The yield of government securities maturing in 2032 has increased to 7 percent. This increase is attributed to factors like high inflation due to supply constraints, geopolitical tensions in anticipation of increased rates by the RBI and other major central banks, etc. how this yield increase impacts them is a more important question for investors. In this article discusses in detail the impact of an increase in bond yields on investors.
But first, what are bond yields?
Bonds are debt instruments issued by governments/companies to raise funds from investors. They are tradable instruments like company shares. Companies/governments pay a coupon rate on bonds in return for investors’ money. As bonds are tradable instruments, they also have returns known as bond yield. The bond yield is the coupon rate divided by the bond’s price. So, for example, if a bond’s price is INR 20,000 and the coupon rate is 5%, then the bond yield will be INR 1000. The 10-year G-sec is the benchmark bond yield in India. bonds move according to this benchmark rate.
The relationship between bond price and yield
A bond’s price (face value) and yield have an inverse association. When one rises, the other falls and vice versa. Several factors impact the price and yield of bonds. But the one factor that affects bond yields most is the level of prevailing interest rates in the economy. An increase in interest rates causes the prices of bonds to decrease, thereby increasing the yields on bonds.
Some thumb rules to keep in mind;
- bond yield is lower than the coupon rate, then it is because the market price is higher than the face value.
- If the bonds yield is higher than the coupon rate, then the market price is lower than the face value.
- If the bond yield is equal to the coupon rate, then the bond’s face value is equal to the current market price.
How does an increase in bond yields impact investors?
Because of the inverse relationship between bonds prices and yields, bonds buyers have to spend less on purchasing a bonds when yields rise. For example, consider a bond with a price of INR 1,00,000 and a coupon rate of 5%. The yield of this bonds is INR 5000 initially or 5%. Now suppose the yield increases to 5.5%. This increase implies that the bonds price has gone down to INR 90,000. Bonds investors can now earn a higher annual yield by buying at a lower face value. Hence, increasing bond yields is a lucrative investment opportunity for those considering investing in bonds.
But what is the impact on the already purchased bonds? If you already own a bond with a fixed interest rate selling it before its maturity will mean selling the bonds at a discounted price. This phenomenon is also called a capital loss. However, if you choose to hold it till maturity, you risk losing the opportunity of earning higher yields. This phenomenon is also known as the interest rate risk.
To illustrate, suppose you hold a bond that offers a yield of 6%. If the interest rates in the economy are raised, corporations and governments will now issue bonds with higher yields. Suppose this new yield is 7%. Naturally, the demand for a bond with a higher yield will be more than the demand for a lower yield bond. This will cause the price of your 6% yield bond to decrease further. If you sell this bond in the secondary market, your sell price will be lower than your purchase price i.e., you will have to sell it at a discount.
What are the long-term effects of an increase in bond yield for an existing bonds portfolio?
If your bond portfolio consists of bonds with the same maturity, you are at a higher interest rate risk. This risk can be mitigated by having a diversified bond portfolio with bonds with differing maturities. This method of holding bonds of different maturities is called bonds laddering. With bonds laddering, the risk of capital loss due to rising interest rates can be spread out allowing you to break even or even profit in the long run.
To illustrate, suppose your portfolio consists of four bonds with differing maturities as follows.
- Bonds A with a yield of 3% and maturity of two years.
- Bond B with a yield of 3.5% and a maturity of three years.
- Bond C with a yield of 4% and a maturity of four years.
- Bonds D with a yield of 5% and a maturity of five years.
The average yield earnings from this portfolio will be the average of the yields of all four bonds. This average is 4% for this bond portfolio. Now, if the yield for the two-year bond increases to 3.5%, an investor can sell the existing bond and reinvest the earnings in a bond with this higher yield. Since the market price will have also decreased, you can reinvest the earnings by buying this bond at a lower face value. Similarly, the yield for bond D also increases to 5.5%. Selling this and reinvesting in the higher yield bond will take the average bond yield of this portfolio to 4.25%.
Investors will make a capital loss in the short term, such a strategy will benefit the bonds portfolio in the long term. Even if an investor wishes to hold the bonds until maturity, diversity in maturities will enable them to tide over the fluctuations in the bond yields as the portfolio will consist of bonds that mature every year or so. Bonds can be purchased at higher rates and earn a higher average yield in the long term.
How can investors benefit from rising bond yields?
- The current time is the best opportunity for new investors to invest in bonds because high-yield bonds offer high returns and a predictable income.
- Along with the current situation being the best time to invest in bonds, it is also wise to invest in a diversified bond portfolio. Different maturity bonds will help you tide over when the bond yields start falling.
- Creating a diversified bond portfolio is as easy as creating an equity portfolio with the advent of bonds platforms. Investors can choose bonds with different maturities, credit ratings, interest payment frequencies, and yields. Adopting a bond ladder strategy is also more accessible with bond platforms, as buying or selling bonds is a highly straightforward process.
- Investors can choose to invest in floating-rate bonds. The yields of such bonds change as per the underlying benchmark rate you are expecting the rates to go up further and floating-rate bonds will help you benefit from such an increase.
Conclusion
Bonds are a lucrative investment instrument in the fixed-income category. Especially in the current market of low-interest rates on other fixed-income classes like fixed deposits and small savings schemes, bonds look more attractive because of their current high yields and traceability. Investment strategies like bond ladders and creating a diversified bond portfolio can be adapted to make the most of rising bond yields.
