In the current global equity turmoil, one particular aspect that’s a common theme in all financial chatter is the US 10-year treasury yield. The yields on US 10-year treasury are going through the roof, which in turn are putting downward pressure on the US equity markets. Through this write-up, an attempt is being made to educate an average investor about the relationship of bond yields and equity market returns and how this whole concept is important when evaluating asset classes.
Why is the ten-year US treasury yield so important?
The importance of the ten-year treasury bond yield goes beyond just understanding the return on investment for the security. The ten-year is used as a proxy for many other important financial matters, such as mortgage rates, student loans, investments of Sovereign wealth funds into the US. When investor confidence in the US is higher, they opt for more risky assets and hence the price of US bonds drops lower, pushing the yields up. But when confidence is low, the price goes up as there is more demand for this safe investment and yields fall. US 10-year treasuries are considered safe havens for investments as they are highly liquid and backed by the US government. Therefore, in times of geo-political crisis the yields tend to be lower as there is a higher demand and hence higher prices for the 10-year debt.
What are Bonds?
Bonds are debt instruments, i.e. fixed-income securities issued by any corporation or government for a specified time period with a variable or fixed interest rate, i.e. coupon rate over the bond period. Bond yield is the amount of return an investor realizes on a bond. Buying bonds means you are lending money to bond issuers. In return, bond issuers agree to pay bond holders interest on bonds throughout their lifetime and to repay the face value of bonds upon maturity. Yield is the money that investors earn by investing in bonds. Investors do not have to hold bonds to maturity, instead, they may sell them for a higher or lower price to other investors, and if an investor makes money on the sale of a bond, that is also part of its yield.
As bond is traded in secondary markets just as equities both bond prices and yields vary as per the market trends. Another important aspect to remember is that bond prices and bond yields have an inverse relationship. As bond prices go up, the yields come down and vice versa. This happens because yields are calculated as interest paid in a year divided by the bond price and since the interest paid is a fixed quantity which depends on the coupon rate and the face value, therefore to maintain the same interest payment the bond prices have to go down if yield or in other words interest rates go up. This relationship also applies when the yields go down and bond prices go up.
What determines Bond yields?
Generally, bond yields are linked to the prevalent economic conditions. In deflationary environments, bond yields tend to be lower as more investors opt for investing in safer investment horizons. On the other hand, during economic boom, bond yields tend to be higher as inflationary pressure leads to Central Bank raising interest rates and thus yields go up. Stocks and bonds have an inverse relationship as when stock markets are up the bond markets are lower and vice versa. This behavior prominently depicts investor appetite for risk reward. For example, when the stock market is going up, there is a lot more interest in the stock market due to possibility of higher returns. Hence bond prices are lower.
At certain times both stocks and bonds can go up in value at the same time. This happens when there is too much money, or liquidity, chasing too few investments. It happens at the top of a market. It could also be the case when some investors are optimistic about the economy’s future, and buy stocks. At the same time, others are pessimistic and buy bonds instead. There are also times when stock and bonds both fall. That’s when investors are in a panic and are selling everything. During those times, you might see gold prices go up.
Impact of bond yields on equity markets
Stock market performance is impacted by bond yields in different ways at different times and investors and traders need to be aware of economic and market conditions to understand the constantly evolving relationship between bond yields and the stock market.
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 and as bond yields go up, equity markets tend to underperform. 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.
The above chart depicts the relationship between the Benchmark 10-Year GOI bond yield and the Benchmark Nifty50. Looking at the past 5 years since late 2012, the benchmark 10-year yields are down by almost (- 17 %) and have been moving consistently downtrend, 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.
Bond yields are the key to calculating opportunity cost of equities
Since bonds are considered safe investments, their yields serve as a minimum threshold for investment returns. Investment in equities is always risky and, therefore, there is a risk premium attached to equity investments. 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%. 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 impact the cost of capital in valuing equities
Bond yields reflect the current interest rate regime. In periods of higher yield, the cost of capital for companies’ increases which leads to lower valuations for the companies as their future cash flows get discounted at higher rates. 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 foreign fund inflows
In a globalized world investors are always looking for attractive yields across asset classes. Therefore, when bond yields in India seem to be more attractive than yields in other countries, there could be a lot of FII inflow into Indian bonds. If bond yields are attractive, there can be foreign outflow from Indian equities and inflows into Indian debt. In the last few months, we have seen outflows from FlIs in equities, but debt has continued to attract interest due to attractive yields. Foreign institutional investors look at Indian equity and debt as competing asset classes and allocate according to relative yields.
(By Rahul Agarwal, Director, EZ Wealth)