Updated: Nov 19, 2019
It is quite interesting that the US bond yields are an important determinant of Indian equity valuations. 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 by a bigger margin and as bond yields go up equity markets tend to falter. The rise in the 10-year bond yield in the US may continue to impact emerging markets, including India. Emerging markets (EMs) have an inverse relationship with bond yields in the US - when bond yields advance, Emerging Markets decline and vice-versa.
The above chart captures the relationship between the Benchmark 10-Year GOI bond yield and the Nifty. If you look at the past 5 years since late 2012, the benchmark 10-year yields are down by almost (- 17 %) and have been moving consistently downward, 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. This relationship may not exactly held in the very short run. But if you consider it over a period of 5-10 years, this relationship will be clearly visible.
What are US Treasury Bond Yields?
When the US government needs to raise capital to source projects, such as building new infrastructure, it issues debt instruments through the US Treasury. The types of debt instruments that the government issues include Treasury bills (T-bills), Treasury notes (T-notes), and Treasury bonds (T-bonds), which come in different maturities up to 30 years. The T-bills are short-term bonds that mature within a year, the T-notes have maturity dates of 10 years or less, and the T-bonds are long-term bonds that offer maturities of 20 and 30 years. the Treasury yield is the interest rate that the U.S. government pays to borrow money for different lengths of time
How it affects the Indian Stock Market:
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 delivering 7% returns 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 of 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 most important reason that explains the negative relationship between bond yields and equity markets.
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.
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 and vice versa.
So, Bond yields have been typically used by analysts and investors as an important lead indicator to gauge the direction of equities.
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