The past few months have been volatile for the Equity Market on account of the rising US Government 10-Year Bond. The US G-Sec 10-year bond yield has significantly risen from its level of 0.66% on 29th March 2020 to 1.7% in March 2021. Not only US bonds, but increasing bond yield across the globe like Indian 10-year sovereign bonds has caused panic in the equity markets. So to know more about this we will be reading about some basics of bonds, bond yields, and how does it affect the stock market in this blog. Lets Start!
Introduction: Bond & Bond Yields?
- A Bond is a fixed instrument where one gives a loan to the corporation or government.
- In return, the individual or institution gets an interest that remains constant over the total tenure of the loan.
- And, in the end, the individual receives the principal amount back, if there is no default by the borrower.
- Normally, Yield refers to the measurement of return an investor can generate if he/she buys any asset at the current price
- So, Bond Yield can be simply defined as the return which an investor gets on the bonds.
- Bond’s value adjusts over the period owing to the prevailing interest rates in the economy which is regulated by the Central Authority of the country.
- Bonds involve the term “Coupon Rates” which is the pre-decided interest rate of the bonds.
- Bond Yield can be derived by dividing the coupon rate of the bond by the Market Price of the Bond.
- For Ex. if the price of the bond is Rs. 100 and the coupon rate of the bond is 5%, then Bond Yield will be 5% (5/100).
How do Bond Yields increase or decreases?
a) Interest Rates and Bond Prices:
- To better understand the changes in bond yields, we will take a simple example of the activity of RBI.
- Assume that RBI determines the interest rates high, then bond prices will be low as the coupon rates are not much attractive for the investors.
- While, if interest rates are decreased by the RBI, then in this case Bond price will increase because now it will lucrative option for investors with a better risk-free return.
b) Role of Inflation:
- Inflation rates also play a crucial role in changes in Bond yield rates.
- If a high inflation rate persists in the economy, investors look for safe parking of their funds and therefore proceed with investing in Bonds.
- Opposite to this, a low inflation rate in the economy leads to the flow of funds in the equity market as the bond market becomes less appealing.
How does the Bond affect the equity market?
- In the above paragraphs, we came to know thorough the meaning of bond. Now we will look at the points as to how these bond yields affect the equity market.
- Simply, Bond Yields act as an opportunity cost of investing inequities.
- An investor will only invest in the equity market, only when it is delivering more returns than the bond yields. The returns generated above the bond yields in the equity market can be termes as risk-premium
- Contrary to the above-mentioned points, when bond yields rise, the equity market becomes less attractive for investments.
- Along with that, the role of inflation in the economy works differently in the cases of equities or bonds. Bond Yields may rise in case of high inflation rates while in these inflationary conditions, the equity market becomes flat.
Bond Yields are the important parameter to ascertain the direction of the stock market. In this scenario, Morgan Stanley suggests 2 cases for investors. In the first case, portfolios should be positioned in domestic cyclical, rate-sensitive, and mid and small caps, when growth accelerates. On the other hand, Investors should bet on technology, healthcare, and consumer staples when inflation makes a rapid return.