It is quite interesting that the bond yields are an important determinant of equity valuations. While there are exceptions, the equity markets have normally moved negatively with bond yields. That means as bond yields go down, the equity markets tend to outperform by a bigger margin and as bond yields go up equity markets tend to falter. This relationship may not exactly hold in the very short run. But if you consider it over a period of 5-10 years, this relationship will be clearly visible. Look at the chart below..
The above chart captures the relationship between the Benchmark 10-Year GOI bond yield and the Nifty. If you look at the past 5 years since late 2012, 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. Actually, there are 5 factors that need to be understood..
Bond yields are the key to calculating opportunity cost of equities
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.
Bond yields are normally compared with 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.
Bond yields impact the cost of capital in valuing equities
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 impact colour of Foreign Institutional 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.
Bond yields impact financial costs..
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.
Bond yields have been typically used by analysts and investor as an important lead indicator to gauge the direction of equities. More often than not, it works to a T!
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