Impact of Bond Yields on Equity Markets

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 is going through the roof which in turn is putting downward pressure on US Equity markets. An average investor needs to know the relationship of Bond Yields and Equity market returns and how this whole concept is important when evaluating asset classes.  

Why is the 10-year US treasury yield so important?

The importance of the 10-year Treasury bond yield goes beyond just understanding the return on investment for the security. The 10-year is used as a proxy for many other important financial matters, such as mortgage rates, student loans, investments of Sovereign wealth funds into 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 realises 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 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 behaviour 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.  

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 under perform. 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.  

Bond yields impact foreign fund inflows

In a globalised world investors are always looking for attractive yields across asset classes therefore when Bond yields in India seem to be more attractive then 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. FIIs look at Indian equity and debt as competing asset classes and allocate according to relative yields.

(The writer is  Director at EZ Wealth)