A spike in bond yields globally has created havoc in the equity markets with the Indian frontline indices down 3 percent in intra-day deals. The US Treasury yields jumped to their highest level in the last one year to 1.6 percent.
The rise in yields was on the back of expectations of a strong economic expansion and related inflation. On a YTD basis, the yields are up 16 percent in 2021.
Back home, the 10-year government bond yield also rose to 6.18 percent.
So what's the relation between bond yields and equity markets?
Theoretically, a higher bond yield is bad for equities and vice versa. However, global brokerage Morgan Stanley pointed out that one must also remember why the bond yields are changing and not just the direction of change.
“Long bond yields reflect the growth and inflation mix in the economy. If growth is strong, bond yields are usually rising. They also rise when inflation is going higher. The impact of these two situations is different for equities,” explained the brokerage in a report.
In the case of strong growth, the impact of higher growth offsets the negative impact of the rise (in bond yields) and causes equity share prices to trade higher. Put another way, the confidence in the future is high, and equities are rewarded with higher multiples, observed MS.
The opposite is the case when bond yields are rising despite sluggish growth— i.e., because of inflation worries. In this scenario, the equity markets decline on the underlying concerns.
It further stated if growth accelerates in the coming months faster than the rise in bond yields, share prices should be fine.
"Equities/bond valuations are at the top end of their 2010-21 ranges – a
period during which India went through its deepest and longest earnings recession. If growth accelerates from here as we expect, it is likely that equities break this range on the upside, consistent with the fundamental relationship," believes the brokerage.
Going ahead, the brokerage sees the growth cycle is turning and a rise in bond yields is consistent with rising share prices. The risks to equities are that bonds offer better value than equities at current levels and/or inflation surges, it added.
So what should investors do when the yields are rising?
Under the first scenario where growth accelerates, portfolios should be positioned in domestic cyclicals, rate-sensitives, and mid-and small-caps, advises MS. It is overweight on consumer discretionary, industrials and financials.
Under the second scenario, where inflation makes a rapid return,a more defensive approach with technology, healthcare, and consumer staples could offer better return outcomes, it suggested.
(Edited by : Ajay Vaishnav)