Why are bond yields rising, what it means for borrowers and investors?

Government bond yields have risen sharply across major economies, raising concerns for governments, borrowers, investors and financial markets. The US 10-year Treasury yield has crossed 5.25%, its highest level since 2004, while Japan's government bond yield has crossed 3.06% and Germany's 10-year Bund is around 3.56%. India's benchmark 10-year government bond yield has crossed 7.2%, a two-year high.

The rise in yields across major economies raises questions about what is driving the increase, how it is affecting India and what it means for governments, borrowers and investors.

Stock markets turn volatile as oil prices, rising bond yields weigh on sentiments

What is a bond yield?

A bond yield is the return an investor earns from a bond based on the price they pay for it. Bond prices and yields move in opposite directions. When bond prices fall, yields rise; when bond prices rise, yields fall.

A bond generally pays a fixed amount of interest, known as the coupon. If the market price of the bond falls, the investor is paying less for the same fixed interest payment. That means the return on the money invested is higher, so the yield rises.

Conversely, if the market price of the bond rises, the investor is paying more for the same fixed interest payment. That means the return on the money invested is lower, so the yield falls.

Why are government bond yields rising globally?

Several factors are pushing yields higher. The most immediate concern is renewed inflationary pressure because of higher energy and commodity prices. Geopolitical tensions are adding to uncertainty, while governments are borrowing heavily to finance fiscal deficits, infrastructure and other spending.

At the same time, monetary policy remains relatively tight, with markets expecting interest rates to stay higher for longer.

The AI-driven data-centre boom is another factor affecting global capital and dollar flows, although experts differ on how directly it affects bond yields.

How important is inflation in the current rise?

Inflation is one of the main drivers of rising bond yields. Recent increases in energy and commodity prices have raised concerns that inflation could remain high. Inflation in the US crossed 3.4% last month, while India's price index is nearing 5%.

Higher inflation matters for bond markets because investors want higher yields when they expect rising prices to reduce the purchasing power of the interest they will receive from their bonds.

How are oil prices affecting bond yields?

The Iran war and the resulting disruption to oil supplies have pushed crude oil prices sharply higher. Crude had crossed $127 a barrel and was trading at around $107 at the time of the report.

Higher oil prices affect more than just the energy market. They can increase transportation and production costs and push up the prices of other commodities and fertilisers. This can add to food inflation and broader inflation.

This raises concerns that central banks may have to keep interest rates higher for longer. Higher interest rates, in turn, put upward pressure on bond yields.

Are central banks expected to keep rates high?

Most central banks have raised interest rates, and markets increasingly expect rates to stay higher for longer. The US has raised rates, while the Bank of Japan, the Bank of England, and the European Central Bank have also raised rates in recent weeks.

In India, market participants expect the RBI to raise the repo rate on October 7, followed by one or two more rate increases by December or February.

When policy rates rise, yields on new bonds generally rise as well. Existing bonds with lower interest payments then become less attractive to investors. As a result, their prices fall and their yields rise.

Is rising government debt another major reason?

Yes. It is one of the biggest concerns for bond markets. The US government debt is about $40.11 trillion, Japan's is $8.6 trillion, Germany's is $3.34 trillion and India's is $2.55 trillion. Total government debt worldwide has reached around $365 trillion, equal to 311% of global GDP of $126.3 trillion.

When governments spend more than they earn and run large fiscal deficits, they need to borrow money by issuing more bonds. When more bonds are available, there needs to be enough demand from investors to buy them. If investor demand does not keep up with the supply of bonds, governments may have to offer higher yields to attract investors.

Abhishek Bisen, head of fixed income at Kotak Mahindra AMC, said rising government debt, driven by large fiscal deficits, higher defence and infrastructure spending, and growing refinancing needs, is forcing governments to issue more bonds. This means governments and companies are competing for the same pool of global savings.

Is the AI boom pushing bond yields higher?

The AI boom is affecting global financial markets, but experts do not consider it the main reason why bond yields are rising.

Madan Sabnavis, chief economist at Bank of Baroda, said the main reason is the recent US Federal Reserve rate increase and its indication that more rate hikes could follow. He said rising government debt is the main reason for higher yields. He added that demand from data centres is one part of rising imports but does not directly affect interest rates.

Bisen also said that the bigger reason for higher bond yields is rising government debt. However, he said the AI-led data-centre boom is mainly responsible for the dollar shortage.

The rapid expansion of data centres is using large amounts of capital and increasing demand for dollars. More than $800 billion has been invested in US data centres.

Why does the AI boom create dollar scarcity?

The huge amount of money needed to build data centres, semiconductor infrastructure and other AI-related facilities is creating strong demand for investment and dollars.

Soumyajit Niyogi, a director at India Ratings, said the AI and data-centre boom is reducing the supply of available dollars. However, the dollar's strength is not driven only by data centres.

He said the wider growth from next-generation technologies is also improving productivity and helping the US economy perform better than other economies.

This creates an additional challenge for emerging markets because global investors now have more opportunities to invest their money in the US and other developed economies.

What is happening to Indian bond yields?

Indian bond yields have risen along with global bond yields. The benchmark 10-year government bond yield has risen above 7.15%, up from around 6.85% in late August. It has crossed 7.2%, its highest level in two years. The rise is partly due to expectations of higher inflation and interest rates.

Niyogi said Indian markets are increasingly expecting inflation to remain higher. The government’s heavy borrowing in the second half of the year, including state development loan issuances, along with recent sales through open market operations, has added to the upward pressure on bond yields.

Why have Indian yields risen less than US yields?

Indian bonds still get support from domestic institutional investors, which has kept the rise in yields lower than in the US. At the same time, the market has already factored in about 100 basis points of interest rate hikes over the next 12 months.

US yields have risen faster than Indian yields, narrowing the difference between the India and US 10-year bond yields to less than 200 basis points. This makes Indian bonds relatively less attractive to foreign investors.

What does the rise in yields mean for the government?

Higher bond yields make it more expensive for governments to borrow money.

When market yields rise, governments have to offer higher interest payments, or coupons, to attract investors. This increases interest payments and can put more pressure on government finances.

Sabnavis said the rise in yields effectively forces governments to pay higher coupons to investors, which increases the cost of government borrowing.

Will higher bond yields make home loans more expensive?

Not necessarily immediately. Sabnavis said that a rise in government bond yields does not directly make retail loans more expensive because retail loan rates depend on the rates banks charge their customers. These bank lending rates had not changed at the time of the report.

However, changes in bond yields can now affect borrowing costs for households and businesses more quickly than before.

Niyogi said more retail and SME loans are now linked to external benchmarks, which are rates outside the banks' control. At the same time, NBFCs are providing a growing share of loans. This means that if market interest rates rise, the cost of loans for households and businesses can eventually rise as well.

What about corporate borrowers?

Companies are likely to feel the impact more directly because their borrowing costs are linked to government bond yields. When government bond yields rise, companies usually pay more interest when they borrow because lending to a company is considered riskier than lending to the government.

Sabnavis said rising government bond yields increase borrowing costs for companies when their loans or bonds are linked to government securities.

Are domestic yields close to their peak?

Some experts believe Indian bond yields may be closer to their peak than to the start of another sharp rise.

Niyogi said Indian bond yields have already moved well above the repo rate (the interest rate at which the RBI lends money to banks), and markets are expecting the final policy rate to be around 6%.

Unless inflation or global bond yields rise much more than expected, he expects Indian bond yields to rise only a little further, by around 20-40 basis points.

What is the outlook for global bond yields?

The near-term outlook is that bond yields are likely to remain high and may remain volatile.

Bisen said high inflation caused by energy prices, heavy government borrowing and growing government budget deficits is likely to keep bond yields high. The US 10-year Treasury yield has crossed 5.25%, while the 30-year yield has reached its highest level since 2004. German and Japanese bond yields have also risen sharply.

Bond yields may not fall for a long time as long as inflation, geopolitical tensions, heavy government borrowing and high interest rates remain concerns.

However, bond yields could fall if economic growth slows and geopolitical tensions ease significantly.

What should borrowers and investors watch?

For borrowers, the main factors are inflation, RBI policy, benchmark bond yields and how quickly changes in market rates affect the interest rates charged by banks and NBFCs.

For investors, the direction of inflation and interest rates matters because it determines whether bond yields rise or fall. If inflation keeps falling and economic growth slows, bond prices could eventually rise and bond yields could fall.

For now, however, high energy prices, geopolitical tensions, heavy government borrowing and higher interest rates mean that bond yields are likely to continue moving up and down sharply in global fixed-income markets.