Bond market holds edge over equities

Written by Devangi Gandhi | Mumbai | Updated: Nov 22 2013, 08:43am hrs
Even as Indian equities trade near historical valuations, its the bond market that continues to attract investor interest. Compared with bond yields, equities still appear less attractive or overvalued. The scenario is not likely to change in the near term , given that a meaningful recovery in the earnings of Indian companies may take time and higher interest rates may persist till inflation eases.

Based on expected one-year forward earnings of Sensex companies , the earnings yield calculated by dividing the earnings per share by the indexs current value stands at 6.7%. This is at a steep discount to the 10-year bond yield, which is at 9.08%. At the current levels, while the bond yields are at a 15% premium to their long-term averages, the earnings yield has been trading a tad above its average value of 6.7% of the last six years.

Generally, the asset allocation between equity and bond is based on how earnings yield compare to the benchmark bond yield. In 2003-2005 and late 2008, a higher earnings yield was followed by a rally in equities. Interestingly, for the most part of last three years, bond yields have maintained an edge over the earnings yield.

However, experts also point out that the correlation between the bond and equity markets of India differs substantially from their global peers where the 30-year bull run in the bond market is expected to end, leading to a substantial inflows into equities.

Debt market is driven by institutional participation unlike equities where retail investors are seen giving higher allocations, said a fixed income fund manager.

Indeed, this classification may well explain the consistent selling of equities by domestic institutional investors (DIIs) that includes mutual funds and domestic financial institutions. Since 2012, DIIs have sold more than $22 billion or R1.2 lakh crore worth of Indian shares.In the first 10 months of 2013, while equity mutual funds saw an outflow of R8,579 crore, income and money market funds saw R1.14 lakh crore of net inflows.

According to Andrew Holland, CEO- Ambit Investment Advisors, in such a scenario of higher interest rates, equities find it difficult to beat the returns given by fixed income products.

It is not surprising then that DIIs may have chosen to exit equities in favour of debt market, especially given the concerns around global and domestic events like US tapering of easy liquidity and Indias general elections. These events have a bearing on investment and earnings cycle of Indian companies, added Holland.

Following Q2 results, market experts have turned hopeful on the downgrade cycle coming to an end, they are still wary of a substantial recovery in earnings of India Inc.