Path ahead for Bond Investors

US Federal Reserve finally cut down interest rates on 18th September after much dilly dallying. It surprised the markets by going for a bigger than expected interest rate cut of 50 basis points. One basis point is 0.01%. The expectation was that it will cut interest rate by 25 basis points only. Chinese central bank also followed suit. It cut down its benchmark interest rate to 1.5% from 1.7%. Reserve Bank of India is expected to start cutting down interest rates soon.

One impact of cutting down of interest rates for bond investors is that yields on bonds may go down. This means that bond prices tend to increase when interest rate cuts are expected or happen. There is an inverse relationship between bond prices and yields on bonds. When yields go up bond prices go down. When yields go down bond prices go up. Yield is calculated by dividing the coupon rate on the bond by its prevailing market price.

So whenever RBI announces an interest rate cut bond prices are likely to go up. And yields will go down. Yields on Indian 10-year government bonds were hovering around 7% by the end of May 2024. European Central Bank then cut down its benchmark interest rate in the first week of June. This increased expectations that other central banks will soon follow suit. This resulted in a decline in the yields on these bonds. As on 27th September 2024, the yield on these bonds is hovering around 6.8%.

Any interest rate cut by RBI will therefore reduce yields and increase prices of Indian bonds. The past two years of high interest rates have benefitted bond investors. But now things are taking turn. Lower interest rates tend to be more favorable for equities than bonds. The required rate of return of investors on stocks goes down because of lower interest rates. This in turn pushes up prices of stocks. So interest rate cuts tend to trigger an increase in stock prices.

US Federal Reserve is expected to go for two more interest rate cuts before the end of this year. When these cuts happen they will impact the yields on Indian bonds too. Yields on these bonds may then fall with their prices going up.

The path ahead for investors may be less favorable than it was in the past two years. Bond yields and bond prices also get impacted by factors other than interest rate cuts. So the relationship between interest rate cuts and bond yields & prices may not hold always.