Explained: How rising bond yields impact stock markets

Mini

In theory, a rising bond yield should be negative for equity prices. Because as we saw earlier, higher yields would make equity investments unattractive.

Explained: How rising bond yields impact stock markets
Bond yields on 10-year government securities (G-Sec) have risen to 6.198 on Tuesday from the lows of 5.966 in May 2021. The yield of 10-year G-Sec is considered a benchmark and it reflects the overall interest rate scenario. From January 2021, the yields are up 6 percent.
How will this impact the markets? Let's try and decipher that and to do so, as Julie Andrews crooned in the Sound of Music, let's start at the very beginning.
What are bonds?
A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental), according to Investopedia.
In the case of companies, just like they share their equities with investors via stocks, they share the debt with investors via bonds. So bonds are units of debt issued by the companies and traded like stocks.
A company issues bonds to raise money and they pay regular fixed interest to the bondholder. This interest rate is called the coupon rate. It is declared on the face value of the bond and remains fixed until maturity.
However, since bonds are tradeable, they also give returns. These returns are called bond yields.
What are bond yields?
Bond yields are returns you get when you buy a bond from the secondary market. For example, if you buy a 10-year bond worth Rs 10,000 with a coupon rate of 5 percent, you will get an interest of Rs 500 per year. But if while trading, the bond price falls to Rs 6,000, your yield will become 8.33 percent.
Bond yields and prices move in opposite fashion -- when bond prices rise, yields fall, and vice versa.
But when the returns are higher, you would want to drop equities and flock to bonds, right? But when do the returns become higher?
Why do yields rise?
Recently, yields are rising because of the hopes of economic recovery on the back of healthy vaccination numbers. While hopes of economic recovery rise, inflation is rising too. And rising inflation pushes bond prices lower, thereby pushing yields higher. When that happens, equity markets react.
How do rising bond yields affect stocks?
In theory, a rising bond yield should be negative for equity prices because higher yields would make equity investments unattractive (more on this later). In other words, higher bond yields will make investing in bonds more attractive as compared to equities.
But and there is a very big but. Investors don't just look at the rising yields alone. They also look at the reason pushing the yields higher. And more often than not, there are two reasons: growth and inflation.
Bond yields reflect the growth and inflation of an economy. When the growth is strong, yields would rise. It shows the economy is recovering or improving.
But again, yields also rise, when inflation rises.
Both these events impact equities differently:
Due to growth: When growth is strong, cash flows and future earnings estimates improve. These improvements offset the negative impact of the rise in the discount factor that higher yields cause (more on this later). So the overall impact of equities is positive.
Due to inflation: But when yields rise and the growth is not strong enough, there is no factor to offset the impact of the high discount factor. This impacts the equity prices negatively.
How do higher yields affect the discount factor (and thus equity market)?
Let's backtrack a little to answer this question.
Every company in the equity market has a valuation. Valuations help us determine the fair stock price of that firm. And there are a lot of methods to do that. One of the common methods is discounted cash flow (DCF method).
The formula for calculating valuations via the DCF method uses the cost of capital in the denominator. The cost of capital is a weighted average of the cost of equity and the cost of debt.
(The weighted average is arrived at by multiplying various components by a factor of their importance.)
The cost of debt in this formula is filled in by the government's 10-year bond yield. So if yields rise, the cost of capital would rise, which would decrease the returns. And make equities unattractive.
What do rising bond yields mean?
Bond yields are one of the metrics available for economists to judge the health of an economy, among others.
When investors sell bonds, prices drop, and their yields rise. A higher yield spells greater risk. If the yield of 10-year bonds is higher than what it was when it was issued, then there would be a possibility that the government is financially stressed and may not be able to repay the capital.  That said, g-secs are relatively stable.