Bond yields have increased to their highest levels in three years as the Reserve Bank of India hikes key interest rates to combat inflation, which is anticipated to continue at over 7% until at least September.

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In the past one year, the yield on benchmark 10-year government bonds has shot up by 149 basis points to 7.50%. Long-term rates have climbed by more than 100 basis points since the beginning of the year, while short-term yields have risen by more than 150 basis points.

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Bond rates have been rising globally in response to higher inflation and policy normalisation objectives.

“Data showing a further increase in inflation leading to higher-for-longer inflation expectations may result in a further increase in bond yields and correction in markets. We expect inflation in India to trend down sharply in the second half of FY23 on high base effects but note upside risks to inflation from higher-than-expected domestic food prices and global fuel prices,” said a report from Kotak Securities.

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The surge in rates indicates that the worst of the rate moves have already been considered in by markets. This also suggests that rates might rise to 6% or higher in the medium term. With current repo rates at 4.90%, this suggests that further rate rises of more than 100 basis points have been baked into bond yields.

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The increase shows that the cost of funds in the financial sector, as well as interest rates, is growing. A segment of the market also relates the rise in yields to the RBI’s intention to abandon its accommodative stance and hike interest rates in the months ahead.

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As a result of the increase, the government will have to pay a higher yield (or return to investors), raising borrowing costs. This will put increasing pressure on the banking system’s overall interest rates. Furthermore, if the RBI chooses to normalise monetary policy and interfere less in the market, interest rates are going to rise.

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The jump in yields indicates that investors are anticipating higher interest rates and are dumping their bonds, as higher rates would cause existing bond prices to fall (and therefore bear the loss on sale before maturity).

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Debt investors will be affected because, as yields rise and bond prices fall, the net asset values of debt funds, which hold a significant amount of government securities in their portfolios, would fall as well. It will also have an influence on corporate bonds, which are more expensive than government bonds.

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Higher bond rates are typically disappointing news for stock investors since they boost the cost of capital for businesses and begin to affect their profitability. As a result, funds migrate away from stocks and towards less volatile debt instruments.

Traditionally bond yields have had an inverse relationship with stocks since a rise in bond yields implies an increase in the risk premium on equity.