Explained: How bond yields impact stock market & what should investors do?

A rally in the stock market tends to raise bond yields as money moves from the relative safer investment bet to riskier equity stock markets

A gradual rise in bond yields globally has created a panic in the equity markets. Indian frontline benchmarks - the S&P BSE Sensex and the Nifty 50 - lost nearly 2 per cent in intra-day trade.

At the global level, US Treasury yields vaulted to their highest since the pandemic began on expectations of a strong economic expansion and related inflation. Back home, the 10-year government bond yield jumped to 6.18 per cent on Thursday, February 25.

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The benchmark bond (10-year tenor) yields had fallen to 5.6 per cent during the peak of the pandemic crisis but have since been rising and jumped 31 bps since the Budget. Year to date, the yields have crept up 16 bps in 2021 so far.

Acuit Ratings now expects the 10-year sovereign yields to rise from 6 per cent in March 2021 to 6.40 per cent by March 2022 given that the Reserve Bank of India may hike repo rate by 25 bps going forward given the likely rate and liquidity normalisation expected next fiscal. READ MORE

But why does a rise in bond yield dent stock markets? Let’s understand.

What is bond and bond yield?

Simply put, bonds are loans the one makes to a corporation or government. The interest payments remain largely unchanged over the life of the loan. Moreover, one receives the principal at the end of the loan tenure if the borrower doesn't default.

Bond yield, on the other hand, is the return that an investor gets on that bond or on a particular government security.

Bond yield and bond prices

A fall/rise in interest rates in an economy pushes up/pulls down bond prices. However, bond yields fall/rise in this situation.

This happens because if RBI, for example, decides to increase interest rates, the bond's price (which is offering similar return as the current interest rates) would fall because its coupon payment is less attractive now on a relative basis. Therefore, investors would chase new bonds with better risk-free return.

Inflation expectation and bond yields

A rally in the stock market tends to raise yields as money moves from the relative safer investment bet to riskier equities. However, if the inflationary pressures begin to look up, investors tend to move back to bond markets and dump equities.

How bonds affect stock markets?

When valuing equities, investors add the equity risk premium they seek to a risk-free rate to compute the expected rate of return. Usually the easiest way to estimate the risk-free rate is to default it to the long government bond yield. This is why long bond yields matter to equities.

Now, theoretically, given that the long bond yield is the risk-free rate, a higher bond yield is bad for equities and vice versa. But one must also remember why bond yields are changing and not just the direction of change.

“Long bond yields reflect the growth and inflation mix in the economy. If growth is strong, bond yields are usually rising. They also rise when inflation is going higher. The impact of these two situations is different for equities,” explains Ridham Desai, equity strategist at Morgan Stanley, in a co-authored note with Sheela Rathi and Nayant Parekh.

When growth is strong, the impact of higher growth in terms of cash flows or, more precisely, dividends more than offsets the negative impact of the rise in yields, causing equity share prices to trade higher.

“The gap between real GDP growth and the 10-year bond yield correlates well with share prices, underpinning the point made above. Indeed, to the extent that growth accelerates in the coming months faster than the rise in bond yields, share prices should be fine,” says Desai, adding that Indian equities/bond valuations are at the top end of their 2010-21 ranges.

“If growth accelerates from here, as we expect, it is likely that equities break this range on the upside, consistent with the fundamental relationship,” he believes.

How should investors trade?

Morgan Stanley suggests two scenarios for investors. Under the first scenario, where growth accelerates, portfolios should be positioned in domestic cyclicals, rate-sensitives, and mid- and smallcaps.

Under the second scenario, where inflation makes a rapid return, the brokerage advises investors to bet on technology, healthcare, and consumer staples.