Rising US bond yields signal high inflation

Mumbai: Even as yield on 10-year US bond rose to 1.6 per cent, the highest yield level since Feb 2020, it gives an early signal for inflation rising faster than expected in that country.

It is nearly 100 bps higher than Covid low of 0.6 per cent. Similarly, Indian 10-year benchmark yield has also risen from Covid- low of around 5.70 per cent (May 2020) to around 6.20 per cent.

Even though extraordinary accommodative monetary policy by US Fed and several Central banks is likely to continue for a year or so, yields rising so sharply have surprised investors.

"It could be an early signal for inflation rising faster than expected especially on the back of sharp rise in crude and commodity prices.

If there's a sustained increase in inflation leading to higher bond yields, it could have a negative impact on risky assets like equities," says Nirakar Pradhan, CEO, PRMIA India. It also means that bonds have become more attractive for the Indian investors than equities. Normally, there is negative correlation between bond yields and equity prices. This means higher the bond yields lower will be stock prices and vice versa. This is because of the opportunity cost of equities, Pradhan says. For example, if risk free bond yield is 6 per cent, and equity risk premium is 5 per cent, then the opportunity cost of equity is 11 per cent (6 per cent+5 per cent). Rising bond yield drives the opportunity cost of equity higher, making investing in equity less attractive.

In that scenario, people tend to exit stocks to invest in bonds. In emerging market like India, the earnings yield (inverse of PE ratio) is compared with bond yield. In India, the PE ratio is around 20. Then the earnings yield is 5 per cent (100/20). If bond yield is let's say above 6 per cent, then bond is more attractive than equity. The yield on bonds is normally used as the risk-free rate when calculating cost of capital. When bond yields go up, then the cost of capital goes up. That means that future cash flows get discounted at a higher rate. This compresses the valuations of these stocks. Foreign portfolio inflows play important role in Indian equity. There is fear that with rise in USA treasury yields, there could be outflows of FIIs in equities.

A rise in bond yield signals that corporates will have to pay a higher interest cost on debt. This gives rise to higher debt- servicing cost and rising risk of default, especially for highly leveraged mid-cap and small-cap companies.

According to Pankaj Thakur, GM, Treasury, GMR, "In Indian context too, yields have moved up by 50 bps. However, it is not much of concern in light of inflation remaining within the RBI tolerance level of 4 per cent+/- 2 per cent. Historically we have seen during 2004-2008, while 10Y G-sec yields went up from 5 per cent to 8 per cent, Nifty delivered 32 per cent CAGR. Our economy is a similar situation as we were in 2004, inflation and current account under check and there has been significant thrust on reforms."

"As of now we are seeing rising bond yields having a negative impact on banking and IT sector while a favourable impact on metals and utilities," says Rusmik Oza, EVP, head of fundamental research at Kotak Securities.