RBI’s Rate Decision Due Tomorrow: How Are Bond Prices Affected If There Is A Rate Cut

The Reserve Bank of India’s (RBI’s) Monetary Policy Committee (MPC) will announce its decision on interest rates on December 5. Many market participants are expecting a rate cut by the panel despite growth showing resilience, as inflation has moderated to record lows, opening space for a rate cut.

Experts say that without a definitive trade deal with the US, growth outlook in India is expected to dwindle, which the RBI could jump on and go for the fourth rate cut of this year, and reduce the benchmark repo rate to 5.25 per cent. However, some remain cautious. The pressure on rupee as its breaches record lows against the dollar could deter the panel to decide on a rate cut, they said

Bond traders have taken bets of a rate cut in some shorter tenure bonds, leading to rise in prices for some. Here’s how rate cut impacts bond prices.

How Rate Cuts Impact Bonds?

When there is a rate cut, overnight borrowing costs fall, which leads to a shift in the yield curve to lower rates across the market. Bond yields are inversely proportional to bond prices. This means when bond yields fall, its prices rise. There is also a flush of money in the system due to lower borrowing costs, which typically leads to a higher demand for all assets, including bonds.

Newly-issued bonds will offer lower interest rates due to the rate cut. This means bonds existing in the market and offering higher yields will see more demand from investors, thus increasing their market prices.

In this sense, shorter tenure bonds are more sensitive to rate cuts, meaning yields will fall immediately as the rate cut happens. For longer tenure bonds though, prices could fluctuate more as comparatively, a 1 basis point (bps) fall in a longer tenure bond leads to higher price appreciation than a similar fall in shorter tenure bonds.

For existing investors who already hold bonds, a rate cut would lead to capital gains since the value of the bond existing in their portfolio will rise. This is typically the reason traders and investors buy bonds if they expect a rate cut, in order to increase their gains.