Long-term bond yield and its effect on your equity and debt investments

A spike in bond yield can shake the stock exchange. Find out why, and what an investor needs to know about it.

Long-term bond yield and its effect on your equity and debt investments

If we take a look at the India 10-Year Bond Yield in the last two years, it stood at close to 7.5% in April 2019, and has been below 7% in 21 out of these 24 months. However, since a low of around 5.8% in October last year, it has shown signs of recovery. The influential US bond yield too has been rising since the second half of last year. It is influential enough to impact your debt and equity investments too!

Understanding bond yields

Government bonds are debt securities issued by the government to finance their expenses. Known as Treasuries in the US, G-Secs in India, and Gilts in the UK, government bonds are issued at a fixed price that is returned at the end of the tenure. For instance, if the India 10-Year bond is offered at Rs 100, you will receive the Rs 100 in the 10th year. Additionally, each year you will receive the bond yield which is around 6.1% per annum in March 2021. 

As the annual yield increases, more and more people get interested to invest in these government bonds. However, as more investors turn their attention to bonds, the demand for bonds increases and that raises its price. In the above example, if the price of the bond increases to Rs 102 due to increased demand, the net yield on it would decrease as the yield is fixed at 6.1%. 

However, if investors find a more profitable alternative to bonds, they will avoid bonds leading to a fall in their demand. This consequently increases the net yield. In recent times, the resurgence of the economy, the rollout of the COVID-19 vaccine and the government stimulus packages had reduced the demand for government bonds. This, too, has led to a spike in government bond yields.

Related: What are tax-free bonds and how they work

Significance of US bond yields

US bonds are a popular choice among investors across the world. Therefore, the impact of changes in its yield is felt globally. It is the safest investment known to investors, and if its yield is rising, investors around the world withdraw money from their existing investments and buy US bonds. In India, it will see a wane in investments as withdrawals will increase. 

Indian G-Secs respond to a hike in US bond yields, increasing in demand for the domestic bonds as well. Either way, it affects private investments, as we will find out. 

Effects on equity markets

Bond yields are an important benchmark for investors in assessing their equity risk and rate of return. A high bond yield is bad for the equity market as an investor stands to earn more with less risk through bonds. Some of the bond yield-related factors that decide its effects on the equity market are listed below:

  • Risk premium: With government yields at around 6% at the moment, let us assume that the equity risk premium is 4%. Together this amounts to 10%, which is the opportunity cost of an equity investment. An investor would claim there is no merit in an equity investment below 10% because of the risk premium involved. Investors often use equity risk premium as a deciding factor while investing in equities.
     
  • Earning yield comparison: The earnings yield of a stock or its earning per share (EPS) is compared to the bond yield in the bond vs equity investment decision. Foreign investors in India pull out of the equity market as yield increases, so this outflow is also closely watched during bond yield spikes. But investors also look at the P/E ratio of the stock. So, in a high bond yield scenario, investors may still look to invest in stocks if their P/E ratio is low. Their decision would be similar in the case of a loss-making company that is expected to make a turnaround in stock prices.
     
  • Cost of capital: Increased bond yield increases the cost of capital for companies. This affects their future cash flows, which can compress future stock valuations. However, an interest rate cut by the apex bank lowers the cost of capital and restores the stock valuation.


Related: 8 Key differences between bonds and debentures

Effects on debt markets

In recent years, the demand for Indian debt has increased as bond yields have risen. With recent bond yield hikes, investors (including foreign ones) have withdrawn from equity investments and invested heavily in Indian debts. Foreign investors look at Indian equities and debts as competing products and create an inverse relationship between the two. 

A fall in the interest rates reduces the demand for debt investments, as the return is lower. If the bond yield at that point is healthier, investors rush towards bonds, thereby raising its demand. This raises the bond price and reduces its yield. This demand-and-supply tussle works its way towards a new equilibrium between debts and bonds. 

Also, the government borrowing costs, i.e. bond yields, are a benchmark for debt pricing in the economy. So changes in bond yields influence the loan market subsequently. 

Related: Payday loans: The next big thing in India’s consumer debt market?

Last words

Investors need to keep an eye on global as well as domestic developments while making an investment decision. Interest rates and inflation influence bond yields, but they, in turn, are affected by the interest rate, government’s borrowing programme, the fiscal deficit, inflation and the state of the economy, sovereign rating, geopolitical factors, and so on.

Under the Biden administration, the US bond yield is expected to rise further, which can have a negative impact on equities and other asset classes. As an investor, you have to look at the various factors that dictate the bond price and yield, and observe its effects on your investments closely. If you are still puzzled about debt funds? Here are answers to six common questions.




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