Introduction

Stock market is the place where you can trade in stocks. Apart from shares, various other securities, including commodities and debt instruments such as bonds, are also traded on the stock market. A variety of factors influence the stock market's performance. One such factor that is commonly overlooked is bond yield. Bond yield and the stock market are related and usually move in opposite directions. The effect of this relationship can be viewed on an international level, too. You need to understand how bond yield and the stock market are related and their implications on your trade.

Are you wondering what all this means? Then, keep reading!

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Understanding Bond and Bond Yields

A bond is a debt security issued by different private and government entities to raise capital. The bond issuer can be a corporation or the government, and the bond signifies that a loan has been issued. Usually, bonds are issued to fulfill capital requirements such as managing debt or funding future projects. Bondholders are entitled to receive interest on the amount in the form of coupons while the principal amount is returned on the bond's expiration or maturity.

As an investor, you earn returns via bonds known as the bond yield. The bond yield is usually expressed as a percentage of the price value of the bond. The bond price and yield are inversely related. This means that if the bond price decreases, then the bond yield increases. Likewise, the bond yield reduces when the bond prices increase. Credit risk, inflation, and interest rates are common factors influencing bond yield. When the interest rates increase, the bond yield also increases and in turn, this results in a decline in the demand for bonds with a lower yield already existing in the market.

Impact of Bond Yields on the Stock Market

Though you may not pay attention to it, the relationship between bond yield and the stock market's performance cannot be overlooked. Bond yields and the stock market are inversely related. After all, both these instruments vie for funds from investors. Here is how this relationship works.

Whenever there is an increase in bond yields, you will look forward to investing in them due to the high returns offered. This means if you were investing in stocks, you will move to bonds, a debt-market instrument. This can result in a reduction in the stock market's momentum. However, when the bond yields reduce, you as an investor will be interested in other ways to increase your earnings and will likely turn to the stock market. In turn, this makes for a positive news for the stock market.

Apart from this, the interest rates and performance of global bond markets also influence how bond yields influence the stock market. Here is how bond yields affect the dynamics of the stock market.

• Opportunity Cost

Opportunity cost is the cost of choosing one option over the other due to the limited availability of resources and numerous choices. When bond yields increase to a level higher than returns on stocks, you as an investor will naturally be drawn to them. In turn, this increases the opportunity cost of choosing stocks, making them less attractive. When an investment is more appealing than another, you will be drawn to the appealing one. By investing in the non-appealing one, you are essentially losing a chance to earn better returns.

• Cost of Capital

The cost of borrowing and higher bond yields are directly proportional. When the cost of borrowing increases, a company's profitability decreases, which in turn reduces stock prices. On the other hand, when bond yields reduce, the cost of capital reduces, propelling stock valuation and business growth.

• Relation to Foreign Funds

You can seek the debt market when the bond yields increase. If the Indian bond market offers better yields than the global market, global investors will be attracted. In turn, this increases the liquidity in the Indian stock market. However, when the global market offers better yields than the Indian one, outflow from the Indian market increases, reducing market liquidity, both these instances influence the stock prices and market sentiment.

Conclusion

There is a direct relationship between bond yields and stock market performance. An increase in bond yields negatively affects the stock market's performance but increases returns in the fixed-income segment. On the other hand, reduced bond yields signal a growth in the stock market. When you understand this relationship, optimising your investment strategies and increasing profitability becomes easier.

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