How Bond Yields Are Playing Out in the Indian Debt Market

From the time bonds are issued until the date that they mature, they trade on the open market, where prices and yields continually change. As a result, yields converge to the point where investors are being paid approximately the same yield for the same level of risk.

Enhanced risk with such bonds is offset by greater returns, adding to their appeal. Government bonds (Gsec) are relatively more stable, but has low demand due to it long duration of maturity and highly sensitivity to interest rate.

As investors sell bonds, prices drop, and yields increase. A higher yield indicates greater risk. If the yield offered by a bond is much higher than what it was when issued, there is a chance that the company or government that issued it is financially stressed and might be unable to repay the capital.

In fact, the bond yield and prices move in opposite directions. Both act like a seesaw, when the bond price increases, yields goes down and vice versa. This happens largely because the bond market is driven by the supply and demand of capital into the system.

The bond yields fell the most in three months, after the Reserve Bank of India (RBI) announced measures to allay the market fears over rising yields and higher borrowing programmes.

Since the bond price and yields are inversely proportional to each other, the current fall in the yields has favoured the bond prices to make debt fund investment lucrative. The debt funds having a higher maturity that are at the longer end of the yield curve--gilt funds and long-term bond funds benefited the most due to the fall in the bond yields.

Among other debt funds, dynamic bond funds are also being considered as an investment option across durations due to its dynamic nature. Recently my colleague Divya explained in her article, "Long Duration Funds are offering Double-digit Returns. Should You Invest?" the same thing.

When the yields move down, prices of existing debt funds go up, as the existing securities become more favourable due to higher interest rates. As a result, the NAV of the debt mutual fund scheme goes up when the yields of securities go down.

On September 1, the 10-year bond yield was trading at 5.944%, its steepest decline since 13 May, from its previous close of 6.117%.

Graph: Softening of 10-year gsec Yield

Among several measures which the RBI took do deal with the widening fiscal deficit, rising unemployment levels, drop in GDP, and inflationary pressure the recent announcement of fresh liquidity measures, and a relaxation in mark-to-market to help calm investors' nerves when a sudden spike in yields hit bond markets and pulled the yields down.

The RBI increased limits on bonds held to maturity from 19.5% to 22% of total deposits, the announcement of additional open market operations (OMO) worth ₹20,000 crore and term repo operations worth ₹1 trillion to infuse liquidity into the market was made.

In order to reduce the cost of funds for banks, RBI also allowed them to swap the funds raised under long term repo operations (LTRO) at 5.15% with the new funds made available under the 1 trillion repo window at 4%

What does it mean for the investors?

Even if the bond yields project the GDP growth, but the relationship between yields and economic activity is more complex for the Indian Debt market. A whole host of factors including recessions, inflation, and bank rate set by central banks can have an impact on bond yields.

Currently, the COVID-19 pandemic (with cases continuing to rise), tensions along the Line of Actual Control with China, a 23.9% contraction in India's GDP growth for Q1FY21 (the worst in four decades), weak consumption, a depressing job scenario, overshooting of India's fiscal by 103% in just four months through the fiscal year 2020-21, downgraded sovereign credit rating, and the risk of a global recession are to be looked at for growth of the Indian economy.

The aforementioned factors are pointing that the economy is severely hit and in such troubled times you as an investor must be extremely cautious. Prudently invest to safeguard your capital and gain returns as well.

Although bank FDs would be a convenient choice, but mind you, the returns are taxable and not capable to beat the inflation bug over the years. So, consider debt mutual funds with eyes wide open because they are not risk free at all. Invest in funds that do not undertake high credit risk.

[Read: Why You Need To Be Extra Careful While Selecting Debt Mutual Funds Now]

It would be prudent to stay away from funds with high exposure to private issuers. Invest in debt funds that have a predominant exposure to government bonds or quasi-government papers because these can offer better safety and liquidity.

[Read: Lessons Learnt from the Debt Fund Crisis]

Select schemes based on your financial objective, risk appetite, investment time horizon, and the following factors:

• The portfolio characteristics of the debt schemes

• The average maturity profile

• The corpus & expense ratio of the scheme

• The rolling returns

• The risk ratios

• The interest rate cycle

• The investment processes & systems at the fund house

At PersonalFN, we arrive at top rated funds using our SMART Score Model. If you wish to select worthy mutual fund schemes, I recommend subscribing to PersonalFN's unbiased premium research service, FundSelect.

Additionally, as a bonus, you get access to PersonalFN's popular debt mutual fund service, DebtSelect.

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Warm Regards,
Aditi Murkute
Senior Writer

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