Sharp rise in bond yields in US, domestic market takes shine off equities

A sharp rise in bond yields in the United States and the domestic market in the past one year is reducing the attractiveness of equity over fixed-income assets such as bonds. This shows in the declining spread between the Sensex earnings yield and that on the US 10-year government bond.

The spread has declined to a three-year low of 108 basis points against 149 basis points in April 2021 and a post-pandemic high of 468 basis points in April 2020. The current spread is less than half the 15-year average spread of 239 basis points. One basis point is one-hundredth of 1 per cent (see the adjoining chart).

The trend is similar for domestic investors. The earnings yield is lower than the 10-year government of India bond by 330 basis points, the lowest since July 2019. Historically, the Sensex earnings yield has been 265 basis points lower than treasury yields on average since 2007.

“A rise in bond yields or the risk-free rate has made the Indian market expensive for foreign investors and this has led to outflows by foreign portfolio investors,” said Dhananjay Sinha, managing director and chief strategist, JM Finance Institutional Equity.

The yield on the 10-year US government bond shot up to a 41-month high of 2.83 per cent on Thursday from a record low of 0.53 per cent in July 2020. In comparison, the Sensex earnings yield was 3.91 per cent on Wednesday, down from a high of 5.3 per cent in April 2020. 

The earnings yield on stocks or a portfolio of stocks such as an index is calculated by dividing the latest trailing 12-month (TTM) net profit by the current market cap, or earnings per share (on a TTM basis) by the latest share price. It indicates the dividend yield for an equity investor if the stock in the portfolio distributes its entire annual profits as dividend to shareholders.

Typically, companies in India distribute 30-50 per cent of their annual profits as dividend. Typically, earnings yields are significantly higher than bond yields to compensate investors for the additional risk involved in holding equity over government bonds, which are risk-free.

Analysts say a tightening of the spread between earnings yields and bond yields means that equity investors have a lower incentive to hold equity over fixed-income assets.  
 

It also means bond yields are rising faster than corporate earnings or earnings yields. For example, treasury yields in the US are up 125 basis points since May 2021 while they have increased 120 basis points in India in the period. For comparison, the Sensex’ earnings yield is up 72 bps in the period.

The decline in spreads has been accompanied by a sell-off in equities by foreign portfolio investors (FPIs). FPIs have been net sellers in six of the last seven months (the current month excepted). They sold nearly 18.3 billion worth of equities in the secondary market since October last year.

However, FPIs have been net buyers of $1.07 billion during April 2022 so far. Sinha expects a further rise in bond yields in the US and India as the Federal Reserve and the Reserve Bank of India tighten their monetary policies.

“Treasury yields in the US can easily climb to 3.25 per cent in coming months while they can climb to 7.75 per cent in India,” he added.

This could trigger more sell-offs in equities unless higher bond yields are more than matched by a rise in corporate earnings.

Most brokerages expect a 20-25 per cent rise in the combined earnings of the Sensex companies in FY23 but forward earnings face downside risks from higher inflation, moderation in economic growth, and a sharp slowdown in government spending in FY23.