Bond yields and stock market

Traders have two broad categories available to invest their money in – equity and debt. The two asset classes are always in competition to attract the maximum amount of funds. But how does one affect the other? The expectation of changes in returns and the level of risk in these asset classes affect the relationship between the two.

In the long term, there is a negative relationship between the yield rates and the equity market returns. This means that as bond yields go down, equity markets move up and vice versa, which is evident below where a 5 year comparison of NIFTY and 10 year Indian Government securities represent a negative relationship between the two.


Bond yields and stock market

Source: Bloomberg

Are bonds safe or risky??

While bonds are considered safer investments because they have low risk and provide periodic returns, equities are risky but may provide higher returns. Naturally investors demand a risk premium as an incentive to invest in equities. If bonds provide a yield of 5%, equity should provide more than that to appear attractive for investment.



What do the yields represent in the long and short term?

A way of looking at the level of bonds yields is by looking at the stage of business cycle the economy is in which can be predicted by the relationship between long term bond rates and short term bond rates. When the long term yields are higher than the short term yield which is generally the case during normal business conditions, depicting a normal yield curve, it depicts that the investors want higher returns for locking up the funds for a long period of time. But when the short term yields are higher than long term yields, what results is an inverted yield curve and signals an incoming of recessionary situation in an economy as investors start demanding higher returns in the short term.

When to invest in the bond markets?

When the economy is expanding, signaling increased output, growth in revenue figures for the companies, investors head towards the equity markets. But when the economy is contracting and companies slow down the production, equities prove risky to invest in and it is better to go for bond markets. The bond yields at this time shoot up as investors demand for bonds and debt becomes expensive. This was witnessed in the financial crisis of 2008 when the US 30 year treasury yields went as up as 4.8% and remained above 4% for the next couple of years.

What do interest rates signify?

Another way is to look at the interest rates in the country. When interest rates are low in an economy, making it cheaper to borrow money for borrowers, it leads to increased expenditure and corporate activity, leading money flow away from bond market due to reduced yields and towards the equity market. This is because as the cost of capital becomes low for the companies because of the future cash flows being discounted at a lower rate, it leads to higher valuations for the corporate, making them more attractive for investment purposes.

Therefore, the prevailing market conditions and the relationship between the bond yields and the stock markets, determine the returns from the two markets.



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