, especially under normal circumstances.
Bond Yields can also change based on Demand & Supply. Let’s try to understand this with examples too. Let’s assume that the US government has issued bonds only to Adam and that there are no other people or entities who own US Bonds.
Next, assume that a new investor, let’s call her Eve, wants to invest in US bonds. This could be for numerous reasons – for example, she feels that US bonds are the safest options for her right now for investing her money.
So Eve decides to contact Adam for selling his bonds to her. Adam does not want to do so. So, Eve offers to pay him $110 for his bonds. Adam thinks that it is a better deal for him to sell his bonds for $110 and gain $10 rather than wait for 5 years to receive an interest of $10 ($2 for 5 years). So he sells his bonds to Eve.
Now, calculating the yield for Eve, we will find that the yield that she receives is now 1.82% ($2/$110) than the 2% that Adam was receiving.
Vice versa, if Adam wants to sell his bonds, there are very few buyers in the market. He can offer his bonds for a price of $90 instead of $100 that was their initial value in that scenario. For the new buyer, the yield would be 2.22% ($2/$90)
Now, let us see what is currently happening in the US. For that, we need to look at the graph of US Bond Yields in the past 5 years, especially in the last 6 months. You might notice that there has been a significant increase in the Bond Yields in this 6 month period.
What does this mean? – rising yields would attract a lot of investors to invest in these US Bonds. This is because US Bonds are considered to be amongst the safest investment opportunities as there is almost a zero risk of default, and a rising return on these investments along with almost zero risk makes them lucrative.
How This Affects Stock Prices? An investor who is invested in stocks deals with the risk of loss as stock prices can significantly lower than the purchase price. There are numerous ways of defining this risk in terms of numbers.
Let us take an easy example. I bought a stock for Rs. 100 with the expectation that it would go up to Rs. 105 within some time. But considering that it can also go down if the price goes below 97, I would sell the stock and book a loss instead of risking losing more money as the stock price keeps on going down. So, my potential risk is Rs. 3 and the potential reward is Rs. 5.
Now, I compare my investment in stocks with the US Bond yield and see that I could earn a return of 1.6% with almost zero risk. This risk is very close to zero because even if the US government runs out of money to pay me, they can easily print new money and repay.
Another risk that an investor from the US faces while investing in Indian equities is Foreign Exchange Risk.
For example, in Jan. 2021, Elon decides to invest $100 into the Indian stock market. First, he will have to convert his US Dollars to Indian Rupees as transactions in Indian stock markets would happen only in Indian Rupee. Let’s say he gets Rs. 7000 for his $100. On 1 Jan., Elon invests this money in Nifty. 3 months later, on 31 March 2021, he notices that his 7000 has become 7500. Happy to be seeing a profit, Elon decides to sell and then withdraw his money. When he converts Rupees back to US Dollars, he sees that the price of 1 Dollar is now Rs. 75. So, what will happen that he will receive only $100 for his Rs. 7500.
As an investor, I might decide that it is better to earn a 1.6% yield taking only a minimal risk in US Bonds instead of investing in Indian equities where I might get a better return. Still, I am also taking 2 extra risks – the risk of loss in value and Foreign Exchange risk.
If several investors decide to do this, it will lead to a significantly increased supply and decreased demand in the Indian Stock market, leading to lower prices. Also, given that Indian stock markets are near lifetime highs, large investors have a big incentive to book the profits and reinvest their money in safer US Bonds.
What should you do? As an investor in the Indian Stock Markets, I would keep one eye on the rising Bond Yields in the US and another eye on the USD-INR rate. If there is a significant weakening of the Rupee, it can mean that Rupees are being sold to buy Dollars to invest them in the US.
We are still not seeing any massive selloff in Indian equities, and we are still quite near to all-time highs. So, no need to be afraid, but one must definitely be cautious.
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