InvestorQ : Why do bond yields actually impact the equity markets and what is the linkage between them?
shrinidhi Rajan made post

Why do bond yields actually impact the equity markets and what is the linkage between them?

Riya Dwivedi answered.
4 years ago

If you look at the period of 5 years between the end of 2012 and the end of 2017, you will find that the benchmark 10-year yields are down by almost (- 17%) and have been moving consistently downward, despite occasional hiccups. At the same time, the Nifty is up by nearly 82%. The graph indicates that the negative relationship has only gotten more pronounced in the last few years. The question is what exactly explains this relationship between bond yields and equity valuations.

Let us look at some key reasons why this happens.

Actually, bond yields go into determining the cost of equity

Bond yields, in a way, represent the opportunity cost of investing in equities. For example, if the 10 year bond is yielding 7% per annum then the equity markets will be attractive only if it can earn well above 7%. In fact, equity being risky there will have to be a risk premium, first of all, to be even comparable. Let us assume that the risk premium on equities is 5%. Therefore that 12% will literally act as the opportunity cost for equity. Below 12%, it does not make sense for the investor to take the risk of investing in equities as even the additional risk is not being compensated. The question of wealth creation only begins after that. As bond yields go up the opportunity cost of investing in equities goes up and therefore equities become less attractive. That is the first reason that explains the negative relationship between bond yields and equity markets.

Investors take a call by comparing the bond yields with the earnings yield

Bond yields are normally compared to the earnings yield. The earnings yield is nothing but the EPS / price of the stock. It essentially tells you what the share is actually earning assuming that you enter at the current price. A stock is attractive only if the earnings yield is higher than the bond yield. Otherwise, why should one take the risk of taking in equities? However, this argument is not always applicable. It is not applicable in cases where the company is loss making and the investors are buying stocks on expectations of a turnaround in the stock performance. There is another way to look at this. Earnings yield is the reverse of the P/E ratio which is a valuation matrix. That means if the bond yields go up then equity investors expect to be able to buy the stock at lower P/E ratios.

Cost of capital in valuations is a function of cost of capital, which is equity and debt

This is a very important relationship and causal effect. The yield on bonds is normally used as the risk-free rate when calculating cost of capital. When bond yields go up then the cost of capital goes up. That means that future cash flows get discounted at a higher rate. This compresses the valuations of these stocks. That is one of the reasons that whenever the interest rates are cut by the RBI, it is positive for stocks. Normally stocks tend to get re-rated as they will now be valued based on a lower cost of capital discounting factor.

Bond yields can also be used as a surrogate for foreign portfolio flows

This is a very interesting relationship we have seen in recent years. When the bond yields in India go up, global investors find Indian debt more attractive in relation to global debt. This leads to capital outflows from equities and inflows into debt. In the last few months, we have seen outflows from FIIs in equities, but debt has continued to attract interest due to attractive yields. Of course, the domestic funds have been large scale buyers in equity and they have supported markets but that is a different issue altogether. The crux is that FPIs look at Indian equity and debt as competing asset classes and allocate according to relative yields.

Finally, don’t forget that bond yields determine the cost of borrowing for corporates

Bond yields are very important fundamental factor that sets the relationship between bond yields and equities. When bond yields go up, it is a signal that corporates will have to pay a higher interest cost on debt. As debt servicing cost goes higher, the risk of bankruptcy and default also increases and this typically makes mid-cap and highly leveraged companies vulnerable.

If you are wondering why are bond yields typically used by analysts and investor as an important lead indicator to gauge the direction of equities, this is the reason. Lower yields make equity attractive in multiple ways.