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Why are Indian Government Bond Yields Spiking? What Does It Mean?

Founder and CEO, Transfin.
May 21, 2020 12:35 PM 7 min read
Editorial

In one of our previous Deep Dives, we comprehensively covered the basics of Bonds. In this one, we will take several strides forward and look at the “not-so-sexy” world of Government Bonds.

Why? Because government bonds and their yields, unlike other asset classes, often act as leading indicators for a country’s economy and general market sentiment. Not only do they offer great read-throughs into the economy, they also have far-reaching tangible consequences rooted deep within finance and economics. They are quite “sexy”, it turns out (geek alert!).

The "Gloss"ary of Bonds

Before deep-diving into this topic, recall that a bond is a loan and yield is the rate of return that it offers.

Now, there is a small list of buzzwords that one needs to be aware of before getting into interpreting bond yield patterns. Let’s go!

Yield Curve

The “yield curve” represents the graphical shape of various government bond yields plotted against their maturities (i.e. The time period in which the borrower, which in this case is the government, is obligated to pay back all interest and principal payments due). Typically, longer the maturity of a bonds, higher is the yield that it carries. This should be fairly intuitive – think about it, the longer the money of investors is locked in, the higher their expected return.

Yield Spread

Yield spread is just the difference between the yields of two different bonds. For example, Government of India 10-yr bonds are currently yielding 5.8% and the Government of India 1-yr bonds are yielding 3.8%. In this case the spread is 5.8%-3.8%=2%. This could give a sense of how much return in excess a bond investor expects for a 10-yr bonds vs a 1-yr bond. Spreads are often expressed in percentage points or basis points (bp) where 1bp = 0.01%.

Credit Spread

Credit spread is the difference between the yields of government bond and a corporate bond of the same maturity. This could give a sense of how much return in excess a bond investor expects for a corporate bond vs a government bond.

(Bonus: Remember that a government bond will be the safest bond possible and consequently would offer lower yield always compared to a corporate bond).

Why are Indian Government Bond Yields Spiking? What Does It Mean?

G-Secs and Treasuries

Bonds issued by Government of India are called G-Secs (Government Securities) while bonds issued by Government of United States are called Treasuries. For same maturity, it should be fairly intuitive that G-Sec will typically yield higher than Treasuries because bonds issued by Government of India carry a higher risk profile than those issued by the Government of United States. Note that Treasuries are considered the safest investment globally and their yields are not just low but also extensively used for wide-ranging economic benchmarking.

Yield Curve Shapes

These are of three kinds.

  1. Normal yield-curve: Short-term bonds carry lower yields while long-term bonds carry higher yields. As alluded to earlier, normal curve takes the shape of an upward sloping curve with yields rising as maturity period increases.
  2. Flattening of the curve: The term 'flattening' is again a graphical representation where the steepness of the curve is somewhat flattening. It essentially means that the difference between the long-term and short-term government bond yields (Treasuries or G-Secs) is narrowing. On the rare case that there is no difference between long-term and short-term yield the curve would indeed appear “flat”.
  3. Inverted Yield Curve: This happens when the short-term yield moves higher than long-term yield. While this appears counter-intuitive, what it signifies is that bond investors see the short term interest rate environment as more risky vs. Longer term. In effect, investors ask for a higher rate of return on short term lending relative to long term, which is often seen as a red-flag for a possible period of economic slowdown.

Check out the different Yield Curve Shapes here.

Now that the bonds-related jargon and basics are behind us, let see what we can interpret from the current bond markets.

Stateside Bonds - Reading the US Treasuries?

COVID-19 has obviously painted an extremely dull economic outlook with a textbook recession looking increasingly likely not just in the US but across the globe. The movement of bond yield patterns can perhaps be best understood by first understanding the following two opposing forces.

Force One: When the economic outlook looks uncertain and choppy, investors often move their money to the safest investment possible in what is called “flight to quality”. The idea is to preserve capital and park money in instruments that are well and truly safe. So what is the safest investment vehicle in the world? US Treasuries or US Bonds! This obviously raises demand for US Bonds and in turn raises their prices, directly resulting in a downswing in their yields. Recall that bond prices and yields move in opposite directions.

Force Two: Now there is another moving piece at play. To manage the current economic standstill, the US government, much like several other governments, has injected money into the system to stimulate the economy through what is known as “fiscal stimulus”. This stimulus is money that is pumped into the economy to stimulate demand and get the economic engines roaring again. But this ought to be funded from somewhere. And that funding happens typically by the government issuing bonds in exchange for cash. Be it the Central Bank, internal markets or wherever, the money needs to borrowed from somewhere. Consequently, while the US Bonds are safest in the world, their risk profile is not static. Said another way, the more it borrows, the higher its risk profile. Think about it - would you rather lend to someone who does not have any outstanding obligations or to someone who is already immersed in debt?

While the impact of both of the above forces is there to be seen in the chart below (source), the first force is so much bigger that it largely offsets the second one and therefore you see a chart which looks like one where the yields have literally fallen off a cliff.

Why are Indian Government Bond Yields Spiking? What Does It Mean?

Domestic G-Secs - How Indian Bonds Dance

The India story is largely the same from a logic standpoint. It operates under a similar framework of the same two forces. However, the general trend of yield downswing (due to Force One) is muddled up with more layered nuances in the Indian context while the second force is significantly more pronounced.

India’s G-Secs are in no way considered as safe as US Treasuries. G-Secs are actually not even beneficiaries of “Flight to Quality” like their US counterparts, which is a fundamental difference. In fact, moving capital away from G-Secs and into US Treasuries is considered a popular “flight to quality” trade. So while a G-Sec might still be a safer investment than various other asset classes, in the larger global scheme of things there are many investments that are deemed far safer than G-Secs. This is driving a meaningful exodus of capital from G-Secs and in turn lifting yields.

Second, as the Government of India steps up its borrowing to drive and stimulate growth, there is an asymmetrically higher adverse impact (compared to US) on the G-Secs' risk profile. A double whammy of sorts!

This obviously has a meaningful upward effect on bond yields. In fact the yields surged quite dramatically in India as bond investors expect more borrowing and significant increase in the bond’s risk profile warranting a higher yield. The Government of India recently raised its borrowing target for FY21 to ₹12Lcr ($160bn) from the previously budgeted ₹7.8Lcr ($104bn). This could be well over 6% of a loosely estimated GDP, which further exacerbates G-Secs' risk profile. As such, any expectation of fiscal slippage resulting in additional borrowing will drive up the yields, which is there to be seen in the market today (source):

Why are Indian Government Bond Yields Spiking? What Does It Mean?

The disconnect between G-Secs and US Treasuries is fairly intuitive once someone understands the nuances. It is also fairly evident that both the yield movements point towards a gloomy economic outlook, albeit by moving in opposing directions!

Corporate Bond Bonus

Much like G-Secs, Indian corporate bonds are also witnessing a meaningful spike in yields. As one would expect, Indian corporate bonds are considered riskier than GSecs and it is fairly intuitive to expect meaningful capital move out of this asset class in-line with the larger “flight to quality” narrative at play.

For instance, Future Retail’s 5-yr bond with a coupon of 5.6% was yielding 40%+ which gives a sense of the inherent risk that was being built into owning debt of the company. Vedanta is another example with bonds seeing sharp spikes across the board. Vedanta’s 10-yr bond (set to mature only next year) with a coupon of 8.25% was yielding in excess of 65%.

The way to interpret such a divergence between coupon and yields is that the expectation of default is so high that investors are demanding exuberant returns to compensate for the risk of lending to this company...even for a short period of time.

FIN.

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