Market rally fails to dent bonds’ charm

Apr 23 2014, 03:31 IST
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SummaryEarnings yields maintain discount to bond yields despite upswing in equities

Although the Indian benchmark indices are trading at record high, the bond market still appears attractive, given that the Sensex earnings yield continues to maintain a significant discount to benchmark bond yields.

Market experts, however, believe that an imminent improvement in the earnings cycle on the back of a macro recovery, which can intensify in case a BJP-led government comes to power, could change this equation. Even a likely turnaround in the inflation trajectory in next 1-2 years may narrow the yield gaps.

Based on the expected earnings of the Sensex companies for 2014-15, the earnings yield — calculated by dividing the earnings per share by the index's current value — at 6.9% maintains a discount to 10-year bond yields which is close to 8.85%. At current levels, while the bond yields are at a 15% premium to their long-term averages, the earnings' yield is trading a tad above its average value of 6.4% of last six years. Bloomberg consensus estimates peg the one-year forward Sensex EPS at R1,573.

According to Andrew Holland, Ambit Investment Advisors CEO, sustained downgrades to earnings expectations also added to the yield divergence between equities and bond markets in last two years.

“While the Street is expecting FY15 earnings to grow anywhere between 12% and 15%, this outlook could rapidly change once the signs of economic recovery get reinforced,” added Holland.

In a recent research note, JPMorgan said that while the equity markets are driven by expectations of a revival in growth after the general election, the bond markets remain concerned about inflation and the sustainability of the recent correction in the fiscal deficit. The brokerage sees a mean ‘reversion’ between the benchmark yields in favour of bonds.

“In the past, restrictive monetary policy and elevated treasury yields have coincided with growth moderation and have not been supportive of equity market performance,” it said in a strategy report recently.

Traditionally, the asset allocation between the equity and the bond markets has been based on the earnings' yields competing against that of the benchmark bonds. In early 2003-2005 and late 2008, a higher earning yield s were followed by a strong rally in equities. Interestingly, for most part of the last three years, bond yields maintained an edge over the earning yields.

“At the macro level, a moderation in interest rates tends to bring down the bond yields. And historically, a significant correction in bond yields

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