How stock markets are affected by bond yields?

Introduction 

On February 25th 2022, when Russia attacked Ukraine, the 10-year T-bill yield in the US jumped to a 1 year high at 1.6%. 

The Sensex plummeted 2702 points on the same day, and Nifty closed at 16247.  

On 14th and 15th Feb 2022, the Indian stock markets saw a massive sell-off.  

Experts believed that the sudden sell-off in the stock market was due to several factors. There was an increased geopolitical tension between Russia and Ukraine, US interest rates were set to rise soon, and the US bond yields were above 2%.  

Since the start of the war, the bond yields have been continuously increasing, and as of March 25th 2022, the 10-year Indian government bond yield was 6.811%. The stock markets were also highly volatile during the same period.  

What are bond yields? 

The bond’s yield is the total return that an investor will receive from an investment in a bond. The yield is usually expressed as an annual percentage, and it is calculated by dividing the bond’s annual interest payment by its market price. 

Bond yields rise and fall due to many factors. One of the critical factors that impact bond yields is monetary policy. Economic forces such as inflation, economic output, and unemployment also play a significant role. 

How do bond yields affect stock markets? 

The bond yields affect the stock market in many ways; let us understand how. 

The opportunity cost of an investment is the return that an investor would have received if they had invested in another asset or investment. Opportunity cost is a valuable metric for evaluating the attractiveness of an investment.  

When bond yields go up, it can have a negative effect on the funds going into equity markets. To invest in equities, investors would want to receive a higher equity premium for the risk they are taking. If they are not receiving that extra return, they will take out their money from stock markets, making it less attractive and buy bonds instead. 

Conversely, if bond yields go down, equity markets may seem more attractive than the bond market.  

In the cost of capital calculation, the bond yields are typically used as the risk-free rate.  

Thus, when yields are higher, the cost of capital will increase, which means the discounting rate used to calculate future cash flows will be higher. This will cause the stock’s valuation to decrease, making the stock market unattractive and bond investment more valuable.  

In contrast, if yields are lower, the cost of capital will decrease, increasing the stock’s valuation and making the stock market attractive.   

It has been generally observed that when bond yields rise in India, foreign investors find the Indian debt market more attractive than global debt, so they will sell other assets, such as equities and invest in debt.  

On the contrary, when bond yields fall, foreign investors find the stock market more attractive than the debt market; thus, they pull out their money from the debt market and invest in the stock market.  

Bond yields and financial costs are positively related, which might impact companies in the stock market.  

When bond yields go up, companies will have to pay a higher interest rate on the money they borrow. When companies’ debt servicing costs increase, so does the risk of bankruptcy and default. Often highly leveraged companies and small-cap companies are more vulnerable in this scenario. 

Conversely, if bond yields fall, the financing cost decreases, making these companies attractive.   

Conclusion 

The bond market is an integral part of the financial market, and it is imperative for investors to understand the relationship between bond yields and equities. 

Further, the yield on bonds is a good gauge of how much confidence investors have in the economy. When the yield on long-term government bonds is low, investors are willing to lend money to the government at a low-interest rate and vice versa.  

Thus, it is essential to understand why bond yields are so important and how they can affect the economy and our investment decisions to make better decisions. 

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