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Why rising bond yields may not impact equities this time around..

stock market
06 Feb 20206 mins readBy MOFSL

One of the key trends that we have seen in the last few months is the rapidly rising yields on 10-year government bonds. If you look at the chart below, you will see the sharp rise in bond yields in the last 1 year.

 

 

So why are bond yield rising in India and is there an effect of rising bond yields on stocks? Above all, what is the relationship between bond yields and stock prices. Let us first focus on this relationship.

 

Why bond yields are rising?

While the benchmark yields in India did cross the 8% mark briefly during the month, it has settled around the 7.8% mark. However, these bond yields are largely dependent on the inflation outlook and the RBI’s approach to rates. In its July credit policy, the RBI has raised rates by 25 basis points and a hawkish stance from the RBI may be instrumental in spiking the bond yields further. In the last 1 year, the bond yields have gone up on the back of rising inflation. Higher inflation is likely to put pressure on rates and that is reflected in the bond yields. Bond yields are also rising because of the global pressure. US Fed has been hiking rates consistently and the US 10-year bond yields are hovering around the 3% mark. To maintain the spread between the US bonds and Indian debt, increase in local bond yields has to follow logically.

 

Why do bond yields impact equities?

Bond yields impact equity valuations in 3 ways. Firstly, when the bond yields go up the cost of capital goes and that means future cash follows are discounted at a higher rate. This puts pressure on valuations. Secondly, rising bond yields also means that the yield on debt becomes more attracting compared to the earnings yield of debt. Currently, the market P/E ratio is around 24X and that means an earnings yield of around 4.2%. A rise in bond yields will increase the yield to a more attractive level compared to equities. Lastly, rise in bond yields also means that companies have to borrow at higher rates. That trend is already evident as even blue chip companies have seen their costs going up by more than 100 basis points in the last 1 year. All these factors tend to weigh on equity valuations.

 

This time around the impact may not be meaningful
It is said that one of the dangerous arguments in the capital markets is “This time it is different”. However, the situation this time around may actually be different. The rise in bond yields may not really have a negative impact on equities. Here is why..

Bond Yields are being driven higher by inflation. Higher inflation tends to be positive for most commodities as they benefit from higher prices. Since the commodity driven companies still have a significant weight in the markets, equities may actually provide you the perfect hedge against inflation. Hence rising rates may not be a real issue for equities.

Bond yields may be higher but there is growth supporting equities. Normally, bond yields tend to be higher than equity yields. This is because equity also participates in growth while bonds don’t. Today the market is also factoring in a turnaround in the earnings cycle, which is just about evident. Hence lower equity yields may be justified.

Equities are emerging as a defensive asset class. That may sound quite paradoxical but the kinds of retail inflows that equities are seeing; that appears to be the case. For example, equity SIPs are getting inflows of more than $1 billion each month. For most investors, equities have emerged as an asset class that can create wealth over the long run. To that extent it has become long term defensive.

India has a cushion of falling yields post demonetization. This is something a lot of analysts are forgetting. When the demonetization was announced in November 2016 most banks were flush with liquidity. Hence they were forced to cut lending rates leading to a sharp fall in bond  yields. The rise in bond yields that we are seeing today is just a reversal of the earlier fall in bond yields post demonetization. The cushion is still there.

The moral of the story is that while bond yields may still be headed beyond the 8% mark, the equity markets need not overly worry about it. This time it may actually be different!
 

 

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Disclaimer: The stocks, companies, or financial instruments mentioned in this blog are for informational purposes only and should not be considered as investment recommendations. It is advised to consult with your financial advisor before making any investment decisions. Investment in securities markets are subject to market risks, read all the related documents carefully before investing. Investors are strongly encouraged to carefully read the risk disclosure documents prior to participating in market-related investments or trading activities. Due to the volatile nature of financial markets, no guarantees can be made regarding investment returns. Motilal Oswal Financial Services Ltd. does not offer any assured returns on market-linked securities. Please note that past performance of stocks or indices is not indicative of future results.
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